The tax treatment of disability payments
by Jamie Golombek
In May 2005's column, we reviewed the Supreme Court of Canada's (SCC) March decision in Tsiaprailis [2005 SCC 8], which dealt with the taxation of a lump-sum settlement under a disability insurance policy.
The SCC's decision
Readers will recall the case involving Vasiliki Tsiaprailis, a Windsor, Ont. resident, who was injured in a car accident in November 1984 that left her permanently disabled. Since the insurance premiums under the policy were paid solely by her employer and not reported as a taxable benefit, her periodic DI payments were fully taxable.
In July 1993, after receiving DI benefits for eight years, the insurance company stopped paying her, claiming that she no longer qualified to receive benefits under the policy. Ms. Tsiaprailis sued the insurer and in October 1996, after much negotiation, reached a compromise and settled for a lump sum payment of $105,000 in lieu of continued benefits under the disability policy. The $105,000 was broken down into three components: Ms. Tsiaprailis' entitlement to past benefits plus interest; 75 per cent of the present value of her entitlement to future benefits under the policy; and about $6,500 for costs, GST and disbursements.
The majority (4-3) opinion in the SCC concluded that the portion of the lump sum settlement paid to compensate Ms. Tsiaprailis for past disability benefits was indeed taxable. With respect to the portion of the settlement paid to settle future liability, however, the SCC concluded that " ... The part of the settlement for future benefits is in the nature of a capital payment and is not taxable".
The CRA technical interpretation
On April 21, 2005, the Canada Revenue Agency (CRA) issued a confusing technical interpretation (2005-0121521E5) that seems to contradict the SCC's comments in Tsiaprailis concerning the taxation of the portion of a DI settlement relating to future benefits.
Specifically, the CRA was asked to determine, in light of Tsiaprailis, the taxable status of a lump-sum payment made by a liquidator of a company to its retired employees in settlement of their lost future long-term disability benefits. The CRA responded that "a lump-sum payment in respect of future benefits under an employer long-term disability plan constitutes proceeds of disposition of a capital property that must be used to calculate the recipient's taxable capital gain resulting from the disposition".
Many practitioners simply assumed that, based on Tsiaprailis, the portion of the payment for future benefits was tax-free. CRA seems to have interpreted the Court's use of "capital" as meaning "capital gain", suggesting that while it may not be taxable as employment income, any such payment would still constitute "proceeds of disposition" resulting from "the disposition of a right". This would suggest that, in fact, capital gains treatment may apply (assuming the adjusted cost base of that right was zero).
Legal fees paid to pursue a DI settlement
On a more positive note, a recent Tax Court of Canada decision (Farrell v The Queen 2005 TCC 352) ruled that legal fees paid to pursue a disability settlement are tax deductible.
Mary Farrell was an employee with the Worker's Compensation Board (WCB) in Prince Edward Island when she became medically disabled and unable to work. Her employment benefit package at the WCB included a disability plan that would compensate her for lost wages should she become disabled.
Ms. Farrell testified in court that she had a lot of trouble trying to get the insurer to pay her disability claim and was forced to declare bankruptcy. Ultimately, she hired two separate lawyers to pursue her disability claim until eventually a settlement was reached with the insurance company and she received a lump-sum settlement amount. She paid over $23,000 in legal fees to pursue her claim and proceeded to deduct those on her 2002 tax return.
Under the Income Tax Act, an individual can deduct legal fees paid "to collect or establish a right to salary or wages owed to the taxpayer by the employer or former employer of the taxpayer". "Salary or wages" includes disability payments made to compensate someone for lost salary or wages.
The CRA did not dispute that the legal fees paid by Ms. Farrell were "incurred to collect a replacement for lost salary or wages". Rather, it took issue with the fact that the legal action was between Ms. Farrell and the insurance company and not between Ms. Farrell and her employer, the WCB.
The question the court had to answer, therefore, was whether the insurance company was paying Ms. Farrell directly or simply paying her "on behalf of the employer". The judge reasoned that since the WCB, as part of its benefits package, entered into an agreement with an insurance company to pay disability benefits to its employees in case of disability, the fact that the payments were actually made by the insurance company was irrelevant.
The judge concluded that the legal fees were properly tax deductible on the basis that the contract with the insurer to pay Ms. Farrell disability benefits was pursuant to her employment contract with the WCB. Since the insurer was paying her on behalf of the WCB, "the amounts were therefore owed by the employer".
"This decision may be less relevant in light of a technical amendment to the Income Tax Act announced in February 2004 (but still in draft form), which would specifically permit a deduction for legal expenses incurred by a taxpayer to collect, or establish a right to collect, an amount that, if received, would be included in computing the taxpayer's employment income, regardless of who actually made the payment. This amendment would be effective for payments made in 2001 and subsequent years."