Name of case: Tsiaprailis v. Canada

Supreme Court Panel: Justices John Major, Michel Bastarache, Ian Binnie, Louis LeBel, Marie Deschamps, Rosalie Abella and Louise Charron

Court appealed from and date of judgment: Judgment of the Federal Court of Appeal, dated March 17, 2003.

Facts: Seriously injured in a 1984 car accident, Vasiliki Tsiaprailis received long-term disability benefits under an insurance policy carried by her employer until 1993, when insurer Manulife terminated the benefits because it claimed she was no longer totally disabled. She sued, and accepted a settlement in 1996. In the negotiations leading up to the settlement, Tsiaprailis initially sought $150,000, comprising 177 weeks of benefits arrears plus interest, 75% of future benefits calculated to her 65th birthday, and additional amounts for such items as drug expenses. The final settlement, however, was for an "all-inclusive" sum of $105,000. As part of the settlement, Tsiaprailis signed a release which stated: "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."

The Minister of National Revenue reassessed Tsiaprailis for the 1996 taxation year to include the full $105,000 as income, based on s.6(1)(f) of the Income Tax Act, which provides: "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." Tsiaprailis appealed her assessment to the Tax Court of Canada, arguing that the lump sum payment was not income from employment or a disability insurance plan, but rather was made pursuant to an agreement that settled a disputed obligation.

Case history: Associate Chief Justice Donald Bowman allowed Tsiaprailis' appeal, ruling that s.6(1)(f) did not apply since "[t]he lump sum payment arrived at after a law suit 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.' " In addition, Bowman rejected the government's argument that the payout counted as income under s.6(1)(a) of the Income Tax Act, a section of general application that includes as employment income "the value of…benefits of any kind whatever received or enjoyed by the taxpayer in the year in respect of, or in the course of, or by virtue of an office or employment." Applying the statutory interpretation rule expressio unius est exclusio alterius [expression of one thing means exclusion of another], Bowman held that a section of general application such as s.6(1)(a) could not be used to sweep into income an amount which did not fit within the more specific provision. "It is not this court's role to dream up imaginative ways of taxing disabled people on lump sum settlements that they receive from insurance companies," Bowman declared. "If Parliament thinks that its revenues are in jeopardy because it does not get its tax on such payments it can amend the legislation."

The Minister of Revenue appealed Bowman's decision to the Federal Court of Appeal, which allowed the appeal in part by a 2-1 majority. Writing for the majority, Judge Denis Pelletier observed that Tsiaprailis' settlement extinguished two different claims she had against the insurer: one for unpaid arrears, and one for the right to receive benefits in the future. Pelletier noted that, in general, Canada's tax courts have held that lump sum settlements of disability insurance claims do not count as income under s.6(1)(f), because they are not "payable on a periodic basis." However, Pelletier ruled that the part of Tsiaprailis' settlement that was paid in satisfaction of accumulated arrears was taxable under s.6(1)(a) of the Act, "because, even though it was paid as a lump sum under the compulsion of litigation, it was in respect of amounts 'payable on a periodic basis.'" On the other hand, Pelletier held that the portion of the settlement paid to Tsiaprailis in satisfaction of any future entitlement was not taxable, because "[a]n insured can agree to surrender his or her rights, thereby extinguishing the insurer's liability, in return for a payment. The fact that the parties choose to negotiate the value of that right/obligation by reference to the amounts which could become payable under the policy … does not mean that the settlement is a pre-payment of the insurer's obligations under the policy."

Supreme Court's decision (4-3): The appeal was dismissed.

Reasons: In a 4-3 decision, the Supreme Court upheld the Federal Court of Appeal's decision and dismissed Tsiaprailis' appeal, ruling that the portion of the settlement that covered benefits arrears was related to periodic payments pursuant to a disability insurance plan and was therefore taxable.

Retroactive payments were "pursuant" to policy, Supreme Court rules

Writing for the majority, Justice Louise Charron adopted the Court of Appeal's holding that "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."

Since awards of damages and settlement payments are inherently neutral for tax purposes, Charron reasoned, the outcome of this sort of case must turn on the surrogatum principle defined in London and Thames Haven Oil Wharves Ltd. v. Attwooll, [1967] 2 All E.R. 124 (C.A), under which "the tax treatment of the item will depend on what the amount is intended to replace." Accordingly, she held that "[t]he 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?"

The answer to the first question, Charron determined, is that "it cannot be disputed on the evidence that part of the settlement monies was intended to replace past disability payments." As to the second question, "[i]t is also not disputed that such payments, had they been paid to Ms. Tsiaprailis, would have been taxable."

Charron accepted on behalf of the Court that the portion of the $105,000 that was paid in settlement of any future liability under the insurance plan was a non-taxable capital payment that was not paid "pursuant to" the plan, because there was no obligation under the terms of the plan to make such a lump sum payment. On the basis of the answers to the questions required by the surrogatum principle, however, the Supreme Court ruled that "the portion of the lump sum allocated to the accumulated arrears is taxable," and dismissed the appeal.

Dissent: bona fide lump sum settlement should not be "recharacterized" as payment

Writing for the minority, Justice Rosalie Abella opined that the entire lump sum should not be taxable, declaring: "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. 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 … [A]bsent 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 … 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."

Date of the Supreme Court's decision: February 25, 2005

Reference: For analysis, see Lancaster's Pension & Benefits E-Bulletin, Issue No. 15.

Full text of decision: http://www.lancasterhouse.com/decisions/2005/feb/scc-tsiaprailis.htm