Lump sum disability payments taxable, Supreme Court rules: Woman sued after insurer cut off periodic benefits

National Post

2005-03-07


Canada's highest court has ruled that lump sum disability payments are fully
taxable. The split 4-3 decision, released by the Supreme Court on February 25,
comes as blow to thousands of disabled Canadians who could now face tax on lump
sum disability settlements they receive.

Vasiliki Tsiaprailis, a Windsor, Ont., resident, was injured in a car
accident in November, 1984, which left her permanently disabled. Under the terms
of her employment, Ms. Tsiaprailis was entitled to long term disability benefits
under a disability insurance policy.

Since the insurance premiums under the policy were paid solely by her
employer and were not included in her employment income as a taxable benefit,
any subsequent claims for periodic disability payments would be fully taxable
under the Income Tax Act.

Under the terms of her disability policy, she was to receive benefits equal
to two-thirds of her monthly earnings, less any Canada Pension Plan benefits.
These benefits were to be payable monthly until either her 65th birthday or
until she ceased to become totally disabled.

In July, 1993, after receiving long-term disability benefits for eight years,
the insurance company stopped paying her, claiming that she no longer qualified
to receive benefits under the policy and that Ms. Tsiaprailis' condition arose
from "pain magnification and overreaction, and not from any injury or illness"
and that she was "not totally disabled."

Ms. Tsiaprailis sued the insurer and in October, 1996, after much negotiation
between her lawyer and the insurance company, they 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: Mrs. Tsiaprailis'
entitlement to past benefits plus interest, 75% of the present value of her
entitlement to future benefits under the policy and about $6,500 for costs, GST
and disbursements.

Much to Mrs. Tsiaprailis' chagrin, the insurance company also issued a T4A
tax slip reporting the full $105,000 to her as a taxable disability benefit. The
question the Supreme Court had to address was whether the $105,000 lump sum
settlement was taxable in the year of receipt as "periodic payments ... under a
disability plan."

Mrs. Tsiaprailis claimed that the settlement should not be included in her
income since it was a tax-free award for damages resulting from her permanent
disability and was not a periodic disability payment under her disability
policy.

The majority opinion in the top court disagreed and held that the portion of
the lump sum settlement that the insurance company paid to compensate Ms.
Tsiaprailis for past disability benefits was indeed "payable on a periodic basis
... pursuant to a disability insurance plan" and was therefore taxable.

The dissenting minority felt that the lump sum payment was the result of a
settlement agreement and therefore not made "pursuant to a disability insurance
plan" and thus, not taxable as a disability payment under the Act.

The Supreme Court said that to determine taxability, we need to answer two
questions. Firstly, what was the settlement payment intended to replace and
secondly, would the replaced amount have been taxable to Ms. Tsiaprailis. The
Supreme Court concluded saying: "In this case, the evidence is clear and cogent:
part of the settlement monies was intended to replace past disability payments
and such payments, had they been paid to [Tsiaprailis], would have been
taxable."

This is a most unfortunate decision for Ms. Tsiaprailis and others who now
face tax on lump-sum disability settlements, but the 4-3 split decision of our
highest court indicates that even the Justices who heard the case could not all
agree on the correct tax treatment of such settlements.