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.