Taxing Personal Injury Damages: Tax Policy Analysis from ... Personal Injury ... * Of University of Saskatchewan College of Law ... background information on how personal injury damages are currently taxed in Canada ...

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<ul><li><p>canadian tax journal / revue fiscale canadienne (2010) vol. 58, no 3, 577 - 608</p><p> 577</p><p>Taxing Personal Injury Damages: Tax Policy Analysis from the Canadian Perspective</p><p>Tamara Larre*</p><p>P R C I S</p><p>Mme si lAgence du revenu du Canada (ARC) maintient que les dommages-intrts pour prjudice corporel sont exonrs dimpt, elle na donn que peu dexplications sur sa position. La pratique de lARC qui consiste ne pas ajouter ces sommes reues dans le calcul du revenu fait en sorte quil est peu probable que les tribunaux puissent se prononcer sur la question du traitement lgal adquat des dommages-intrts pour prjudice corporel. Le prsent article analyse les consquences pour la politique fiscale de limposition de chacun des types suivants de dommages-intrts pour prjudice corporel : la perte de capacit de travailler, le dommage non pcuniaire et le cot des soins de sant futurs. Larticle propose que les dommages-intrts pour la perte de capacit de travailler et les dommages-intrts pour dommage non pcuniaire devraient tre pleinement imposables puisquils sont perus au mieux comme le remplacement dune immobilisation ayant un cot de base minime. Larticle montre aussi que lon obtient une meilleure quit la fois horizontale et verticale si les dommages-intrts pour le cot des soins de sant futurs sont pleinement imposables, compte tenu du crdit dimpt qui est actuellement accord pour les frais mdicaux. La question du regroupement des revenus nest pas juge comme tant assez significative pour justifier le traitement dun gain en capital, mme si lexonration de la moiti des revenus est plus viable sur le plan politique que ltalement du revenu sur les annes suivantes. En conclusion, si lexonration fiscale actuelle des dommages-intrts pour prjudice corporel est maintenue, il y aurait tout lieu de la justifier en tant que dpense fiscale plutt que par dautres explications lies la politique fiscale.</p><p>A B S T R A C T</p><p>The Canada Revenue Agency (CRA) maintains that all personal injury damages are exempt from income tax, but has provided little explanation for its position. The CRAs practice of </p><p> * OfUniversityofSaskatchewanCollegeofLaw(e-mail:tamara.larre@usask.ca).Iamindebtedtomythesissupervisor,LisaPhilipps,forherinsight,guidance,andsupport.IalsowouldliketothankNeilBrooks,JinyanLi,DavidDuff,KateSutherland,KenCooper-Stephenson,AlanMacnaughton,andtheanonymousreviewerofthisarticlefortheircommentsandsuggestions,andEmilyLutherforherexcellentresearchassistance.Ipresentedpapersonthistopicatanumberofconferences,andIthanktheconferenceparticipantsfortheirfeedback.Anyshortcomingsinthisarticlearemyowndoing.</p></li><li><p>578 n canadian tax journal / revue fiscale canadienne (2010) vol. 58, no 3</p><p>not including such receipts in income makes it unlikely that Canadian courts will have the opportunity to fully consider the proper legal treatment of personal injury damages. This article examines the tax policy implications of taxing each of the following types of personal injury damages: loss of working capacity, non-pecuniary damages, and cost-of-care awards. It is argued that damages for loss of working capacity and non-pecuniary damages should be fully taxed, since they are best viewed as replacing capital assets with low basis. It is also shown that horizontal and vertical equity may be better achieved if damages for cost of care are fully taxed, given the existing medical expense tax credit. Income-bunching concerns are not considered significant enough to justify capital gains treatment, although a one-half exemption would be more politically viable than forward averaging. In conclusion, if the current tax exemption for personal injury damages is maintained, it must be justified as a tax expenditure rather than on other tax policy grounds.</p><p>KEYWORDS: DAMAGES n TAXATION n TAX POLICY</p><p>C O N T E N T S</p><p>The Taxation of Personal Injury Damages: The Need for Clarification 578Introduction 578Background 579</p><p>The Current Law 579The Debate 582Calculating Personal Injury Damages 584</p><p>Tax Policy Analysis 587The In Lieu of Approach 587Neutrality: The Behavioural Effects of Taxing Damages 589Equity and Simplicity: The Pragmatic Application of Income Theory 591</p><p>Damages for Cost of Care 592Damages for Loss of Working Capacity 596Non-Pecuniary Damages 600Deduction of Legal Fees 602The Capital Gains Preference 602Bunching and Income Averaging 605</p><p>Unresolved Issues and Concluding Remarks 607</p><p>THE TA X ATIO N O F PER SO N A L INJURY DA M AGE S: THE NEED FO R CL A RIFIC ATIO N</p><p>Introduction</p><p>Scholars intheUnitedStateshavebeendebatingthetaxationofpersonal injurydamages for half a century, and published articles have revealed theoretical andconceptualdifficultieswiththeexistingtaxexemptionforpersonalinjurydamages.However, the issue of how personal injury damages should be taxed has beenlargelyignoredinCanada.1TheCanadaRevenueAgency(CRA)hasofferedvery</p><p> 1 SeetheliteraturereviewunderBackgroundbelow.</p></li><li><p> taxing personal injury damages n 579</p><p>littleexplanationforitslongstandingviewthatpersonalinjurydamagesarenottax-able.2GiventheCRAsposition,itseemsunlikelythatthecourtswillencountertheopportunitytoclarifythepropertreatmentofsuchdamagesundertheIncomeTaxAct;3therefore,theuncertaintyinthecurrentlawwouldbebestresolvedthroughanamendmenttotheAct.Theissue,then,isthecontentofthislegislativeclarifica-tionoramendment.Thepurposeofthisarticleistoanalyzethisissue,withaviewtoencouragingfurtherpolicydiscussiononhowpersonalinjurydamagesshouldbetaxedinCanada.</p><p>WhiletherehavebeennumerousAmericanarticlesonthetaxationofpersonalinjurydamages,myanalysisseekstoextendthisliteratureinseveralways.First,Iassess and analyze each type of personal injury damages, including the seldom-consideredcategoriesoflossofhomemakingcapacityandcostofcare.Thissystematicapproachensuresthatalltypesofdamagesarefullyconsidered.TheAmericanlitera-turehastendedtofocusondiscreditingthepotentialjustificationsforthecurrentexemption,andhasnotfocusedonprescribingtheappropriatetaxtreatment.Inthisarticle,Idrawattentiontolargelyneglectedmattersthatmustbeconsideredbeforechangescanberecommended,includingtheamountofbasisintheassetsdisposedof,theavailabilityofthemedicalexpensetaxcreditwhereacost-of-careawardisgranted,andwhetherthecapitalgainspreferenceshouldextendtopersonalinjurydamagesiftheyaretaxed.AnotherimportantcontributionofthisarticleisthatitaddressestheCanadiancontext,includingpublicinvestmentinhumancapitalandCanadian lawrelating to thecalculationofdamages, the taxationofmedicalex-penses,andthedeterminationofbasis.</p><p>Thearticleisdividedintothreeparts.Intheremainderofthisfirstpart,Isetoutbackground information on how personal injury damages are currently taxed inCanada,reviewtheexistingliteratureontaxingpersonalinjurydamages,andsum-marizehowthevariouscategoriesofdamagesarecalculatedunderCanadianprivatelaw.Inthesecondpart,Iapplythetraditionaltaxevaluativecriteriaofequity,neu-trality,andsimplicitytopersonalinjurydamages.Iconcludethatthemostattractiveoption,fromataxpolicyperspective,istotaxpersonalinjurydamages.Inthethirdpart,Isetoutmyconclusion,andpointoutthatthenextstageofanalysisshouldbetodeterminewhetherthetaxexemptioncanbejustifiedasataxexpenditureaimedatfurtheringthegoalsoftortlaw.</p><p>Background</p><p>The Current LawAlthoughthisarticleisconcernedwithhowpersonalinjurydamagesshould betaxed,asopposedtohowtheyaretaxed,thecurrentlawisbrieflyconsideredhereinorderto</p><p> 2 SeeCanadaRevenueAgency,Interpretation BulletinIT-365R2,Damages,SettlementsandSimilarReceipts,May8,1987,paragraph2.Alsoseeinfranote6andtheaccompanyingtext.</p><p> 3 RSC1985,c.1(5thSupp.),asamended(hereinreferredtoastheAct).Unlessotherwiseindicated,statutoryreferencesinthisarticlearetotheAct.</p></li><li><p>580 n canadian tax journal / revue fiscale canadienne (2010) vol. 58, no 3</p><p>providecontextanddemonstratetheneedforlegislativeclarification.4BecausethereisnoprovisionintheActspecificallydealingwiththetaxationofpersonalinjurydam-ages,theirtaxtreatmentdependsontheapplicationofthegeneralrulesintheAct.5</p><p>TheCRAhasrepeatedlystateditspositionthatpersonalinjurydamagesarenotsubjecttotax.IntheoriginalversionofIT-365,Damages,SettlementsandSimilarReceipts,6issuedin1977,theDepartmentofNationalRevenue(asitthenwas)indi-catedthatdamagesrelatingtoapersonalinjuryactionwereexemptfromtax,withtheexceptionofspecialdamagesforpre-triallossofearnings.Thatpositionchangedinlaterversionsofthebulletintoexemptalltypesofpersonalinjurydamages,7likelyinresponsetothe1978decisionoftheFederalCourtinD Cirella v. The Queen,8discussedbelow.TheCRAhasconfirmeditspositionmorerecentlyinanumberoftechnicalinterpretations,butithasnotofferedanexplanationfortheexemption.9</p><p>Cirellaistheonlytaxcasedirectlyonpoint.Inthatcase,theFederalCourtTrialDivision held that personal injury damages for out-of-pocket expenses, loss ofpre-trial income, and general damages were not taxable since they did not fallwithinthemeaningofemploymentincomeintheAct.TheFederalCourtreasonedthatthedamageswerenotincomefromasourceandwerecapitalinnature,partlyasaresultofitsconclusionthatdamagesforlostearnings(bothpre-andpost-trial)compensatedforlostearningcapacity.TheFederalCourtsdecisionwasinlinewiththeSupremeCourtofCanadasobitercommentsinits1966decisioninThe Queen v. Jennings et al.,10thatdamagesforlossoffutureearningswerecompensationforalostcapitalasset(earningcapacity)andthereforewerenotsubjecttotax.</p><p>The reasoning in Cirella is consistent with the surrogatum principle, whichcourtshaveusedtodeterminetheappropriatetaxtreatmentofreplacementpay-ments.11 In Tsiaprailis v. The Queen, the Supreme Court of Canada articulated atwo-stepprocessforapplyingthesurrogatumprincipletoresolvetheissueoftheappropriatetaxtreatmentofasettlementpayment:(1)[W]hatwasthepayment</p><p> 4 Foradescriptionofthetaxationofdamagesingeneral,seeJoelA.Weinstein,Damages,Fines,andPenalties:AnUpdate,inReport of Proceedings of the Fifty-Second Tax Conference,2000ConferenceReport(Toronto:CanadianTaxFoundation,2001),7:1-33.</p><p> 5 Anarrowexceptionisprovidedforinparagraphs81(1)(g.1)and(g.2),whichprovidethatincomeearnedondamageawardsisexemptfromtaxifpaidtoplaintiffsunder21yearsofage.</p><p> 6 DepartmentofNationalRevenue,Interpretation BulletinIT-365,Damages,SettlementsandSimilarReceipts,March21,1977,paragraph5.</p><p> 7 See,forexample,IT-365R2,supranote2.</p><p> 8 [1978]CTC1(FCTD);revg.[1976]CTC2292(TRB).</p><p> 9 See,forexample,CRAdocumentnos.2006-0187391E5,February5,2007,and9932545,January10,2000.</p><p> 10 [1966]SCR532.</p><p> 11 ThesurrogatumprincipleoriginatedinthecaseofLondon &amp; Thames Haven Oil Wharves Ltd. v. Attwooll,[1967]2AllER124(CA).Foradiscussionofthesurrogatumprinciple,seeMarthaOBrien,Surrogatum,Source,andTsiaprailis:IsThereaPrincipledBasisfortheTaxTreatmentofReplacementPayments?(2006)vol.54,no.4Canadian Tax Journal862-906.</p></li><li><p> taxing personal injury damages n 581</p><p>intendedtoreplace?And,iftheanswertothatquestionissufficientlyclear,(2)wouldthereplacedamounthavebeentaxableintherecipientshands?12Ineffect,thecourtsinCirellaandJenningsappliedthesurrogatumprincipletocharacterizethenatureof the damages by determining whether the damages replaced lost income or adamagedordestroyedcapitalasset.Asnotedabove,inbothcases,thecourtscon-cludedthatpersonalinjurydamagesforlossofearningsreplacedacapitalasset.</p><p>ItisnotablethatthecourtinCirelladidnotconsiderwhetherthedispositionofthecapitalassetcouldleadtoacapitalgain.Thetaxationyearreassessedinthatcasewas1972,thesameyearinwhichcapitalgainsbecametaxable.Arguably,thetran-sitionalruleinincometaxapplicationrule26(1)couldhavebeenappliedtoarguethatthedamagesshouldnotbesubjecttothenewregime.Therulestatesthattheprovisions imposing tax on capital gains apply only to dispositions of propertymadeafter1971,andinCirellatheaccidentleadingtothedamages(andthereforethedispositionofproperty)occurredin1968.WhateverthereasonforexcludingthisanalysisfromthedecisioninCirella,itiscertainlyrelevanttodiscussthepossibilityoftaxingpersonalinjurydamagesasacapitalgain.</p><p>Assumingthatthereisadispositionofcapitalpropertyuponpersonalinjury,thetaxpayerscost(orbasis)ofthatassetwouldhavetobedeterminedinordertocalcu-latethecapitalgainorloss.Althoughtheliteratureonhumancapitaldiscussedlaterinthearticlesuggestsapositivebasis,itisextremelydifficulttoascertaintheexactamountofbasisinapersonsworkingcapacityorcapacitytoenjoylife,andasare-sult,itwouldbenearlyimpossibleforacourttodeterminetheamountofagainorlosswithanyprecision.ThispracticaldifficultymaybeoneexplanationfortheCRAsdecisionnottoimposetaxonpersonalinjurydamages,and,alongwiththegeneralstateofuncertaintywithrespecttotheapplicationoftheActtopersonalinjurydam-ages,itisapersuasivereasonforlegislativechange.</p><p>Theliteraturediscussingthetaxationofpersonalinjurydamagesisreviewedinthenextsectionofthearticle.MostofthepublishedarticlesonpointoriginateintheUnitedStates,where,unlikeinCanada,thelawonthetaxationofpersonalinjurydamageshasbeencodified, in section104(a)(2)of the InternalRevenueCode.13Commentatorshavespeculatedthatthepolicyunderlyingthepredecessortosec-tion104(a)(2)wasthatpersonalinjurydamagesshouldnotbetaxedbecausetheyareareplacementofcapital.14In1996,section104(a)(2)wasamendedaspartofthe</p><p> 12 [2005]DTC5119,atparagraph15(SCC).InTsiaprailis,theamountinquestionwasintendedtoreplacepastdisabilitypayments,whichwouldhavebeentaxableinthehandsofthetaxpayer.Therefore,thedamagesrepresentingcompensationforlostpastbenefitsweresubjecttotaxundersubparagraph6(1)(f )(ii).</p><p> 13 InternalRevenueCodeof1986,asamended(hereinreferredtoastheIRC).</p><p> 14 SeeLauraSagerandStephenCohen,DiscriminationAgainstDamagesforUnlawfulDiscrimination:TheSupremeCourt,Congress,andtheIncomeTax(1998)vol.35,no.2Harvard Journal on Legislation447-508,at452;andJ.MartinBurkeandMichaelK.Friel,TaxTreatmentofEmployment-RelatedPersonalInjuryAwards:TheNeedforLimits(1989)vol.50,no.1Montana Law Review13-47.</p></li><li><p>582 n canadian tax journal / revue fiscale canadienne (2010) vol. 58, no 3</p><p>SmallBusiness JobProtectionActof1996torestrict theexemptiontopersonalinjurydamagesforphysicalinjuries.15The1996changeshavebeencriticizedasbeingarbitrary,16unjustifiable,17andeveninvidious,18butthusfar,theyhavewithstoodconstitutionalscrutiny.19</p><p>The DebateTheAmericanliteraturehasexaminedanumberofthepossiblejustificationsforexemptingpersonal injurydamagesfromtax.Inthissection,I introducethekeyargumentsthatappearinthedebate.Theliteraturethatitisrelevanttothepolicyanalysiswillbediscussedinmoredepthinthenextpartofthearticle.</p><p>NumerousAmericanauthorshaveexaminedthepossibilitythattheexemptioncanbejustifiedonhumanitariangrounds,basedonsympathyandpityforinjuredplaintiffs.Forexample,YoriotakesnoteoftheemotionalandtraditionalfactorsthatmayunderlietheexemptioninIRCsection104(a)(2).20Heconcludesthatthisexplanationisneitherlegallynorlogicallyconvincing,sincesomedamagesthatareexemptdonotevokesympathy,whileotherdamagesthatarenotexemptcouldinvolveanemotionallyupsettinginjury.21Similarly,SagerandCohendismissthisjustificationbecausetheexclusionappliestominorinjuries.22Thehumanitarianjus-tificationhasalsobeendismissedonthegroundsthatitiscontrarytothegoalsofdisabilitypolicy.23Sinceithasbeendiscreditedintheliterature,sympathyisnot</p><p> 15 Pub.L.no.104-188,110S...</p></li></ul>

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