Are Damages Income? 

Tax Strategy

Are Damages Income?

FROM: JUL-AUG 2006 ISSUE | BY J. THOMAS McCALLUM

Accountants often find the taxation aspects of damage awards and settlements to be bewildering and uncertain, much like tax laws on these topics. Damage awards may or may not be taxable and may or may not be on account of capital (versus income), or may be the result of a personal injury claim. For ease of reference, this column defines damages as compensation received by an injured party for harm inflicted by another legally responsible party.

Some awards and settlements for commercial disputes and the treatment of their remedies are specifically addressed in the Income Tax Act (the Act). These include expropriation of property, bankruptcy, mortgage foreclosure, conditional sales, contract repossession, and debtor gains on settlement of debt. Others, such as some shareholder oppression remedies under the Business Corporations Act, are addressed in the Act, but are not easily found. For example, when shares are ordered by a court to be purchased by the corporation from the oppressed shareholder, you need to apply the "usual" rule regarding a corporation's purchase of its own shares, rather than a rule directly referenced in the Act.

Employment Related

Damages received for loss of employment are specifically dealt with in the Act. Since late 1981, damages of this nature fall within the definition of retiring allowances. As such, they are fully taxable, although there are provisions for deferring this income by transferring (within limits) it to a registered retirement savings plan. Legal fees incurred to establish the right to these damages or to collect them are deductible.

Other types of employment related damages, such as awards from the Workers' Compensation Board (WCB) for illness, injury, or death, are actually included in income, but excluded from taxable income by an offsetting deduction. However, when an employer continues the employee's wages or salary, perhaps pursuant to a collective bargaining agreement, any salary or wages in excess of the WCB award will be taxable under the "usual" employment income provisions of the Act.

Personal Injury Related

All damage awards received for personal injury — including death — are non-taxable. This includes both special damages and general damages, even if some or all of the damages are determined by reference to lost earnings. Many personal-injury awards are based on the individual's after-tax earnings, which have been lost. As an interesting aside, damage awards based on compensation for earnings capacity (as opposed to lost earnings) are often based on pre-tax amounts.

When the injured party is under 21 years of age, the Act provides that income, including capital gains, earned from property acquired with the damage award is non-taxable until the beginning of the taxation year in which the taxpayer turns 22 years of age. The subject income includes compounded income.

There is one additional important Act provision for these under-21 taxpayers, who, on the day before they turn 21 years of age, can elect to recognize a fair market value deemed disposition of any capital property acquired with the damages. This can give them a step-up in the adjusted cost base of that property, without having the interim gain taxed.

Other notable aspects of personal-injury awards are that pre-judgement interest is considered to be part of the award, and hence non-taxable. When an award is paid in periodic instalments, none of the award is considered taxable, notwithstanding that it might appear to be an annuity under the Act. An annuity is rather broadly defined in the Act as including an amount payable on a periodic basis whether payable under a will or trust, contract, or otherwise.

Damages paid by a casualty insurer, which are arranged as a "structured settlement" (generally by purchase of a single-premium annuity contract) will also be non-taxable provided the requirements noted at CRA's IT-365R2 are met.

Business Related

The tax treatment of damages received from an award or settlement on business matters is much more difficult to categorize because the claim and settlement can be multi-faceted. The answer to the question, "what do the damages compensate?" is the first key to the solution roadmap. Here you can apply a couple of broad principles. First, recall the purpose of the remedy — to place the injured person in the same position they'd have been in had the injury not occurred.

If the damage award is for lost profits, say for example, due to a breach of contract, generally that damage award will be business income, particularly if there has been no loss or destruction of a capital asset. When there is a loss or destruction of a trading asset, such as inventory, then the damage award will also be income.

When there's loss or destruction of a capital asset or intangible asset, then the damages will be on account of capital, resulting in a capital gain. The gain may be a recapture of depreciation, or a reduction in the cost of the asset. Some intangible assets, whether identifiable or non-identifiable, are eligible capital property, and the damage award will be accountable for tax purposes through its effect on the cumulative eligible capital account.

If the damage award is compensation for the destruction or material crippling of the profit-making apparatus of the business (at least a substantial portion of the business is affected and its very structure is undermined or dislocated) then the damage award is capital. Here the damage award could be related to a specific asset or assets, thus treated as above with any residual or non-attributable amount affecting eligible capital property, or one or the other depending on the facts.

One final caution: don't confuse the determination of damages by reference to profits or lost profits as evidence of the damage on account of income rather than capital. While this article has just skimmed the surface of the taxation of damages, hopefully these basics will prove valuable in your client services; yet another tool in the adviser's toolbox.

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J. Thomas McCallum, CBV, FCGA, is a business valuation and income tax consultant based in Whitby, Ontario. E-mail jtmc@jthomasmccallum.com.

The information appearing in "Tax Strategy" is provided for the interest of the readers. Neither CGA Magazine nor the column authors and co-ordinator assumes any responsibility or liability to any persons relying on the information in the article to perform tax planning and/or compliance of any kind.