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.
