How to avoid paying taxes on settlement money in class actions

If you think taxes and injuries have no business mixing with each other, think again. 

In personal injury cases, including class action lawsuits, there may be instances where the government gets a share of that settlement money. However, there are also many ways to avoid paying taxes on settlement money in class action lawsuits.  

In this article, we’ll discuss these methods and more about the basics of class actions in relation to taxes. 

How are settlement money in class actions taxed in Canada? 

Generally, settlement money is exempt from taxes, whether it’s for general or special damages. However, there are some parts of a settlement money that are not exempt from taxation, either by law or applying the surrogatum principle. 

Settlement money, whether it’s for a class action or any other personal injury case, is taxed similarly with compensation and damages awarded by the court. This means that even though a settlement may be reached by the parties, and with the court’s approval of the settlement, it’s still equated as a court-awarded damages for taxation purposes. 

Under Canadian tax laws, settlement money or award of damages will be taxed depending on what it intends to replace for its recipient. This is called the surrogatum principle, which is followed by the Canadian Revenue Agency (CRA). To determine how settlement money should be taxed, the question would be what its nature and purpose are. 

Further, the tax exemption of settlement money does not distinguish on the type of damages that are awarded to the plaintiff. Canada’s laws on torts and personal injury provide for two common types of damages: general and special. These two types will also play a role in determining how settlement money in class actions is taxed. 

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Surrogatum principle in settlement money 

Simply, if the money that you received is meant to replace your taxable income (salaries, wages, other benefits), then that’s also taxable, applying the surrogatum principle. The thought behind it is that, under usual circumstances, you would’ve earned it and it would be part of your taxable income. It’s just that it is now given to you in the form of settlement money or compensation for damages. 

How the surrogatum principle applies 

In Tsiaprailis v. Canada, 2005 SCC 8, the Supreme Court explained how the surrogatum principle applies. Under this principle, to determine whether the damages or settlement money are taxable or not, the Court says that the taxability will depend on the nature of the settled interest. 

In the words of the Court, it then presented two determinative questions:  

• First, what was the payment intended to replace? 
• Second, would the replaced amount have been taxable in the recipient’s hands? 

Here, part of Tsiaprailis’ settlement was meant to replace her past disability payments. This would’ve been taxable, even if it was paid to her. As such, this part of the settlement money is taxable under the Income Tax Act (ITA), applying the surrogatum principle. 

What components in a class action settlement money are taxable? 

Using the surrogatum principle and other regulations by the CRA, below are the items in a settlement money that are taxable. However, there are certain exceptions that you should take note of. 

When it’s tax-free, the CRA says that these are not just included in the taxpayer’s income, but also to the taxpayer’s dependents. This rule is relevant to class actions, since most of these lawsuits take years to resolve. In some cases, the original plaintiffs may have already passed away before the damages are awarded or a settlement is reached. 

Here’s a video of one of the largest class action settlements in Canada: 

If you need help regarding a class action, consult the Lexpert-ranked best class action law firms in Canada. 

Not taxed: General and special damages 

Award of damages for personal injury, such as in a class action suit, are excluded from the recipient’s income taxes. This rule does not qualify whether the damages are awarded by the court or agreed by the parties through a settlement. Nor does it matter if the award of damages was determined with reference to the lost income. 

Also, it doesn’t matter if it’s for general or special damages, even though these two are different under the law: 

• general damages: the compensation for the pain and suffering of the plaintiff, including loss of enjoyment of life and loss of earning capacity 

• special damages: the compensation for the actual and out-of-pocket expenses of the plaintiff (e.g. hospital expenses, past and future lost earnings) 

Taxable: Replacement on income 

The exception is when the amount is considered as a replacement for the recipient’s income from employment. Even though it’s considered as one of the special damages, it has become taxable because it replaces something that is taxed in the first place. Again, the surrogatum principle applies. 

Not taxed: Interest on damages 

In class actions, interest may be included in the settlement money or judgment damages. Interest is not taxable and not a part of the plaintiff’s income in their returns.  

This includes the interest earned by the damages, which are also not taxable. Interest is usually earned when there’s a delay in giving the compensation to the plaintiff or when it’s specifically stated in the court order or settlement. 

Taxable: Interest earned on damages held in a deposit account 

However, when the award of damages is held on deposit, the CRA says that the interest earned out of this award will be taxable. In such a case, the earned interest will be included in the recipient’s income for income tax purposes. 

The exception to this is if the recipient is under 21 years old, as stated in the ITA. This only applies when the income is received during the tax years before the recipient reaches the age of 21. 

Not taxed: Punitive damages 

Another component of compensation in a class action that is not taxed is punitive damages. These, however, are not typically included in a settlement agreement, since they are court-adjudicated damages. While special and general damages can be agreed by the parties, punitive damages are rarely included in a settlement agreement. 

Regardless, when it’s awarded to the plaintiffs in a class action (e.g. when the case was not settled and trial continued), it’s still excluded from their income tax. 

Summary: taxable and non-taxable items in a settlement in a class action 

What are the ways to avoid paying taxes on class action settlement money? 

Unlike in other personal injury cases, settlement in a class action must be approved by the court that handles the proceedings. This puts the issue of taxation out in the open court, especially as the court can disapprove a settlement if it’s unfair or it’s not in the best interest of the suing class. 

Still, there are some similarities when it comes to the methods of avoiding paying taxes on settlement money in class action lawsuits. We’ll discuss some of these methods below: 

Talk to your class action lawyer before settling 

While the whole process of a class action may be confusing, there’s no other way but to talk about it with your own lawyer. In settlement negotiations, class action lawyers are at the forefront in ensuring that your settlement money is framed in a way that minimizes your tax liabilities. Although some taxes may not be prevented in some instances, there can be ways to minimize them at the very least. 

Re-organizing the settlement agreement 

A settlement agreement is created by the will of the parties. This means that it can be organized in any way they can, for as long as they agree to all its terms. To avoid paying taxes on a class action’s settlement money, parties can devise the agreement by using most tax-free items. 

That is why you’ll wonder why there are some items in your settlement that seem misaligned or weird, especially when these involve a lot of items listed as damages. For instance, instead of putting them as a replacement for income, a settlement may designate them as part of special damages. This way, they become tax free. 

Of course, putting an amount in a non-taxable category is only possible if the recipient is entitled to such an amount under the settlement agreement. Otherwise, it would have to be categorized under a taxable amount. 

Using a structured settlement 

Another usual strategy to avoid paying taxes on settlement money, including class action lawsuits, is to create a structured settlement. The goal is to use this legal method to minimize the impact of tax on the amount to be received by the plaintiff. 

As a tax-free annuity, the plaintiffs in an action will gradually receive their compensation over time through the structured settlement. Similar with an installment basis, this version of releasing the damages or settlement money is usually compared to a lump-sum basis. 

Requisites for a structured settlement 

The CRA says that structured settlements are tax free only if the following conditions are met: 

• damages are made to compensate a personal injury or death 
• the claimant and the casualty insurer agreed to do a structured settlement 
• the casualty insurer:   
• purchases a single premium annuity contract 
• remains liable to pay the claimant under the settlement agreement 
• the contract: 
• cannot be assigned, converted, nor transferred to another 
• directs the issuer to directly pay the claimant 

Factors to consider in a structured settlement 

When entering a structured settlement, here are the factors that plaintiffs should look at: 

• total amount to be invested 
• term or total period of the payments 
• frequency of doing the payments 
• start and end date of the contract 
• when lump sum payments may be allowed 

All about numbers: How to avoid paying taxes on settlement money in class actions 

Regardless of the number of litigants, there are a lot of ways to avoid paying hefty taxes when a settlement is reached in a class action lawsuit. While still being cautious of not committing tax evasion, it’s better to consult a class action lawyer on how a settlement can be structured to minimize the impact of taxation. In any case, legal counsel is important, so that litigants can enjoy their rightful settlement money, without too much tax burden. 

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