Supreme Court Rules on Disability Insurance

FORUM Magazine


Decision could affect future DI settlements
by Jamie Golombek

Advisors who are life-licensed and who sell disability insurance are, no doubt, intimately familiar with the taxation of disability insurance (DI) payments. In short, the general rule is that if an employee pays.

The premiums under the DI policy and the employee should become disabled, any periodic disability payments received from the insurer will be tax-free.

On the other hand, if the employer pays the premiums under the DI policy, without reporting them as a taxable employment benefit, any subsequent claim by the employee under the DI policy will be fully taxable. Both this approach and the "employee pay all" situation described above are quite common, whereas funding shared between employers and employees is less so. In this case, all benefits are taxable, but an employee's total contributions to the plan can be deducted against that income on a "non-taxable first dollar" basis.

In February, the Supreme Court of Canada (SCC) released its decision in the Tsiaprailis [2005 SCC 8] case, which dealt with the taxation of a lump-sum settlement under a DI policy. As will be seen, the 4-3 split decision of the SCC may have a major impact on DI settlements going forward.

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 DI policy equal to two-thirds of her monthly earnings, less any Canada Pension Plan benefits. 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 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, she 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 insurance company issued a T4A tax slip to Ms. Tsiaprailis, reporting the full $105,000 to her as a taxable disability benefit. The question the courts 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".

Ms. 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 Tax Court heard the case in 2001 and concluded that "the lump-sum payment arrived at after a lawsuit was commenced and negotiated as a compromise cannot on any basis of statutory interpretation be described as an "amount ... payable to the taxpayer on a periodic basis.'"

In other words, since a crucial condition under the Tax Act was not satisfied (i.e., the "periodic" basis of payment), the amount was simply not taxable. The CRA appealed the decision to the Federal Court of Appeal (FCA), which specifically looked at whether the portion of the payment relating to Ms. Tsiaprailis' entitlement to past (as opposed to future) disability benefits was taxable. The Appeal Court focused its analysis on the phrase "payable on a periodic basis" and, in particular, on the word "payable".

The FCA felt that as long as the disability policy provided that the payments were payable on a periodic basis, the periodic requirement in the Tax Act was met. In other words, just because the payments were made late, as a result of the legal action taken by Ms. Tsiaprailis, and were received as one lump sum, does not mean the payments change in nature from being periodic.

The majority, therefore, concluded that the portion of the $105,000 payment meant to compensate Ms. Tsiaprailis for the accumulated disability payment arrears was fully taxable, even though it was paid as a lump-sum settlement, because it was meant to replace amounts "payable ... on a periodic basis". Ms. Tsiaprailis appealed this decision to the SCC.

The majority opinion in the SCC agreed with the FCA and found that the portion of the lump-sum settlement that was paid to compensate Ms. Tsiaprailis for past disability benefits was, indeed, taxable. The dissenting minority felt that since the lump-sum payment was the result of a settlement agreement and, therefore, was not made "pursuant to a disability insurance plan", it should not have been taxable.

With respect to the portion of the settlement paid to settle future liability, however, the SCC concluded that "monies paid in settlement of any future liability under the disability insurance plan were not paid "pursuant to' the plan because there is no obligation to make such a lump-sum payment under the terms of the plan. The part of the settlement for future benefits is in the nature of a capital payment and is not taxable".