2015-0580521E5 Settlement amount for disability benefits

Principal Issues: Whether a lump-sum payment received in lieu of past and future disability payments is taxable under the Act?

Position: It is a question of fact, in this case most likely yes.

Reasons: See response.

Author: Underhill, Cynthia
Section: 5(1), 6(1)(a), 6(1)(f), 56(1)(a)(ii), 110.2(1), 110.2(2), 248(1)

XXXXXXXXXX                                            2015-058052
                                                                    C. Underhill

August 11, 2015

Dear XXXXXXXXXX:

Re:  Settlement amount for past and future disability benefits

We are writing in response to your letter dated February 9, 2015, which was received by the Income Tax Rulings Directorate on April 9, 2015, concerning the tax consequences under the Income Tax Act (Act) of a settlement amount in lieu of past and future disability benefits.

In the situation described, your employee sustained an injury on XXXXXXXXXX, that prevented him or her from working. XXXXXXXXXX (your insurer) denied the employee disability benefits under your employer-funded group disability plan. In the absence of coverage under your group plan, you paid disability benefits to the employee, without prejudice, from XXXXXXXXXX until XXXXXXXXXX. The employee’s employment was terminated effective XXXXXXXXXX. Under a settlement agreement reached in XXXXXXXXXX, you agreed to pay a lump-sum amount of $XXXXXXXXXX to the employee in satisfaction of past and future disability benefits (“Payment”). You provided the following breakdown of the Payment:

*     $XXXXXXXXXX for past disability benefits (XXXXXXXXXX and XXXXXXXXXX taxation years); and,
*     $XXXXXXXXXX for future disability benefits.

You and counsel for the former employee agree that the portion of the Payment for past disability benefits is taxable and considered a “qualifying amount” as that term is defined in section 110.2 of the Act. However, counsel for the former employee has referred to the decisions in Tsiaprailis v. Canada, 2005 DTC 5119 (SCC) and Kopet v. Simon Fraser University, 2013 BCCA 143, to support the position that the portion of the Payment for future disability benefits is not taxable under the Act.

Our Comments

This technical interpretation provides general comments about the provisions of the Act and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R6, Advance Income Tax Rulings and Technical Interpretations.

Generally, an amount received pursuant to a settlement agreement (“settlement amount”) to avoid or terminate litigation is accorded similar income tax treatment as an amount received pursuant to a judicial ruling. In determining the proper tax treatment of a settlement amount, the Canadian courts have relied on the common law concept referred to as the “surrogatum principle.” This principle essentially determines the tax consequences of a settlement amount based on the nature and purpose of the settlement. In other words, the tax treatment of a settlement amount should be the same as the amount it is intended to replace.

A settlement amount received in lieu of past and future disability benefits may be employment income, a retiring allowance, non-taxable, or a combination thereof. The tax treatment of the amount will depend on whether the plan or arrangement is a group disability insurance plan as described in paragraph 6(1)(f) of the Act (“IP”). Such a determination is a question of fact, which requires a review of all relevant facts and documentation (e.g., collective agreement, employment contract, settlement agreement) of each particular case.

Is the employer’s arrangement an IP?

An employer’s arrangement will be considered an IP if:

*     the employer makes contributions;
*     the arrangement covers two or more employees; and
*     the arrangement contains an undertaking by one person to indemnify another person, for an agreed consideration, from a loss or liability in respect of an event, the happening of which is uncertain.

It is not necessary that there be a contract of insurance with an insurance company, however, the arrangement must be based on insurance principles. That is, funds must be accumulated, normally in the hands of trustees or in a trust account, and calculated to be sufficient to meet anticipated claims. If the arrangement merely consists of an unfunded contingency reserve on the part of the employer, the arrangement would not be an IP. Whether a particular employer’s arrangement is considered an IP, requires a finding of fact that can only be made on a case by case basis.

Generally, where an individual receives a lump-sum settlement amount for future benefits that would have been otherwise paid under an employer’s group disability plan or arrangement as described in paragraph 6(1)(f) of the Act (i.e., the plan or arrangement is an IP), the lump-sum amount is not taxable under paragraph 6(1)(f) of the Act or any other provision of the Act. However, a lump-sum amount received for past benefits, which were made pursuant to an IP, would be included in the recipient’s employment income in the year it is received under paragraph 6(1)(f) of the Act even though it was paid as a lump-sum. These positions are consistent with the decision in Tsiaprailis. It should be noted that the plan in Tsiaprailis was an IP. The decision in Tsiaprailis, however, does not apply to a settlement amount received in lieu of past or future benefits in respect of a plan or an arrangement that is not an IP. Instead, the settlement amount is included in the individual’s employment income under subsection 5(1) or paragraph 6(1)(a) of the Act.

Where a plan is administered by an insurance corporation using an administration services only (“ASO”) contract, the contract is not generally considered to be an insurance policy, since the contract with the insurance corporation does not typically contemplate a transfer of any risk to the insurance corporation. However, such a plan may constitute an IP, where the above-noted conditions are satisfied.

In Kopet, the employer’s group disability plan was administered by an arm’s length plan administrator under an ASO contract. The court concluded that the employer’s group disability plan was an IP because the plan was based on insurance principles (i.e., it was an IP). Therefore, the settlement amount in lieu of future benefits under that plan was not taxable under the Act.

In the situation described, you paid the disability benefits because your employee was denied benefits by your insurer. It does not appear that you intended to provide disability benefits under a separate self-funded employer arrangement whenever your employees were denied coverage by your insurer. Although it is a question of fact whether an employer’s plan or arrangement is an IP, your arrangement does not appear to be based on insurance principles, and would not likely be an IP. Thus, the Payment would likely be included in the former employee’s income under subsection 5(1) or 6(1) of the Act.

Retiring allowance

Subparagraph 56(1)(a)(ii) of the Act requires a taxpayer to include in computing income for a taxation year, the amount of a retiring allowance received by the taxpayer in the year. The definition of “retiring allowance” in subsection 248(1) of the Act includes an amount received “in respect of a loss of an office or employment of a taxpayer, whether or not received as, on account or in lieu of payment of, damages or pursuant to an order or judgment of a competent tribunal.” In this context, the words “in respect of” have been held by the Canadian courts to imply a connection between the loss of employment and the subsequent receipt, where the primary purpose of the receipt was compensation for the loss of employment. Thus, a settlement amount received in connection with a loss of employment may fall within the definition of a retiring allowance.

The Canadian courts have set out two questions to determine whether a connection exists for purposes of a retiring allowance:

1.    But for the loss of employment would the amount have been received? and,
2.    Was the purpose of the payment to compensate a loss of employment?

Only if the answer to the first question is no and the answer to the second question is yes, will the amount received be considered a retiring allowance.

Qualifying retroactive lump-sum payment

Subsection 110.2(2) of the Act provides a deduction from taxable income for an individual who receives a lump-sum payment if certain conditions are met and the payment is considered a “qualifying amount” as defined in subsection 110.2(1) of the Act. An amount is generally considered to be a “qualifying amount”, where the amount:

*     is a lump-sum amount paid to an individual (which does not include any interest component);
*     is included in the individual’s employment income or is damages received in respect of a loss of employment;
*     is received under a settlement agreement; and
*     relates to prior years and is greater than $3,000.

It appears that the portion of the Payment for past disability benefits would be a “qualifying amount” under subsection 110.2(1) of the Act where the amount is included in the former employee’s employment income under subsection 5(1) or 6(1) of the Act.

Summary

The treatment of a settlement amount for income tax purposes is generally based on the nature and purpose of the amount, which is a question of fact. In most cases, the parties to the settlement agreement are in the best position to make this determination.

Based on the limited facts provided, it appears that the Payment was received in connection with a loss of employment, therefore it would likely be a retiring allowance and included in the former employee’s income under paragraph 56(1)(a)(ii) of the Act. Since the Payment is not for damages in respect of the loss of employment, no part of the Payment would be a “qualifying amount” as described in subsection 110.2(1) of the Act.

However, where it can be demonstrated that the Payment is not a retiring allowance (i.e., the Payment is unrelated to the loss of employment), the Payment would be included in the former employee’s income under subsection 5(1) or paragraph 6(1)(a) of the Act as income from an office or employment. The portion of the Payment for past disability benefits would then likely be a “qualifying amount” as described in subsection 110.2(1) of the Act.

We trust these comments will be of assistance.

Yours truly,

Nerill Thomas-Wilkinson, CPA, CA
Manager

Business and Employment Income Section
Business and Employment Division
Income Tax Rulings Directorate

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