Pre-judgment Interest: Introduction

Pre-judgment interest is possibly the least sexy topic imaginable. But there is perhaps no better vehicle for a discussion of the fundamental issues involved in financial loss quantification. Over the next four posts, I hope to explain what I mean by that.

A short article of mine dealing with a very large PJI award (over $70M) appears in this week's edition of Lawyers Weekly* (here). The court decision I discussed contains a useful discussion of some of the key issues relating to PJI, and I tried to summarize as many of them as I could within the claustrophobic confines of an 800-word limit, but there is much more that can be said. In the coming days, I will post on the following issues relating to PJI:

• What it is meant to measure, and whose rate should be used?
• The issue of hindsight and risk in financial loss quantification
• The interaction between capital, profit and interest.
• PJI and income taxes

*It has always bothered me that "Lawyers" is not a possessive form of the singular, but rather a nominative form of the plural. Unlike, say, "Men's Health". Confusing.

Why do I say that PJI is the perfect lens through which to analyse loss quantification? There is no noise, no uncertainty. By the time the court arrives at the point of calculating PJI, all of the inputs into the damages award have been decided - the grey areas have been shaded in, and the picture of what the "but for" world would have looked like has been sharply defined. All that remains is to translate the award for past damages into a current amount.

But the confusion is only just in fact just beginning...

Personal Injury Damages and Taxation

A couple of weeks back I posted on the issue of damages and taxation. The discussion was focused on awards in respect of lost profits. Someone asked me whether the same concepts apply to personal injury damages? The short answer is no. For a longer answer, please keep reading.

Personal injury damages occupy a unique position within the spectrum of financial loss calculations. The goal in quantifying financial losses is generally considered to be to return the plaintiff to the financial situation he or she would have been in if not for the wrongdoing.  Arguably, that is not what happens in many personal injury cases, and the reason has to do with income taxes.

Consider a simple example of Joe, a construction worker. Joe typically earns $70,000 per year and pays taxes at an average rate of roughly 30%; his typical after-tax income is normally $49,000 ($70,000 x (1-30%)). Assume Joes slips and falls on an icy sidewalk one winter, and his doctor says he will be unable to work for the next three years. The municipality, recognizing its wrongdoing, agrees immediately to compensate Joe for his loss of income. The question is, should the municipality pay Joe $70,000 per year (i.e. his lost pre-tax income), or $49,000 (his lost after-tax income)?

The Supreme Court, in R. v. Jennings et al., [1966] SCR 532, 1966,  discussed precisely this issue of whether income taxes ought to be deducted in calculating Joe’s loss of income. It argued that no deduction should be made (unless, of course, there is a specific statute – such as many of the various provincial Insurance Acts – to the contrary). Here is what the Supreme Court wrote:

It has been said that if the incidence of taxation on future earnings is ignored, the plaintiff is being over-compensated. With this I do not agree. A lump sum award under this head is at best no more than rough-and-ready compensation. There must be very few plaintiffs who are compelled to take a lump sum who would not be better off with their earning capacity unimpaired or a periodic reassessment of the effect of its impairment. There is, as things are at present, no possibility of such a reassessment. But mathematical precision is impossible in assessing the lump sum, and where large amounts and serious permanent disability are involved, I think that the award is usually a guess to the detriment of the plaintiff.

To assess another uncertainty—the incidence of income tax over the balance of the working life of a plaintiff—and then deduct the figure reached from an award is, in my opinion, an undue preference for the case of the defendant or his insurance company. The plaintiff has been deprived of his capacity to earn income. It is the value of that capital asset which has to be assessed. In making that determination it is proper and necessary to estimate the future income earning capacity of the plaintiff, that is, his ability to produce dollar income, if he had not been injured. This estimate must be made in relation to his net income, account being taken of expenditures necessary to earn the income. But income tax is not an element of cost in earning income. It is a disposition of a portion of the earned income required by law. Consequently, the fact that the plaintiff would have been subject to tax on future income, had he been able to earn it, and that he is not required to pay tax upon the award of damages for his loss of capacity to earn income does not mean that he is over-compensated if the award is not reduced by an amount equivalent to the tax. It merely reflects the fact that the state has not elected to demand payment of tax upon that kind of a receipt of money. It is not open to the defendant to complain about this consequence of tax policy and the courts should not transfer this benefit to the defendant or his insurance company.

In case you are like I am and cannot resist glossing over lengthy block quotations, what the Supreme Court alludes to – and what is in fact standard practice in personal injury damages – is that Joe will be entitled to compensation of $70,000 per year. There should be no deduction for income taxes in calculating Joe’s lost income; but Joe will not need to pay taxes on award either. In effect, Joe will be left with significantly more money, on an after-tax basis, than if he had not slipped on the icy sidewalk ($70,000 per year as opposed to $49,000).

There are a number of very interesting ideas – four of them to be precise - packed into the two paragraphs I quoted above, and it is worthwhile unpacking them. They are as follows:

      i.      Imprecision of any calculation: The SCC begins by arguing that the calculation of loss of income will never be very precise anyway, as there are many variables that are difficult to define with all but the broadest brush strokes. Tweaking our model to reflect income taxes would not add precision to what will always be at best a “rough and ready” estimate.

     ii.      Policy reasons: Calculations for loss of future income are one-time awards based on the best evidence available to the court at the time. The physical and emotional capacity of the plaintiff may take a turn for the worse; interest rates may be lower than expected. The court argued that it was better to err on the side of overcompensating the individual plaintiff, even at the expense of the defendant or his or her insurer.

    iii.       Capital asset: The plaintiff’s loss is that of a capital asset. The value of such an asset is equal to the value of its future net income on a pre-tax basis.

    iv.       Lack of legislation: The Canada Revenue Agency’s position is that awards (or settlements) in respect of losses due to personal injury are not taxable – see here (http://www.cra-arc.gc.ca/E/pub/tp/it365r2/it365r2-e.html). If the relevant legislatures are unhappy with awarding damages based on pre-tax income, they can easily remedy this. Alternatively, the Income Tax Act could be revised to make personal injury damages taxable.

Let us know explore each of these arguments in more detail.

The Imprecision Argument

As accountants, we are inclined to feel we can model and quantify everything with a high degree of accuracy; this is hard to accept at first. But of course, any model is only as good as its assumptions, and the real point of the court is that assumptions regarding hypothetical future events are inherently imprecise. The degree of random error in modeling the future income of any given individual will be high. To invoke a commonly invoked metaphor, damage awards are often carved with a “broad axe”, not a fine chisel.

This argument is fine as it goes, and it suggests, for example, that it might be appropriate to round all personal injury calculations to the nearest $100,000. But it is a logical stretch to say that because there will always be imprecision in our projections, we should ignore a factor that will always serve to lower the damages award. The plaintiff’s marginal tax rate may be uncertain; but, as was long ago pointed out, the existence of some degree of taxation is one of the few certainties in life. The solution to estimation difficulty is surely not to introduce systematic bias.

It is also pertinent at this point to discuss the issue of what is commonly referred to as an “income tax gross-up”. The argument in favour of applying such a “gross-up” is that since the investment income earned on the lump sum settlement will be taxable, it is necessary to compensate the plaintiff with an amount sufficient to offset these taxes. But if one of the main reasons for ignoring taxes is simply to produce a calculation that is “rough and ready”, it would seem counterproductive to then go on to introduce an oftentimes complex upwards adjustment due to the very same income tax considerations.

The Policy Reasons Argument

This brings us to the second reason for not deducting taxes. The court argued that we would prefer to err on the side of overcompensation rather than undercompensation. One way of doing so is to ignore income taxes (and, possibly, to apply a “gross-up” to the damages award).

There is certainly no denying that ignoring taxes will increase the chances that the plaintiff will receive his or her full compensation. But one might question the merits of introducing a factor that will always result in an upwards adjustment to whatever the trial judge might have thought was a fair award.

Capital Asset

This line of reasoning holds that the plaintiff is being compensated based on the impairment in the value of his or her “capital asset”. The argument contains two elements, each of which invites interesting avenues for analysis. These are as follows:

·     Payment in respect of a capital asset is not taxable, even if the asset has a low “cost base” or historical cost.

·     The value of a capital asset is measured based on its pre-tax level of earnings or profits, discounted at an appropriate rate.

Concerning the first argument, it is important to note that Jennings was decided in 1966; this was before there were any capital gains taxes in Canada. While subsequent decisions of the SCC have confirmed the “capital asset” rationale insofar as it relates to personal injury damages and taxes (D Cirella v. The Queen [1978] CTC 1 (FCTD); rev’g. [1976] CTC 2292 (TRB)), it is unclear why there should be no taxable capital gain at all on the disposition of the individual’s ability to work. By comparison, if a business asset – a factory or piece of equipment – is damaged and proceeds are received, the transaction (unless the asset is being replaced) is deemed tantamount to a sale of the asset, and the normal tax rules of recapture and capital gains apply. See this paper for a further elaboration of this argument. 

As for the second argument, it is true that in business valuation, shareholder level taxes are not normally taken into account. The main reason for this is that a large portion of institutional investors who set market prices (e.g. pension funds or sovereign wealth funds) are non-taxable; taxes paid at the corporate level thus represent the totality of all taxes payable for these entities. In order to value an asset where some bidders are not subject to taxes below the corporate level, it is necessary to ignore shareholder level taxes, as the non-taxable investors will bid up the price of these assets.

It is difficult to see the relevance of this argument to individual labour. Anyone who is an employee is selling his or her labour based on an expected after-tax value; taxes are very much part of the equation for employees choosing between base salary versus deferred compensation or other forms of tax-favoured compensation.

(It is also important to note that the discount rate used in to convert future personal injury losses to a lump sum is in fact an after-tax discount rate, again dictated by the marginal bidders for risk-free assets such as government bonds. It is clear, in other words, that the plaintiff is receiving a pre-tax award.)

Legislation

I have relatively little to say concerning this last argument. In many provinces, legislation exists that deducts income taxes for personal injury cases involving motor vehicle accidents; some do so for past losses only, others for future losses as well.

Conclusion

Personal injury damages are subject to unique treatment when it comes to taxes. They are calculated on a pre-tax basis, yet are not subject to tax. As we have seen, there are a variety of reasons for this treatment, some of which may be more persuasive than others. But barring any further action by the CRA (in assessing taxes on such awards) or the legislatures (in requiring the deduction of taxes in computing the awards), this unique treatment will continue to exist.

Financial Statements, Disclosure and the Arthur Wishart Act

The topic of what types of financial statements must be included in a disclosure document in order to comply with the disclosure requirements of the Arthur Wishart Act (“AWA”) was discussed at a recent dinner put on by the OBA’s Franchise Law section. This brief post attempts to clarify a number of the issues relating to this topic, some of which were raised during the course of one of the presentations. (The analysis presented here is my own, and not necessarily that of the presenters at the dinner).

Background

Section 5(4)(b) of the AWA requires that the disclosure document include “financial statements as prescribed”. Section 3 of the Regulations defines these financial statements as follows:

 3.  (1)  Every disclosure document shall include,

(a) an audited financial statement for the most recently completed fiscal year of the franchisor’s operations, prepared in accordance with generally accepted auditing standards that are at least equivalent to those set out in the Canadian Institute of Chartered Accountants Handbook;

(b) a financial statement for the most recently completed fiscal year of the franchisor’s operations, prepared in accordance with generally accepted accounting principles that are at least equivalent to the review and reporting standards applicable to review engagements set out in the Canadian Institute of Chartered Accountants Handbook;

The Regulations then go on to identify certain exceptional circumstances in which such financial statements are not required to be disclosed.

Two types of standards

There are two types of standards that apply to financial statements.

The first are accounting standards, which govern how various transactions should be recorded in a company’s books and reported on its financial statements. For example, should an expenditure be capitalized (i.e. recorded as the purchase of an asset on the balance sheet), or should it be expensed (i.e. shown as a deduction on the income statement)? Different sets of accounting rules (e.g. Canadian generally accepted accounting principles (“GAAP”), US GAAP, International Financial Reporting Standards (“IFRS”)[1]) will have different standards or rules for how various transactions should be recorded.

The second are auditing standards, or (more properly) assurance standards. These speak not of the content of the financial statements, but rather of the degree of investigation undertaken by the external accountants in verifying and providing assurance that the financial statements are not materially misstated. The highest level of assurance is an audit, which provides a positive level of assurance that the financial statements are not materially misstated. Below the level of an audit is a review engagement, which provides only negative assurance (“nothing has come to our attention that causes us to believe that the financial statements are not prepared, in all material aspects, in accordance with (insert name of applicable financial reporting framework…”). Review engagements consist only of inquiries and discussion with management and analytical procedures.

Section 3(a) of the Regulations

The phrasing of section 3(a) is unclear.

The regulation begins by speaking of how the franchisor’s financial statements are “prepared”.  However, financial statements are “prepared” by its management, not its external auditors. When section 3(a) therefore speaks of how the financial statements were “prepared”, it is presumably a reference to the content of the financial statements, and in particular the accounting rules that were followed in presenting items on the statements. But section 3(a) does not tell us which accounting standard must be used.  For example, Canadian GAAP? US GAAP?  IFRS? Section 3(a) does not say.

What section 3(a) does say is that the financial statements must be “in accordance with generally accepted auditing standards that are at least equivalent to those set out in the Canadian Institute of Chartered Accountants Handbook”.  "Auditing” standards, not “accounting” standards. There is no reference to Canadian GAAP in section 3(a).

Therefore, one possible reading of section 3(a) might therefore be that if financial statements were prepared based on some foreign set of accounting standards – even if they are completely different from Canadian accounting standards - but were audited to a degree of assurance equivalent to a Canadian audit engagement, those financial statements would be acceptable.

Section 3(b) of the Regulations

Section 3(b) is also imprecise, but for a different reason.  It speaks of statements “prepared in accordance with generally accepted accounting principles that are at least equivalent to the review and reporting standards applicable to review engagements set out in the Canadian Institute of Chartered Accountants Handbook”.

Breaking this down, this section begins by describing GAAP - accounting principles - but then goes on to refer to those standards as being equivalent to the “review and reporting standards” (i.e. assurance standards) that apply to review engagements. Again, it mixes apples and oranges in comparing accounting standards to assurance standards. But there is – if one applies some syntactical reengineering – at least more of a suggestion here that we are concerned with the accounting standards being used in the financial statements as well as the level of assurance being provided, and that if the accounting standards are radically different from those used in Canada, the disclosure may be deemed insufficient.

Towards an Interpretation (?)

What is one to make of this terminological hodge-podge? It may make sense to step back to examine the issue from first principles.

It makes ample sense to speak of equivalency between assurance standards. Assurance standards will be universally applicable, regardless of the particular accounting standards to which they are applied. One can apply Canadian audit standards to a US GAAP financial statement, an IFRS financial statement, or any other type of financial statement.

However, what does it mean for one accounting standard to be “at least equivalent” to another? Does it mean that the treatment of the franchisor’s financial transactions must be equivalent and identical under US and Canadian accounting standards, and therefore that a US and Canadian financial statement will look exactly the same before the US financial statement can be included in an Ontario disclosure document? This seems unlikely because, if so, what does the phrase “at least” mean?  Either the two statements are equivalent or they are not; there are no degrees of equivalency under this definition. To say something must be “at least equivalent” implies that it can also be “more than equivalent” (which has an Orwellian ring to it), or “better”. How can one financial statement be “better” than the other?

Perhaps we can suggest an alternate explanation. Suppose that a certain expenditure is deemed to be an expense under US GAAP but a capital purchase (i.e. an asset) under Canadian accounting standards. Assuming all other transactions are treated identically, the US financial statement will show the franchisor to be in a worse financial position than the Canadian statement; they will show the franchisor as having fewer assets and less net income.

Suppose the franchisor is shown the US financial statement and proceeds, nonetheless, to purchase the franchise. It would be illogical for the franchisee to argue that, had it been provided with the Canadian statement it would not have bought the franchise, because the Canadian statements would show a rosier financial picture than their US counterparts. If the situation were reversed, however, such an argument might be plausible. Possibly, the degree of difference between the two versions might dictate whether a rescission remedy would be available under 6(1) or 6(2) of the Arthur Wishart Act, although what the relevant degree of difference would be is, to say the least, unclear.

Conclusion

Section 3 of the Regulations to the Arthur Wishart Act uses inconsistent terminology, and its intent is – at least in my layman's reading – murky. It is clear that the financial statements contained in a disclosure document must be either audited or reviewed, and the US and Canadian standards in this regard are essentially the same. As for whether US GAAP is an acceptable basis on which to present the financial statements –  I honestly don’t know.

---

[1] IFRS are the financial reported standards currently in place for Canadian public companies, having replaced Canadian GAAP several years ago.

Top Ten Most Common Errors in Damages Calculations – #1: Failure to Consider Saved Expenses

Towards the end of the Great War (or World War I as it came to be called), the American president, Woodrow Wilson, proclaimed Fourteen Points outlining his goals for the reconstitution of Europe, and the international state system as a whole, following the war. The French prime minister at the time, Georges Clemenceau, is purported to have remarked of the self-important American that even “Le bon Dieu n'en avait que dix!”.* For whatever reason, Top 14 lists have never really caught on; Top 10 lists remain en vogue. So, over the next little while, I will be posting on the Top 10 most common errors in damages calculations.

*Clemenceau failed to note, of course, that the Ten Commandments themselves actually contain more than ten commandments**. (Sorry, I am an accountant).

**Now, in fairness, the Hebrew Bible actually does not use the term “Ten Commandments” at all.

By far the most common error I encounter, especially from claims prepared by non-experts but also in occasional decisions of trial judges[1], is the failure to deduct saved expenses. People are generally well aware of their loss of revenue; they are generally less conscious of the fact that the event that caused them to lose revenue has also caused them to save certain expenses. The fact is, almost all situations involving a loss of revenue will also involve a savings in expenses.

All lost profit analyses can be expressed in the following equation. It is so fundamental that I have shown it in a red box:

Now, not everyone thinks in terms of red boxes; I, for one, prefer examples. So consider a simple example of a retail store that is forced to close by flooding originating from a neighbouring property. The store’s annual financial statements for the year preceding the flood are as follows:

 

 

The closure results in a loss of revenue. But it will save some expenses.

The store will certainly experience a savings in variable costs. Variable costs are costs that – you guessed it – vary in proportion to the level of business activity. For example, to make a sale, the store must give the purchaser the item he or she purchased; it incurs a “cost of sales”. This cost, in our example, has historically been equal to 2/3rds (or 66.66%) of revenue.

The store will also likely experience a savings in its fixed costs. Fixed costs are those that do not vary directly with small fluctuations in business activity, but which are affected by large changes in the business, such as a prolonged shutdown. In the case of our store, if the store is closed long enough the lease may contain a clause relieving the business from paying rent while it is closed; the store may lay off its staff. If the business closes permanently, the annual loss of profit may simply be the difference between the normal revenue and the normal expenses, which in the example of our store is $184,000.

This is, of course, a very schematized example. Calculating saved expenses can be very challenging in practice, in particular when the projected revenue levels contemplate significant growth (or contraction). I will discuss this issue more in future posts, but for now I leave you with this basic lesson:

Lesson: When a business experiences a loss of revenue, it will almost always also experience a savings in expenses. This savings must be offset against the revenue loss to arrive at a proper assessment of lost profits.

 

 

 

 

 

 

---

[1] For example, see 1397868 Ontario Ltd. v. Nordic Gaming Corporation (Fort ErieRace Track), 2010 ONCA 101, where the failure to deduct saved expenses resulted in the Ontario Court of Appeal ordering a new trial. It noted that:

 

[34]         I appreciate that the trial judge was confronted with a difficult task in assessing damages in this case.  However, her reasons explain how she came to the damages award and it is apparent that she did not account for the cost of sales.  Clearly, the cost of sales is an integral part of any loss of profits calculation.  Importantly, a deduction for the cost of sales could have a significant impact on the calculation of 139’s loss of profits.  In oral argument on appeal, 139’s counsel indicated that if 40 percent of revenues is used to calculate the cost of sales it would “decimate” the damages award.  Whatever the case, the failure to deduct the cost of sales could be significant.

Tax Rates, Timing and Damages II: Small Businesses

As a follow-up to yesterday’s post, I wanted to add that the same phenomenon of declining tax rates be observed for businesses that are eligible for the small business deduction. The following chart shows the small business tax rate since 2000:

 

In addition, the limit up to which a corporation can claim the small business deduction has also risen over the years, from $200,000 in 2000 to $500,000 in 2014. As a result, a business receiving a damages award in 2014 as opposed to 2000 will pay less corporate tax.

I underline the word “corporate”, because in many instances of business disputes involving small companies, the shareholder(s) of the plaintiff corporation are also named as parties to the suit. While there are no doubt different legal considerations that go into the decision to name individual plaintiffs, as a general rule when a dividend is declared to the individual shareholder, the combined taxes payable at both the corporate and personal level will be very close to the taxes that would have been payable had the income been earned by an unincorporated entity. In such situations, changes in the small business rate over time will (arguably) be largely irrelevant.

Tax Rates, Timing and Damages

The deadline for most individuals in Canada to file their income taxes is today, so I thought I would post on the issue of damages and taxation.

In Canada, as a general rule, damages awards are subject to the same tax treatment as the monetary amounts they are meant to replace. For example, awards for lost profits are taxed as business income.[1] Litigation can often take a long time to resolve; some lawsuits span decades. What happens when the tax system undergoes significant changes between the year the lost profits would have been earned and the year in which the damages award is paid?

In Canada, corporate tax rates have fallen significantly in recent years. The following chart shows the combined corporate tax rate for income earned in Ontario for income not subject to the small business deduction. Rates have fallen from slightly over 50% in the 1960s to under 30%. This can have a significant impact on damages calculations:

Consider the case of Eli Lilly and Company v. Apotex Inc.,2014 FC 1254. Apotex was found to have infringed Eli Lilly’s patents for the drug cefaclor; after many years, in late 2014 the court awarded Eli Lilly approximately $31M in damages resulting from the infringement over the period 1997 to 2000.

There is no discussion of income taxes in the written decision, and it is not clear if the issue was raised at trial. I refer to this case simply to illustrate the concept, and impact, of differential tax rates.

Had Eli Lilly and its Canadian subsidiary not been deprived of their lost profits in the period 1997 to 2000, they would have paid an average income tax rate of roughly 35% for sales made in Ontario; rates were similar in most other provinces. By comparison, on receiving its damages award in 2014 or 2015, Lilly will pay taxes at a rate of around 26.5%, a differential of 8.5%.

Had Lilly earned the profits in question in the period 1997 - 2000, its after-tax profit would have been $31M x (1-35%) = $20.15M. Receiving the same profit in 2014, the after-tax value is$2.64M higher. This is a factor that should have been taken into consideration in assessing, (and reducing) Lilly's losses.

Stated otherwise, had the court wished to give Lilly an award in 2014 that would equate to $20.15M in after-tax dollars (the amount of after-tax profit it would have received in 1997-2000), the award should have been $27.4M, or $3.6M less than the actual award ($27.4M x (1-26.5%) = $20.15M).

Considering that prejudgment interest of $75M was also awarded on the damages assessed - and I will return to this spectacular prejudgment interest award in future posts - the issue of declining tax rates likely represented a $10M issue in this case.

---

[1] http://www.cra-arc.gc.ca/E/pub/tp/it365r2/it365r2-e.html