When a client and an insurer settle a dispute for unpaid disability benefits, the amount paid to cover past benefits will be taxable, the Supreme Court of Canada has decided.

Advisors can now guide disabled clients who are embroiled in disputes with their insurers, knowing how insurance litigation settlements will be taxed. Advisors should tell clients to hire a litigation lawyer who is familiar with disability insurance and the potential impact of taxes on settlement negotiations. Otherwise, clients could negotiate an amount that is less than they deserve.

The highly contentious case, known as Tsiaprailis v. Canada, split the courts that heard it. The Federal Court of Appeal split 2:1 and the SCC split 4:3. The Tax Court of Canada decided in favour of the taxpayer.

“The fact that it was a split decision suggests that, even in the minds of the highest court, it wasn’t crystal clear,” says Ron Sanderson, director of policyholder taxation and pensions at the Canadian Life and Health Insurance Association in Toronto.

The SCC decided in February that an insurance settlement meant to pay for past benefits should be characterized as if it was money that had been paid on “a periodic basis … pursuant to” an insurance plan.
Disability benefits, paid periodically under employer benefit plans, are taxable.

However, the court decided on a different characterization for the portion of a settlement that is geared toward a claim for future benefits. It reasoned that there would be no obligation under a plan to pay future benefits. Therefore, that part of the settlement should be considered a “capital payment” and not be taxable.

Despite the different characterization of two portions of a disability insurance settlement, Tsiaprailis is now the law of the land.

Advisors with clients in a situation similar to Tsiaprailis can now have certainty as to the tax treatment of a disability insurance settlement, says Jamie Golombek, vice president of taxation and estate planning at Toronto-based AIM Funds Management Inc.

The case goes back to 1984, when Ontario resident Vasiliki Tsiaprailis was severely injured in a car accident. Between May 1985 and May 1993, she received long-term disability benefits through her employer-provided benefits package. The insurance provider was Toronto-based Manufacturers Life Insurance Co.

In 1993, however, Manulife cut her off, and early in 1994 she went to court to obtain a declaration that she was entitled to continued benefits. A settlement was negotiated through an exchange of letters between the lawyers for her and Manulife. In 1996, she was given a total of $105,000.
The amount represented her entitlement to past benefits, 75% of the then-present value of her future benefits, and about $6,455 for costs, GST and disbursements.

The Canada Revenue Agency reassessed her 1996 taxes to include the entire $105,000 in her income for that year. She decided to fight back.

The courts involved in the battle looked at all three elements of Tsiaprailis’s settlement.
The principal issue for the SCC was whether taxes could be imposed on the portion of her settlement that was intended to compensate her for unpaid past benefits.

The SCC relied on a specific provision in the Income Tax Act, which states benefits “payable on a periodic basis … pursuant to a disability insurance plan” should be included in a taxpayer’s income.

The SCC noted that Donald Bowman, chief justice of the Tax Court of Canada, held that the entire lump sum was negotiated as a settlement. It could not be described as an amount payable on a periodic basis within the meaning of the act, reasoned Bowman.
Therefore, none of it could be taxed.

The majority of the Federal Court of Appeal disagreed with Bowman. It held that the lump-sum payment for past benefits represents an amount that would have been paid on a periodic basis and, therefore, taxed as income.

At the SCC, Tsiaprailis argued that the amount for past benefits was not made pursuant to a disability insurance plan.
Instead, it was made as part of an
agreement to settle a court dispute.

The SCC majority disagreed. “The tax consequences of the damage or settlement payment is then determined according to this characterization,” wrote Judge Louise Charron, in the majority opinion. “In other words, the tax treatment of the item will depend on what the amount is intended to replace.”