In this decision the Supreme Court of Canada upheld a finding that a portion of settlement funds was taxable as income. At issue were funds received in settlement of a dispute over long-term disability benefits. The Minister of National Revenue initially assessed the entire settlement as income, the Tax Court of Canada set aside the Minister’s decision, and the Federal Court of Appeal held that because a portion of the settlement was attributable to benefits arrears, it replaced monies paid pursuant to a disability insurance plan, and was therefore taxable under section 6(1)(f) of the Income Tax Act.

Tsiaprailis v. Canada, [2005] S.C.J. No. 9, Supreme Court of Canada

The Plaintiff was seriously injured in a car accident and received long-term disability benefits pursuant to her employer’s insurance policy. After receiving benefits for eight years, the insurer terminated the benefits. The Plaintiff sued, and the parties settled for $105,000 and a release in which the insurer denied all liability. One portion of the lump sum settlement was intended to compensate for benefits arrears owing at the time of the settlement.

The court considered the surrogatum principle, a factual enquiry into the nature and purpose of the settlement payment for taxation purposes, to determine what funds it is intended to replace. Writing for the 4-3 majority, Charron JJ. held that the portion of the settlement intended to compensate for past benefits was indeed taxable within the meaning of section 6(1)(f) of the Income Tax Act. The taxability of settlement funds will depend upon the nature of the settled interest. The issues are: first, what was the settlement amount intended to replace? Second, would the replaced amount have been taxable in the recipient’s hands? Settlement funds received on account of non-pecuniary damages, for example, would not be taxable. Because part of the settlement monies were intended to replace past disability payments, and such payments, had they been paid to the Plaintiff originally, would have been taxable under section 6(1)(f) of the Act, the settlement amount was held to be similarly taxable.

In dissent, Abella JJ. for the minority would have held that the entire settlement was tax exempt. She therefore opined that the settlement was not made “pursuant to a disability insurance plan” and absent a contrary statutory provision, the legal realities of a transaction should be respected for tax purposes. The settlement resulted from a court action, therefore, the amount was paid to avoid a judicial determination of what amounts were owing under the policy. The sum was paid not as disability benefits but to extinguish any liability for claims. To interpret the payment as “pursuant to a policy” necessitates a recharacterization of the settlement, a manipulation of the legal realities of the transaction.

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