A former civil servant has won her Tax Court fight to avoid paying income tax on the portion of an insurance settlement that covers legal costs. The settlement was the result of a civil court battle to obtain disability benefits.

While she was employed by Prince Edward Island’s Workers’ Compensation Board, Mary Farrell became disabled and unable to work.

She had trouble getting Great-West Life Assurance Co. to pay her claim for lost wages under her benefits plan. She went through two lawyers in her battle against the insurer, and was forced to declare bankruptcy.

However, a settlement was reached with Great-West Life, composed of past benefits owed under the plan, interest and legal fees.

In the Tax Court case, the Canada Revenue Agency argued that Farrell’s legal fees should be considered part of the insurance payment and taxed accordingly. However, Tax Court Judge Diane Campbell, in her May 2005 judgment, reasoned that the insurer paid the disability benefits on behalf of the employer. Therefore, the legal fees should be considered deductible.

Under the Income Tax Act, legal fees are deductible when an employee pays them to obtain lost wages. Farrell’s disability benefits were to be made in lieu of wages.

In Farrell’s case, the legal fees covered under the settlement amounted to almost $11,000, but she was charged almost $12,600 more in legal fees that were not covered by the court settlement.

In her 2002 tax return, she attempted to deduct all of her legal fees, but her deduction claim was denied by the CRA.

Normally, legal fees are deductible under the Income Tax Act, which states that in computing income from employment, legal expenses “to collect or establish a right to salary or wages owed to the taxpayer by the employer or former employer” may be deducted by the taxpayer. However, in the Farrell case, the CRA argued the legal fees should be considered part of the insurance payment and, therefore, taxable. The CRA bolstered its argument by saying it was the insurer, not the Workers’ Compensation Board, that paid the settlement.

The agency based its arguments on the recent Supreme Court of Canada case, Tsiaprailis v. Canada. In that case, Ontario resident Vasiliki Tsiaprailis also fought her employer’s insurer for payment of disability benefits.

Tsiaprailis’ settlement was broken down into three parts: her entitlement to past benefits plus interest; 75% of the current value of her entitlement to future benefits; and legal costs.

The SCC decided that the past benefits should be considered taxable wages, but that the future benefits should be considered a “capital payment” and, therefore, not taxable. In the Farrell case, the settlement involved only past benefits.

Taking her cue from the Tsiaprallis case, Campbell wrote: “It is now clear that insurance payments are a ‘salary or wage’.”

But that still left the question of legal fees, not considered by the SCC in the Tsiaprailis case.

Campbell, however, stated she had “no problem looking behind the origin of the benefit funds to the underlying employment contract [and finding] that it is the employer that owed [Farrell].”

Therefore, reasoned Campbell, “Since the insurer was paying [Farrell] on behalf of the employer … the amounts were therefore owed by the employer and, consequently, the legal fees are deductible.”

The judge looked at the nature and purpose of the payment instead of its strict legal character, says Heather Evans, tax lawyer and partner with Deloitte & Touche LLP in Toronto.

The taxpayer got exactly what she wanted, says tax lawyer Robin MacKnight, a partner with Wilson Vukelich in Markham, Ont. — past wages, which were owed by her benefits plan as part of the employment contract. Therefore, he says, the legal fees should be deductible.

“The judge made the right decision,” adds Jamie Golombek, vice president of taxation and estate planning at Toronto-based AIM Funds Management Inc. “The payment was made on behalf of the employer and should fall squarely within the legislation.”

Campbell’s decision is in line with a 2004 proposed amendment to the Income Tax Act, designed to ward off Tax Court battles following a dispute with an employer’s benefit plan provider. The proposed paragraph, retroactive to the 2001 taxation year, leaves out the phrase “owed by the employer or former employer.” Therefore, the CRA will not be able to split legal hairs by arguing that an insurer, rather than the employer, has paid the amount considered to be wages.

@page_break@Usually taxpayers have to take the cautious approach and comply with proposed, retroactive legislation. Apparently, the CRA does not. IE