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Taxes — one of the things that we dread, simply because it reduces our hard-earned income. Similarly, it is also the last thing that we want in our settlement money. But while Canadian law provides that some items in a personal injury settlement are taxable, there are some amounts that are (thankfully) non-taxable.
In this article, we’ll discuss what are tax-exempt when it comes to settlement and awards in personal injury cases. We’ll also show the methods you can use to avoid paying taxes on settlement money, legally.
Are personal injury settlements taxable in Canada?
The tax treatment of personal injury settlements is found in the federal Income Tax Act (ITA), and its IT-365R2. Generally, the ITA provides that personal injury settlements and compensation awards are non-taxable.
However, there are exceptions to this rule, where a part or the whole settlement money you’ll receive may be taxed by the Canada Revenue Agency (CRA).
When the law speaks of what is taxed or not, note that it does not distinguish whether it’s from an out-of-court settlement, a judgment from the court, or an award from a jury.
What is taxable in personal injury settlements
Following the surrogatum principle in taxation law, the settlement or damages will be taxed or not, depending on what it intends to replace. If it replaces the victim’s employment income, such as severance pay, then it will be taxable as part of their income.
What happens with the settlement or damages after it has been received will also affect its taxability. If the amount is invested, taxes will be applied on the interest of that investment. This applies whether it’s held on a deposit or on a trust.
Have a look on how personal injury lawyers can help you calculate your compensation or settlement money in case of an accident:
Looking for a lawyer to consult with about your personal injury case or the effects of taxes on your settlement money? Check out this directory of the best personal injury lawyers in Canada as ranked by Lexpert.
What is tax exempt in personal injury settlements
The ITA provisions that give life to this tax exemption of personal injury settlements are in Section 81(1)(g1) and (g2). These provisions exclude from the computation of one’s taxable income:
- the personal injury awards they receive; these are damages given for one’s physical and mental injuries
- the taxable capital gain when they dispose a personal injury award property
Looking at it differently, there are also other components of the total compensation for damages that are tax-free, such as:
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special damages: these compensate the victim for their out-of-the-pocket expenses to physically and mentally recover from the injury (e.g. medical bills, lost wages)
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general damages: also called damages for pain and suffering, these damages are not considered an “income” per se and is therefore not taxable
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punitive damages: these are tax exempt damages that are awarded by the court or the jury to deter the defendant or anyone from committing future similar conduct
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damages for human rights violations: compensation for an employee whose human rights, under a federal or provincial statute, was violated is free from tax
These exemptions also apply the surrogatum principle; since it’s not meant to replace your taxable income, then it’s not taxed.
What are the ways to avoid paying taxes on settlement money?
“Avoiding” the paying of taxes is misnomer, as it may lead to tax evasion, which is illegal in Canada. However, there are allowed methods that you can use to minimize the impact of taxation on the settlement amount that you’ll be receiving.
Here are some best practices, that are both acceptable and legal, to reduce the taxes you may have to pay on your settlement money:
Allocating settlement amounts
Whenever justifiable and within the bounds of tax laws, settlement amounts can be allocated to non-taxable amounts (e.g. general or special damages). However, parties are cautioned not to over-allocate these amounts, as it may result in the amount being required to be reported with the CRA.
Receiving compensation through structured settlements
Instead of a lump sum, you may want to receive your settlement money through a structured settlement. Here, you’ll be receiving the amount due to you in instalments, in a manner agreed upon (e.g. weekly, monthly, biweekly, quarterly).
Structured settlements are tax exempt because these are still in the form of awards for personal injury. A tax-free structured settlement is defined by IT-365R2, which has the following conditions:
- made for a claim for damages in respect to a personal injury or death
- agreed by the receiver and the defendant’s insurer that periodic payments will be made, either for either a fixed term or for the recipient’s life
- purchased through an annuity contract by the defendant’s insurer
- non-assignable, non-commutable, and non-transferable
- has an irrevocable direction to the issuer to make all payments agreed upon
The insurer is then responsible to report the:
- the structured settlement as non-taxable payments for damages; but
- the interest as income of the annuity contract
Aside from being exempt from tax, another advantage of structured settlements is that it ensures the constant flow of money for your regular needs.
Investing in tax-free accounts
Another possible way to minimize your tax liability is simply to reduce your taxable income. Spending the settlement money in a wiser way is important, so that it will not add to your tax burden.
One method that you can do is to invest this money in a tax-free account, or those which are taxed minimally. Some examples of these accounts are:
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Tax-Free Savings Account (TFSA)
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Registered Education Savings Plan (RESP)
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Registered Disability Savings Plan (RDSP)
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Registered Retirement Income Fund (RRIF)
Of course, it’s better to consult with a personal injury lawyer before considering these options. They will know the appropriate ways to minimize the paying of taxes on settlement money based on your case.
Talk to the best Canadian law firms for personal injury cases to learn more about how to avoid paying taxes on settlement money.