Deduction – Page 4 – Doug Carroll

Adding insight to injury – Payment options for personal injury awards

We all hope to live healthy and productive lives, but sometimes fate can intervene in unexpected and unwelcome ways. When a person suffers a personal injury, the impact will often be both a shortened expected lifespan, and adversity in coping with new physical, mental and emotional challenges.

The premise underlying a personal injury legal claim is to make the injured individual whole again, understanding that money is at best a proxy for intact health. In large part this involves calculating the cost of future accommodations and rehabilitation, and rendering that back to a present value.

Having determined an appropriate figure, attention then turns to the form of payment, a decision very much guided by tax considerations.

Taxation of damage awards

Depending on the type of claim, damage payments may be taxable, non-taxable or a combination of the two. For example, commonly in employment disputes the bulk of the claim will relate to lost wages. As this would be compensation for loss of an otherwise taxable receipt, the substituted payment would itself be taxable.

A variety of types or ‘heads’ of damages may be claimed in a personal injury matter, with the key one generally being for loss of future earning capacity. On the face of it, that would seem to look a lot like that lost wages claim, but in fact — or rather, in law — there is a critical tax distinction between the two. Loss of earning capacity is considered the loss of a capital asset capable of producing income, not income itself.

Accordingly in our legal system, personal injury damages are generally non-taxable capital payments.

Origin of structured settlements

Structured settlements, or ‘structures’ as they are often called, extend the logic of a single damage payment to making a series of payments. If the purpose of the payment remains the same, the non-taxation should apply to either a lump sum or a series.

The basis for this tax treatment does not appear in the Income Tax Act directly, but is instead expressed through the Canada Revenue Agency’s administrative practice. Interpretation Bulletin 365R2 “Damages, Settlements and Similar Receipts” restricts the treatment to physical injuries. It applies where the damaging party acquires an annuity that is non-assignable, non-commutable, and non-transferrable to make payments for the agreed upon amount.

A key benefit of this approach is that it encourages the alleged offending party toward settlement. Commonly a lump sum award goes through a gross-up calculation to account for future taxes on investment growth. No such calculation (nor increased cost to the payor) would be required under a structure.

Court-ordered ‘structures’

A structure is an option available for a damage award, not necessarily a mandatory procedure. Still, when the claimant is under a disability a judge may be able to make such an order even if the claimant opposes, if the judge determines that it is nonetheless in the person’s best interests.

In a 2013 judgment, Melvin v. Ontario (Correctional Services), a judge considered whether to order a structured settlement. Thomas Melvin suffered brain injuries at the hands of two other inmates while incarcerated at an Ontario correctional facility in 1997. After four mediation attempts, the matter was eventually settled in 2012. As his litigation guardian, his mother had agreed to the amount of compensation, but subsequently opposed having it paid as a structured settlement.

In addition to submissions from the parties, a report was receive from the Public Guardian and Trustee. The judge allowed a small lump sum amount, but otherwise ordered a structure would be most appropriate for a number of reasons:

Little or no prospects for Mr. Melvin’s future employment
Predictable monthly income flows (with some indexing) without need for investment decision-making
The guardian Mrs. Melvin had no specific investment expertise to counter the guarantee and predictability of a structured settlement
Preservation of Ontario Disability Support Plan(ODSP) payments that would otherwise be at risk if the lump sum was owned, and/or when taxable income was earned
Associated benefits from being a continuing ODSP recipient, including better health care coverage

Investing a lump sum payment

Not all injured persons will be so affected that a full structured settlement is necessary. In such cases, some or all of the funds will be paid in the form of a lump sum.

This is a classic situation where a comprehensive financial plan is called for, before making any commitments. The tough balancing act will be to preserve current and future supports, while producing sustainable income.

Initial investment inclination may be toward guaranteed income options such as annuities. Again though, tax considerations should be carefully factored-in, perhaps a combination of annuity income and drawdown of capital from an investment portfolio.

Restricted farm losses – Chief income source rule reinstated

At issue

Like any other endeavour, farming can sometimes be a profitable undertaking, and at other times a losing proposition. Should losses arise in a year, the ability to deduct them depends on whether there had been an intention to undertake a commercial activity, and what other income sources the taxpayer may have had:

Where a farming business is the chief source of income, losses can be applied against other income sources, including 3 year carryback and 20 year carryforward.
At the other extreme where there is no expectation of profit – so-called ‘hobby farming’ – losses are not deductible, despite that any net income is fully taxable.
In between, where the “chief source of income … is neither farming nor a combination of farming and some source of income” [Income Tax Act s.31(1)], the ‘restricted farm loss’ rules apply.

It is this in-between category that is often a bone of contention between taxpayers and the Canada Revenue Agency (CRA). A formula is used to cap the amount of losses that may be claimed in a given year to $8,750. As with the chief income source, these losses may be carried back 3 years and forward 20 years, but can only be used against farming income.

A taxpayer win over the CRA at the Supreme Court of Canada (SCC) in 2012 drew the government’s attention, with a double-edged response making its way into the 2013 Federal Budget.

Moldowan v. The Queen, [1978] 1 S.C.R. 480

This SCC decision sets forth the three classes of farming taxpayers summarized above. On the facts, the Court found that Mr. Moldowan’s farming business was subordinate to his other sources of income, and therefore the farm loss deduction limitations applied.

This case has been considered and followed in dozens of subsequent cases.

Gunn v. Canada, 2006 FCA 281

In the approximate three decades that elapsed since Moldowan, there had been much criticism of the judgment. It required farming to be the chief source of income in both the first and second classifications, despite that nothing in the relevant ITA sections appears to require that.

In the Gunn decision, the Federal Court of Appeal sought to give effect to the word “combination” in the second classification, and declined to follow Moldowan.

Canada v. Craig, 2012 SCC 43

In Craig, both the trial and appeal courts followed the FCA in Gunn, effectively purporting to overrule Moldowan. The SCC in the present case remarked that the lower courts should have merely given reasons why they found Moldowan problematic, but otherwise followed it. Still, the matter now stood before the SCC.

The judges then proceeded to review the troubled history of Moldowan, and the concurrent development in legislative interpretation at the SCC. There is a delicate balance between the values of correctness and certainty when the top court considers overruling one of its own decisions, but in the end that is what it did.

The revised view of “combination” is to look at a variety of factors including capital invested, time spent, farming history and future intentions. If a taxpayer places significant emphasis on both farming and non-farming income, the combination suffices to be the chief source of income whether or not the farming income is greater.

Mr. Craig was entitled to his approximate $425,000+ losses for the two years in question.

Federal Budget – March 21, 2013

The Budget document briefly recaps the preceding history culminating in Craig, then proposes to restore the interpretation in Moldowan. Assuming passage of the Budget, for taxation years ending after March 21, 2013, “a taxpayer’s other sources of income must be subordinate to farming in order for farming losses to be fully deductible against income from those other sources.”

Concurrently, and in recognition that the deduction limits have not changed for 25 years, the formula will be amended to effectively double the annual deduction limit to $17,500.

Practice points

Certainty is an important part of legal and tax planning. Unfortunately for part-time farmers, it is now the certainty of being caught by the restricted farm loss rules where farming is not the chief source of income.
For those taxpayers with more modest farming losses than the six figure amounts in these high-profile cases, the doubling of the deduction limit is the good news in this development.

Deductibility of securities trading losses

At issue

Business losses incurred in the course of securities trading may be deductible to a taxpayer where it can be shown that they arose while the person was either a “trader” as defined under the Income Tax Act, or was otherwise engaged in an “adventure in the nature of trade”. To determine whether this latter characterization applies, a court will generally weigh five factors:

Frequency of transactions
Duration of holdings
Intention to acquire for resale at a profit
Nature and quantity of securities
Time spent on activity

Whether considering any one of the factors or the set of five together, there is no bright line test to know for certain that a given taxpayer has satisfied the requirements. So while there is plenty of case law fleshing out these factors, taxpayers who are at odds with the Canada Revenue Agency are often left to plead their unique facts before a judge.

Here’s how a few taxpayers fared recently in litigation.

Walsh v. The Queen, 2011 TCC 341

Mr. Walsh had retired from his chartered accountancy practice due to health issues, but wished to continue in a business that was compatible with his skill set. Eventually he settled upon securities trading, purchased a sophisticated software package and participated in both online and in-person training and discussion groups.

For the two years in issue, there was only a small amount of trading activity, but this was not determinative against him.

The claimed expenses were not aggressive attempts to allocate household expenses to a home-office or the like, but were specifically related to the investing activity. The bulk of them were however for training, and the relative timing of the outlays was critical. Rather than being in the preliminary exploitation of a business opportunity, Mr. Walsh was held to be in a pre-exploitation stage, and therefore the $26,500 losses were held to be personal and not deductible.

Zsebok v. The Queen, 2012 TCC 99

The taxpayer filed his 2001 to 2004 tax returns together in 2006, claiming business losses due to online trading. These losses were denied, and thus the appeal to the court.

Though trades occurred on only 5-10% of the available trading days, there was a discernible strategy for identifying highly volatile shares trading in high volume, and trades ensued therefrom. At one point, Mr. Zsebok even dipped into his RRSP account to fund his non-registered margin account, exacerbating the losses with the fact that he had to pay tax on those withdrawals.

At points the judge viewed the activities as “feverish”, “foolishly” undertaken, and in pursuit of “get rich quick dreams”, though in the end unsuccessful. Despite these impressions and misgivings about the late-filed returns, the issue before the court was whether the actions constituted an adventure in the nature of trade. On this point, the taxpayer won on 3 of the 4 years’ assessments.

Mittal v. The Queen, 2012 TCC 417

Reproduced in this judgment is a nine-part business plan that includes personal development goals, buy and sell rules, monetary and time commitments, and even a contingency plan: “Take one week off from the markets to reevaluate my trading, current market conditions, my risk management and my mental and emotional stability. If a vacation is necessary, take one.”

The business plan guided the investing activities of Mr. Mittal, a retired engineer and self-described workaholic. In the judge’s view, this was an organized and businesslike approach to investing, though ultimately leading to losses of almost $70,000 over two taxation years.

The combination of a well-documented plan and carefully tracked activities contributed to the judge’s ruling that there was a clear intention to conduct business activity, despite the lack of success. Together with the favourable findings on the other factors, Mr. Mittal was entitled to his deductions.

Practice points

Understanding the five factors will help a taxpayer decide whether it is worth the cost and aggravation to appeal an assessment.
The act of good recordkeeping can be strong evidence of a taxpayer’s intentions, on top of the obvious benefit of quantifying claims.
The implication of successfully claiming a deduction would likely be that trading gains would be fully taxable, rather than one-half treatment of capital gains. Accordingly, would-be claimants should obtain tax advice before taking a position, as this could have lifelong repercussions.