A recent technical interpretation from the Canada Revenue Agency (CRA) highlights the importance of seeking tax advice before entering into a settlement involving lawsuits over investment losses.

That’s because what the payment is meant to cover will be critical in how the money is taxed and could have a negative impact for either the investor or the investment firm and its financial advisor, says Ash Gupta, tax lawyer with Gowling Lafleur Henderson LLP in Toronto. It depends on how the payment is treated.

“A lot of people get really focused on the settlement itself and coming to the right dollar figure,” Gupta says. “Only then do they turn their minds to what the tax treatment is going to be.”

David Thompson, tax litigator in London, Ont., points out: “It really depends on what’s intended to be compensated.” Questions that should be asked include: “‘What was the damage done to you?’ and ‘What is the settlement intended to replace?'”

The tax treatment of settlements is something that arises regularly. Last year, the Ombudsman for Banking Services and Investments (OBSI) found that compensation was warranted in 37% of the cases it heard; firms agreed to pay more than $4.6 million in total for these cases. OBSI receives more than 400 complaints a year.

The CRA’s technical interpretation, issued on July 24, involves an unidentified couple who sued an investment firm for losses in their account due to unsuitable investments. The matter was settled out of court for an undisclosed sum, with no admission of wrongdoing by the investment firm. The couple wrote to the CRA asking whether the money was taxable.

The CRA responded in its interpretation by outlining that each case is fact-specific and based on the “nature and purpose of the settlement”: “In most cases, the parties to the settlement agreement are in the best position to make this determination.”

The CRA’s interpretation also notes that a settlement would be treated the same as a damages award in a judicial ruling. Under the Income Tax Act, money is taxable if it “constitutes income from a source or if a specific provision of the act applies to the type of payment…. In reviewing the tax consequences of a settlement, the essential question is to determine what the settlement was intended to replace.”

Thompson explains that a cornerstone of Canadian tax law is the “surrogatum principle,” which means a settlement has the same tax treatment as the amount it is intended to replace.

The CRA’s interpretation outlines three categories of payments: ordinary income, personal injury and a windfall.

Ordinary income. A settlement will be taxed as income if it compensates someone for the loss that replaces income from a business, property or employment source.

According to the CRA: “Any part of the settlement payment that was intended to compensate for investment income, which would have been earned had there been no negligence, would be considered income from property and taxable.”

However, a settlement that is received as compensation for loss or damage to a capital asset generally will be considered on account of capital and taxed as proceeds from the disposition of property, which has more favourable tax treatment than income.

Personal injury. If the settlement proceeds are to cover personal injury, emotional distress or losses from negligence, then the amount is exempt from taxes.

For example, according to the CRA: “If it is determined that the payment, or portion thereof, was compensation for actual financial losses resulting from the bad investment advice (i.e., tort of negligence), the payment or a portion thereof would likely be considered damages for personal injury and not taxable.”

Thompson notes that in Canada, courts tend not to award damages for emotional distress, but rulings and settlements often don’t delineate what’s being compensated, which makes taxation tricky.

Windfalls. Amounts considered to be windfalls are not taxable, but they require certain factors to be present. For example, the taxpayer made no organized effort to receive the money, had no enforceable claim to it, neither sought nor solicited the payment and had no expectation or reason to expect the payment.

The CRA interpretation notes that the payment in the instance involving the couple did not constitute a windfall because they sought compensation for their losses.

Gupta says the CRA interpretation highlights the importance of putting in writing what a settlement is intended to cover. From an investment firm’s perspective, he adds, the ability to write off payments depends on what those payments are designed to compensate. So, if a payment is intended to replace lost capital, that’s not something an investment firm can deduct.

But if an investor is suing to recover investment fees, Gupta says, those are payments a financial advisor would have incurred in running his or her business and would be deductible by the investor.

That’s why it’s important to consider the tax ramifications prior to a settlement.

© 2014 Investment Executive. All rights reserved.