SUPREME COURT OF CANADA
Citation: Tsiaprailis v. Canada, [2005] 1 S.C.R. 113, 2005 SCC 8 |
Date: 20050225 Docket: 29777 |
Between:
Vasiliki Tsiaprailis
Appellant
v.
Her Majesty the Queen
Respondent
Coram: Major, Bastarache, Binnie, LeBel, Deschamps, Abella and Charron JJ.
Reasons for Judgment: (paras. 1 to 16)
Dissenting reasons: (paras. 17 to 59) |
Charron J. (Bastarache, Binnie and Deschamps JJ. concurring)
Abella J. (Major and LeBel JJ. concurring)
|
______________________________
Tsiaprailis v. Canada, [2005] 1 S.C.R. 113, 2005 SCC 8
Vasiliki Tsiaprailis Appellant
v.
Her Majesty The Queen Respondent
Indexed as: Tsiaprailis v. Canada
Neutral citation: 2005 SCC 8.
File No.: 29777.
2004: November 4; 2005: February 25.
Present: Major, Bastarache, Binnie, LeBel, Deschamps, Abella and Charron JJ.
on appeal from the federal court of appeal
Income tax — Computation of employment income — Disability insurance benefits — Surrogatum principle — Taxpayer’s disability insurance benefits terminated by insurer — Taxpayer suing insurer and settling claim on basis of lump sum payment — Release denying all liability on part of insurer — Whether lump sum payment made “pursuant to a disability insurance plan” — Whether portion of lump sum based on amount owing for past disability benefits taxable — Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), s. 6(1)(f).
T was seriously injured in a car accident and received long-term disability benefits in accordance with her employer’s insurance policy. When the insurer terminated her benefits more than eight years later, T sued the insurer for a declaration that she was entitled to a continuation of these benefits. The parties settled and T received a lump sum payment of $105,000 after signing a release in which the insurer denied all liability. For the 1996 taxation year, the Minister of National Revenue reassessed T to include the full $105,000 as income, however, the Tax Court of Canada set aside the Minister’s decision, holding that the lump sum settlement was not taxable. The Federal Court of Appeal allowed the Minister’s appeal on the basis that the portion of the lump sum payment attributable to benefits arrears was made to replace monies “payable . . . on a periodic basis . . . pursuant to a disability insurance plan” and was therefore taxable under s. 6(1)(f) of the Income Tax Act.
Held (Major, LeBel and Abella JJ. dissenting): The appeal should be dismissed.
Per Bastarache, Binnie, Deschamps and Charron JJ.: The portion of the lump sum settlement intended to compensate T for past disability benefits was “payable . . . on a periodic basis . . . pursuant to a disability insurance plan” and is taxable within the meaning of s. 6(1)(f). To conclude that the payment for past benefits was not made “pursuant to” the insurance disability plan because it was paid to obtain a release from liability under the policy is to render the surrogatum principle meaningless. The fact that the parties may have used a taxable item as the reference point in calculating damages or negotiating a settlement does not conclusively determine whether the damages or settlement monies are taxable or non‑taxable. Rather, the taxability will depend on the nature of the settled interest. There are two determinative questions: first, what was the payment intended to replace? Second, would the replaced amount have been taxable in the recipient’s hands? 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 T, would have been taxable under s. 6(1)(f). [13] [15-16]
Per Major, LeBel and Abella JJ. (dissenting): The lump sum payment was not made “pursuant to a disability insurance plan” and is therefore not taxable under s. 6(1)(f). Absent a contrary statutory provision or evidence of a sham, the legal realities of a transaction will be respected for tax purposes. In this case, the payment resulted from a court action seeking declaratory rights arising from and in consequence of disputed eligibility under a disability policy. The parties settled to avoid a judicial determination of what amounts, if any, were owed under the policy, and a lump sum was paid to extinguish any liability for claims that might be asserted because of the disability policy. A payment “resulting from” an insurance policy but made pursuant to a bona fide lump sum settlement agreement should not be recharacterized as a payment made “pursuant to” that policy. [39] [56-58]
Even if the surrogatum principle applies, which is doubtful in the circumstances, the arrears would not be taxable. Damage and settlement payments are inherently neutral for tax purposes and must be compartmentalized into their constituent portions to determine which are taxable. The general nature of the settlement payment was to release the insurance company from a claim that it was liable and, concurrently, to extinguish T’s claim for entitlement under the disability insurance policy. Although the parties’ negotiations were related to what T felt she was entitled to under the policy, the amounts were used more as a way to gauge the reasonableness of any compromise, rather than as a replacement mechanism. [48] [54-55]
Cases Cited
By Charron J.
Considered: M.N.R. v. Armstrong, [1956] S.C.R. 446; referred to: London and Thames Haven Oil Wharves, Ltd. v. Attwooll, [1967] 2 All E.R. 124.
By Abella J. (dissenting)
Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622; Ludco Enterprises Ltd. v. Canada, [2001] 2 S.C.R. 1082, 2001 SCC 62; M.N.R. v. Armstrong, [1956] S.C.R. 446; The Queen v. Sills, [1985] 2 F.C. 200; London and Thames Haven Oil Wharves, Ltd. v. Attwooll, [1967] 2 All E.R. 124; Canadian National Railway Co. v. The Queen, [1988] 2 C.T.C. 111; Prince Rupert Hotel (1957) Ltd. v. Canada, [1995] 2 C.T.C. 212; Bellingham v. Canada, [1996] 1 F.C. 613; Schwartz v. Canada, [1996] 1 S.C.R. 254; Curran v. M.N.R., [1959] S.C.R. 850.
Statutes and Regulations Cited
Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), ss. 6(1), 110.2, 120.31.
Authors Cited
Black’s Law Dictionary, 8th ed. Edited by Bryan A. Garner. St. Paul, Minn.: Thomson/West, 2004, “pursuant to”.
Canada. Royal Commission on Taxation. Report of the Royal Commission on Taxation, vol. 3, part A, “Taxation of Individuals and Families”. Ottawa: Queen’s Printer, 1966.
Hogg, Peter W., Joanne E. Magee and Jinyan Li. Principles of Canadian Income Tax Law, 4th ed. Scarborough, Ont.: Thomson/Carswell, 2002.
Krishna, Vern. The Fundamentals of Canadian Income Tax, 8th ed. Toronto: Thomson/Carswell, 2004.
APPEAL from a judgment of the Federal Court of Appeal (Strayer, Evans and Pelletier JJ.A.), [2003] 4 F.C. 112, 225 D.L.R. (4th) 697, 301 N.R. 336, 35 C.C.P.B. 151, [2003] 3 C.T.C. 171, 2003 D.T.C. 5246, [2003] F.C.J. No. 431 (QL), 2003 FCA 136, setting aside a decision of Bowman A.C.J.T.C. (2001), 32 C.C.P.B. 106, 2002 D.T.C. 1563, [2002] 1 C.T.C. 2858, [2001] T.C.J. No. 856 (QL). Appeal dismissed, Major, LeBel and Abella JJ. dissenting.
Donald W. Leschied, Myron Shulgan and Crista L. Rea, for the appellant.
Gordon Bourgard and Wendy Burnham, for the respondent.
The judgment of Bastarache, Binnie, Deschamps and Charron JJ. was delivered by
1 Charron J. — I have had the benefit of reading the reasons of my colleague Justice Abella. For the reasons that follow, I reach a different result and would dismiss the appeal.
2 Under the terms of a settlement of her claim against her group disability insurer, Vasiliki Tsiaprailis received a total of $105,000. This amount represented her entitlement to past benefits under the insurance plan, 75 percent of the present value of her future benefits, and an amount for costs, disbursements and GST. The evidence in support of this allocation of the settlement amount is clear from the letters exchanged by the parties, and is confirmed in the agreed statement of facts. The details are set out in my colleague’s judgment. The issue on this appeal is whether Ms. Tsiaprailis can be taxed on that portion of the settlement intended to compensate her for the past benefits.
3 The question turns on whether the amount allocated for past benefits was “payable . . . on a periodic basis” and “pursuant to a disability insurance plan” within the meaning of s. 6(1)(f) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.). Section 6(1)(f) reads as follows:
6. (1) There shall be included in computing the income of a taxpayer for a taxation year as income from an office or employment such of the following amounts as are applicable:
. . .
(f) the total of all amounts received by the taxpayer in the year that were payable to the taxpayer on a periodic basis in respect of the loss of all or any part of the taxpayer’s income from an office or employment, pursuant to
. . .
(ii) a disability insurance plan . . . .
4 Bowman A.C.J. of the Tax Court of Canada held that the lump sum settlement was negotiated as a compromise that could not be described as an amount payable on a periodic basis within the meaning of s. 6(1)(f). Hence none of it was taxable: [2002] 1 C.T.C. 2858. The majority of the Federal Court of Appeal (Pelletier and Strayer JJ.A. concurring) allowed the appeal on the basis that the portion of the lump sum payment which represented payments already due was made to replace monies payable on a periodic basis under the insurance plan and was therefore taxable: [2003] 4 F.C. 112. Evans J.A., dissenting, essentially agreed with Bowman A.C.J. and would have dismissed the appeal.
5 Ms. Tsiaprailis did not dispute before this Court that a lump sum paid in respect of an obligation to pay accumulated periodic payments would be taxable. She argued, however, that the payment was not made “pursuant to a disability insurance plan”. Instead, she submitted that it was made pursuant to an agreement that settled a disputed obligation.
6 My colleague, Abella J., accepts Ms. Tsiaprailis’s position and concludes that the settlement monies were not paid “pursuant to” the disability insurance plan because they were paid pursuant to a settlement agreement which extinguished any liability under the policy.
7 In my view, this conclusion runs counter to the principle that awards of damages and settlement payments are inherently neutral for tax purposes. My colleague takes no issue with this principle. As she explains, in assessing whether the monies will be taxable, we must look to the nature and purpose of the payment to determine what it is intended to replace. The inquiry is a factual one. The tax consequences of the damage or settlement payment is then determined according to this characterization. In other words, the tax treatment of the item will depend on what the amount is intended to replace. This approach is known as the surrogatum principle. As noted by Abella J., it was defined in London and Thames Haven Oil Wharves, Ltd. v. Attwooll, [1967] 2 All E.R. 124 (C.A.), and subsequently adopted in a number of Canadian cases: see P. W. Hogg, J. E. Magee and J. Li, Principles of Canadian Income Tax Law (4th ed. 2002), at pp. 91-93; and V. Krishna, The Fundamentals of Canadian Income Tax (8th ed. 2004), at pp. 413-15.
8 In determining the nature and purpose of the payment, Abella J. concludes that the payment was not made “pursuant to” the insurance policy because it was paid to obtain a release from liability under the policy. My colleague relies on this Court’s decision in M.N.R. v. Armstrong, [1956] S.C.R. 446, in support of her analysis. In Armstrong, the Court concluded that a lump sum settlement paid in full satisfaction of an ex-wife’s claim to further payments under a divorce decree was not made “pursuant to” a decree, order or judgment. Rather, it was an amount paid “by reason of” or “in consequence of” a legal obligation imposed under the judgment. The distinction between a payment “pursuant to” a judgment and “by reason of” or “in consequence of” a judgment thus determined the outcome of the case in Armstrong.
9 Abella J. correctly notes that, in Armstrong, the Court was not dealing with arrears but with future support payments payable under the judgment. However, she finds that this fact does not change the decision’s interpretative value in relation to the meaning of the words “pursuant to”. I do not quarrel with that observation but, in my view, the manner in which the case dealt with future obligations is highly relevant to the application of the surrogatum principle and explains the result reached in that case, a result that cannot follow here.
10 As noted by Kerwin C.J., Armstrong was under no obligation under the divorce judgment to pay a lump sum for future support payments. His obligation was to pay ongoing support at a rate of $100 per month. Hence it could not be said that the lump sum was paid “pursuant to” the judgment. To emphasize the fact that the settlement was not made pursuant to the underlying court order, Kellock J. pointed out that if Armstrong had agreed to purchase a house for his ex-wife in return for a release, he could not deduct the value of the house because “[s]uch an outlay made in commutation of the periodic sums payable under the decree is in the nature of a capital payment to which the statute does not extend” (p. 448). In Kellock J.’s view, the payment of a lump sum for future benefits would, like the house, be characterized as a capital payment.
11 When the reasoning in Armstrong is applied to the present case, it is clear 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 under s. 6(1)(f) of the Act.
12 As we have seen, the decision in Armstrong relies on the application of the surrogatum principle, and concludes that Armstrong was not obligated by reason of the Court’s judgment to pay a lump sum for future support payments. However, it does not suggest that past benefits like those at issue in this case are likewise not payable pursuant to or in consequence of a court’s judgment or an insurance contract. Hence, I am of the view that the decision in Armstrong does not lend support to the conclusion reached by my colleague.
13 My colleague further concludes that, even if one applied the surrogatum principle, the payment would not be taxable in this case because the liability under the policy was simply used as a way to gauge the reasonableness of the proposed settlement amount. I would not disagree that the fact that the parties may have used a taxable item as the reference point in calculating damages or negotiating a settlement does not conclusively determine whether the damages or settlement monies are taxable or non-taxable. Rather, the taxability will depend on the nature of the settled interest. However, with respect, I do not agree with the conclusion reached by my colleague in her application of the surrogatum principle on the facts of this case.
14 Abella J. appears to base her conclusion in large part on the fact that the insurer, by the terms of the release, explicitly denied liability under the insurance contract. In my view, this factor is of no moment to the inquiry. As aptly noted by the majority in the Federal Court of Appeal, it is the tax liability of the insured that is in issue and, on this point, I agree with the following observation:
. . . Ms. Tsiaprailis cannot assert the insurer’s liability under the policy in her action, recover an amount from the insurer in that action, and then argue that the payment does not flow from the obligations of the insurer under the policy. [para. 23]
15 The determinative questions are: (1) what was the payment intended to replace? And, if the answer to that question is sufficiently clear, (2) would the replaced amount have been taxable in the recipient’s hands? In this case, the evidence of what the amount was intended to replace is clear and cogent. As my colleague noted, the evidence established that the negotiated lump sum was “based on three aspects of liability under the policy: an amount to extinguish Ms. Tsiaprailis’s claim for accumulated arrears, an amount to extinguish her claim for future benefits, and an amount to extinguish her claim for costs” (para. 54 (emphasis added)). Hence, it cannot be disputed on the evidence that part of the settlement monies was intended to replace past disability payments. It is also not disputed that such payments, had they been paid to Ms. Tsiaprailis, would have been taxable.
16 To conclude that the payment for past benefits was not made “pursuant to” the insurance disability plan in these circumstances is to render the surrogatum principle meaningless. Hence, I would conclude that the portion of the lump sum allocated to the accumulated arrears is taxable and I would dismiss the appeal, with no order as to costs.
The reasons of Major, LeBel and Abella JJ. were delivered by
17 Abella J. (dissenting) — As a result of the failure by an insurance company to pay disability benefits to her, Vasiliki Tsiaprailis sued for a declaration that she was entitled to those benefits. The parties settled and Ms. Tsiaprailis received a lump sum payment after signing a release in which the insurer denied all liability. The issue in this appeal by Ms. Tsiaprailis is whether a portion of the lump sum settlement is taxable.
I. Background
18 Ms. Tsiaprailis was employed by Tamco Limited. Under the terms of a collective agreement between Tamco and Ms. Tsiaprailis_s union, she was entitled to long-term disability benefits through an insurance policy carried and paid for by her employer. The insurance company ultimately responsible for the policy was Manufacturers Life Insurance Company (“Manulife”).
19 On November 10, 1984, Ms. Tsiaprailis was seriously injured in a car accident. From May 11, 1985 to May 10, 1993, she received long-term disability benefits in accordance with the insurance policy. In May 1993, however, Manulife terminated the benefits, claiming that Ms. Tsiaprailis was no longer totally disabled.
20 On March 30, 1994, Ms. Tsiaprailis sued Manulife for a declaration that she was entitled to a continuation of her disability benefits.
21 In the course of five letters exchanged between September 13, 1996 and October 11, 1996, a settlement was negotiated.
22 The first letter sent by her lawyer on September 13, 1996 indicated that Ms. Tsiaprailis was willing to accept approximately $150,000 to settle her claim. The amount was calculated based on an estimate of the 177-week period of arrears plus pre-judgment interest totalling almost $36,000; an estimate of future benefits calculated to Ms. Tsiaprailis_s 65th birthday and totalling about $141,000 reduced by a 25 percent discount to about $113,000; and additional amounts under her policy for extended health care benefits such as drug expenses, which were calculated at between $4,000 to $5,000 per year.
23 The insurer’s counter-proposal acknowledged that the operative monthly figure was $746.75 and that, for settlement purposes, Ms. Tsiaprailis would not likely work again before her 65th birthday. However, Manulife claimed that the proposal for future benefits was about $60,000 too high, and the one for arrears too high by about $3,000. Their counter offer, including a 25 percent reduction “for contingencies”, amounted to $84,685.61.
24 This resulted in Ms. Tsiaprailis insisting on the value of the arrears remaining at almost $36,000, but acknowledging her willingness to reduce the claim for future benefits to just over $62,500 plus an additional $5,000 for drug benefits and $8,000 for costs, making her new total proposal $111,545.98.
25 This time, Manulife responded by rejecting the $5,000 for drug benefits but stated that “in an effort to put this matter to rest, Manulife is prepared to increase its previous offer to the all inclusive sum of $100,000.00”.
26 A few days later, Ms. Tsiaprailis_s lawyer proposed $105,000 as the final settlement figure, stating in his letter:
I reviewed your letter of October 8th with my clients at length yesterday, October 10th, and they have given me firm instructions to settle this claim for a lump sum in lieu of monthly benefit payments and the insured is prepared to release Manulife in exchange for the all-inclusive sum of $105,000.00; otherwise, she is content to accept the past benefit to date with interest and a reasonable sum for legal fees and continue to receive her monthly benefit through to age 65. That offer, by way of a lump sum, essentially means that Manulife is paying the past benefits plus interest, 75% of the present value of the future benefit and about $6,455.00 for costs, GST and disbursements . . . . [Emphasis added.]
27 Manulife accepted this “all-inclusive sum”, entering into a settlement agreement with Ms. Tsiaprailis on October 18, 1996 for a lump sum of $105,000, from which Ms. Tsiaprailis paid $18,068.97 in costs, plus GST and disbursements.
28 Ms. Tsiaprailis’s release in favour of Manulife stated, in part:
it is understood and agreed by the releasor that this is a compromise settlement of a disputed claim and that the payment of consideration for this Release shall not be deemed nor construed as an admission of liability by the said Releasee in any manner whatsoever.
29 As a result of the settlement, the action was dismissed on October 21, 1996.
30 After paying the lump sum, Manulife issued and delivered a T4-A to Ms. Tsiaprailis. She responded by filing a T1 Adjustment Request. On September 8, 1997, the Minister of National Revenue reassessed Ms. Tsiaprailis for the 1996 taxation year to include the full $105,000 as income. On December 15, 1997, a further reassessment allowed her to deduct her legal expenses.
31 Ms. Tsiaprailis appealed the assessment to the Tax Court of Canada ([2002] 1 C.T.C. 2858). The issue before Bowman A.C.J. was whether the full settlement payment received by Ms. Tsiaprailis from Manulife was taxable pursuant to either s. 6(1)(a) or s. 6(1)(f) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), which provide:
6. (1) There shall be included in computing the income of a taxpayer for a taxation year as income from an office or employment such of the following amounts as are applicable:
(a) the value of board, lodging and other benefits of any kind whatever received or enjoyed by the taxpayer in the year in respect of, in the course of, or by virtue of an office or employment . . . .
. . .
(f) the total of all amounts received by the taxpayer in the year that were payable to the taxpayer on a periodic basis in respect of the loss of all or any part of the taxpayer’s income from an office or employment, pursuant to
. . .
(ii) a disability insurance plan . . . .
32 The parties proceeded based on an agreed statement of facts, the essence of which has been distilled in the preceding paragraphs. It is, however, worth setting out para. 11 of the agreed statement of facts. It states:
In October 1996, the Appellant entered into a settlement agreement with Manulife and received a lump sum payment of $105,000 in lieu of continued benefits pursuant to the terms of settlement. The sum of $105,000 essentially meant Manulife was paying:
(a) the Appellant’s entitlement to past benefits, plus interest;
(b) 75% of the present value of the Appellant’s entitlement to future benefits under the policy;
(c) $6,455 for costs, GST and disbursement.
33 The trial judge held that only s. 6(1)(f) was potentially engaged by these facts. However, he concluded that the lump sum settlement was not taxable, holding 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”. [para. 18]
34 The majority in the Federal Court of Appeal disagreed, and divided the total payment into a portion it attributed to arrears, and one attributed to future benefits ([2003] 4 F.C. 112). Pelletier J.A., Strayer J.A. concurring, held that the portion of the lump sum payment attributable to arrears was taxable pursuant to s. 6(1)(f). Unlike the trial judge, they were of the view that Ms. Tsiaprailis had two kinds of claims against her insurance company: a claim for arrears and a claim for future benefits, claims that could and should be distinguished for tax purposes. The agreed statement of facts, they felt, demonstrated that the parties allocated the settlement between arrears and future benefits.
35 They concluded, however, that only the portion of the settlement allocated to arrears should be taxed. Even though they were in the form of a lump sum payment, the majority found the arrears to be “payable . . . on a periodic basis” because, under the insurance policy, they were so payable. Because the settlement was “referable to” the insurance contract, it was, accordingly, paid “pursuant to” a disability insurance policy.
36 It was, moreover, not determinative in the majority’s view that the liability was disputed, as demonstrated by the terms of the release. From the taxpayer_s perspective, the liability was not disputed. In their view, the nature of the underlying transaction and not the terms of a release should govern the characterization of a settlement payment. Because this transaction included an amount for arrears, that portion of the settlement was taxable under s. 6(1)(f). They agreed with the trial judge that s. 6(1)(a) of the Income Tax Act did not apply.
37 Evans J.A., in dissent, disagreed with the majority’s treatment of the arrears. In his view, the trial judge_s interpretation of s. 6(1)(f) is the most obvious reading of that provision. He disagreed with both the majority_s conclusion that the lump sum was “payable . . . on a periodic basis”, as well as its conclusion that it was paid “pursuant to a disability insurance plan”. While he agreed that if a lump sum payment is made towards the arrears of periodic payments due under an insurance policy it can be considered “payable . . . on a periodic basis”, Evans J.A. found that this conclusion by itself provided no answer to whether the lump sum payment was made “pursuant to” a disability insurance contract. He concluded that the lump sum payment was made pursuant to a settlement agreement, not pursuant to the provisions of the insurance contract.
38 This Court granted leave to appeal to Ms. Tsiaprailis on January 22, 2004: [2004] 1 S.C.R. xv.
II. Analysis
39 This Court has consistently held that taxpayers’ legal relationships should be respected in tax cases absent a contrary provision in the Income Tax Act or a finding that they are a sham. McLachlin J. explained this principle in Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622, at para. 39:
[T]his Court has never held that the economic realities of a situation can be used to recharacterize a taxpayer’s bona fide legal relationships. To the contrary, we have held that, absent a specific provision of the Act to the contrary or a finding that they are a sham, the taxpayer’s legal relationships must be respected in tax cases. Recharacterization is only permissible if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect: Continental Bank Leasing Corp. v. Canada, [1998] 2 S.C.R. 298, at para. 21, per Bastarache J.
See also Ludco Enterprises Ltd. v. Canada, [2001] 2 S.C.R. 1082, 2001 SCC 62, at paras. 38-39.
40 In its 1966 report, the Carter Commission recommended that all compensation for personal injuries, including disability insurance benefits, should be taxable as a form of income replacement: Report of the Royal Commission on Taxation (1966), vol. 3, at p. 438. At the time, disability insurance benefits were not taxable. Parliament, however, chose not to follow this recommendation in the tax reform budget of 1971. Instead, Parliament rejected the wholesale taxation of compensation for personal injury, and chose to tax it only in certain defined circumstances as set out in what was then a new provision, s. 6(1)(f).
41 Section 6(1)(f) sets out two relevant requirements, both of which must be met if employment insurance plan benefits are to be taxed. First, the amount must be “payable to the taxpayer on a periodic basis”. Second, the amount must be paid “pursuant to” a disability insurance plan. Unless the amount is payable “pursuant to” a disability insurance plan, it is irrelevant whether it is payable “on a periodic basis”. In my view, the amount was not so payable, and it is therefore unnecessary to determine whether the lump sum payment was payable on a periodic basis.
42 The phrase “pursuant to” was applied by this Court in M.N.R. v. Armstrong, [1956] S.C.R. 446. The taxpayer had been ordered to pay $100 per month to his former wife for child support. After payments had been made for two years, the taxpayer gave her a cash settlement of $4,000 in full satisfaction of her claim to further payments under the divorce decree. The issue before the Court was whether the lump sum payment was made “pursuant to” an order or judgment in a divorce or separation action, a condition precedent to taxation under the relevant section of the Income Tax Act. All three justices who wrote reasons agreed that the payment was not made “pursuant to” a decree, order or judgment. In the words of Locke J.:
It cannot . . . be properly said that this lump sum was paid, in the words of the section, pursuant to the divorce decree. It was, it is true, paid in consequence of the liability imposed by the decree for the maintenance of the infant, but that does not fall within the terms of the section. [Emphasis in original; p. 449.]
43 Kerwin C.J. applied “pursuant to” similarly:
The test is whether it was paid in pursuance of a decree, order or judgment and not whether it was paid by reason of a legal obligation imposed or undertaken. [Emphasis added; p. 447.]
44 Kellock J. reached the same conclusion:
In my opinion, the payment here in question is not within the statute. It was not an amount payable “pursuant to” or “conformément à” . . . the decree but rather an amount paid to obtain a release from the liability thereby imposed. [p. 448]
See also The Queen v. Sills, [1985] 2 F.C. 200 (C.A.), at pp. 204-5.
45 Even though Armstrong dealt with a settlement paid to extinguish a claim for future, not past benefits, that does not diminish its interpretive value. I share the view that “pursuant to” is different from and narrower than “as a result of”. Black’s Law Dictionary (8th ed. 2004) also attributes a narrower definition to the phrase: “[i]n compliance with” or “in accordance with”; “[a]s authorized by”; and “[i]n carrying out”. In this case, the lump sum settlement payment was not paid to Ms. Tsiaprailis “in compliance with” or “in accordance with” a disability insurance plan, it was paid “in compliance with” and “in accordance with” a settlement agreement.
46 Although the arrears component, assuming it was properly divisible from the rest of the settlement, was in consequence of a claim for arrears justified by the disability insurance plan, that does not, in my view, bring it within the scope of s. 6(1)(f). The payment to Ms. Tsiaprailis was not paid pursuant to the insurance contract, it was, as Kellock J. said in Armstrong, “an amount paid to obtain a release” (p. 448) from the liability imposed, in this case, by the insurance policy.
47 There is no doubt that Parliament intended that at least some lump sum payments can, potentially, be taxable, as evidenced by their inclusion in the lump sum averaging provisions of ss. 110.2 and 120.31 of the Income Tax Act. But where, as here, the lump sum payment does not even fall within the ambit of s. 6(1)(f), the inclusion of some lump sum settlements in those sections is not germane.
48 Even if one applied the surrogatum principle, as the respondent urges, an application I question both on the facts of this case and the statutory provisions under consideration, I would not find the arrears to be taxable. Damage and settlement payments are inherently neutral for tax purposes and must therefore be classified to determine whether they are taxable. This is the surrogatum principle, as defined by Lord Diplock in London and Thames Haven Oil Wharves, Ltd. v. Attwooll, [1967] 2 All E.R. 124 (C.A.) as follows:
Where, pursuant to a legal right, a trader receives from another person compensation for the trader_s failure to receive a sum of money which, if it had been received, would have been credited to the amount of profits . . ., the compensation is to be treated for income tax purposes in the same way as that sum of money would have been treated if it had been received instead of the compensation. [p. 134]
49 When applying the surrogatum principle, the question is what the damage or settlement payment is intended to replace: Canadian National Railway Co. v. The Queen, [1988] 2 C.T.C. 111 (F.C.T.D.), at p. 114. It is a factual inquiry: Prince Rupert Hotel (1957) Ltd. v. Canada, [1995] 2 C.T.C. 212 (F.C.A.), at pp. 216-17.
50 However, as explained by Robertson J.A. in Bellingham v. Canada, [1996] 1 F.C. 613 (C.A.), it is not an all or nothing inquiry:
As the law presently stands we must look to the nature and purpose of a particular payment or award when assessing how it will be dealt with for tax purposes. This is certainly true with respect to the tax treatment of awards or settlements stemming from contractual or tortious claims. Such receipts are not treated automatically as a unitary sum. [p. 636]
51 The need to compartmentalize global payments into their constituent portions to determine which are taxable was explained by Professor V. Krishna in The Fundamentals of Canadian Income Tax (8th ed. 2004):
A global payment covering several different heads of damages . . . should be broken down and distributed into its taxable and non-taxable segments. The allocation is fairly easy where a court awards damages as a result of litigation and the judgment sets out the various heads of damages. An amount paid in settlement of a cause of action is more difficult to allocate and one should allocate amounts during negotiation of the settlement. [p. 414]
52 The allocation will be based on the totality of the evidence in each case. In Schwartz v. Canada, [1996] 1 S.C.R. 254, the taxpayer accepted an offer of employment from a company. A few months later, the company informed him that his services were no longer needed. After negotiations, the parties agreed that the taxpayer would be paid $360,000 in damages. The issue in that case was how to allocate the payment between loss of salary and stock options, taxable items, and non-taxable items, like embarrassment, anxiety and inconvenience. In deciding how the settlement should be allocated, this Court considered letters between the parties_ lawyers as well as the taxpayer’s testimony about the settlement negotiations. Because the Court considered the evidence to be inconclusive, no portion of the lump sum payment was found to be taxable.
53 In Curran v. M.N.R., [1959] S.C.R. 850, the issue was how to allocate an amount between payment for services and loss of a capital right. This Court looked at a second agreement between the parties, the source of the payment, and the evidence of the payor about the purpose of the payment.
54 In applying the surrogatum principle to this case, the general nature of the settlement payment was to release the insurance company from a claim that it was liable and, concurrently, to extinguish Ms. Tsiaprailis_s claim for entitlement under the disability insurance policy. The lump sum settlement payment was negotiated based on three aspects of liability under the policy: an amount to extinguish Ms. Tsiaprailis_s claim for accumulated arrears, an amount to extinguish her claim for future benefits, and an amount to extinguish her claim for costs.
55 This is a different characterization from that proposed by the respondent, who asserts that the lump sum was “comprised of” an amount for accumulated arrears and an amount for future benefits. As the release states, Manulife explicitly denied liability under the insurance contract. Moreover, throughout the settlement process, it disputed Ms. Tsiaprailis_s claim that she was totally disabled and entitled to any payments under the policy. Although the parties_ negotiations were undoubtedly related to what Ms. Tsiaprailis felt she was entitled to under the policy, those amounts were used more as a way to gauge the reasonableness of any compromise, rather than as a replacement mechanism.
III. Conclusion
56 The payment resulted from a court action seeking declaratory rights arising from and in consequence of disputed eligibility under a disability policy. The parties never came to an agreement about the value either of the arrears or the future benefits. They did not settle pursuant to liabilities flowing from the policy, but to avoid a judicial determination of what amounts, if any, were owed under it.
57 The lump sum payment is, in short, an amount paid to extinguish any liability for claims that might be asserted because of a disability policy. It is not, however, a payment made in accordance with or in compliance with that policy, and is not, therefore, a payment made pursuant to it.
58 As discussed above, absent a contrary statutory provision or evidence of a sham, the legal realities of a transaction will be respected for tax purposes even if they seem to conflict with its economic ones. The respondent concedes that the parties negotiated a settlement agreement in good faith, that the transaction was not a sham, and that there was no collusion. Absent such colourability, as this Court said in Shell, the taxpayer’s bona fide settlement agreement should not be recharacterized. In this case, a payment resulting from an insurance policy but made pursuant to a bona fide lump sum settlement agreement should not be recharacterized as a payment made “pursuant to” that policy.
59 Accordingly, I would allow the appeal with costs.
Appeal dismissed, Major, LeBel and Abella JJ. dissenting.
Solicitors for the appellant: Miller Canfield Paddock & Stone, Windsor; Wilson Walker, Windsor.
Solicitor for the respondent: Deputy Attorney General of Canada, Ottawa.