Settlements: Tax Outcomes Every Litigator Needs to Know

Damages, settlement payments and indemnity payments frequently arise as a result of disputes in the commercial context. The income tax treatment of such payments can significantly impact their financial consequences for both the payor and recipient.

Depending on their characterization, such payments may be fully taxable, partially taxable, and in certain cases, non-taxable. This article highlights key tax implications and planning strategies relevant to the taxation of settlement and indemnity payments, and discusses the importance of considering the tax implications of such payments to optimize financial outcomes and minimize tax liability when the circumstances allow for it.

Not All Damages Or Settlement Payments Are Equal (After Tax)

When determining the tax consequences of a settlement or damages payment, the payment should generally be characterized in the same manner as what it is intended to replace (e.g., business income, capital property, or salary). 

In the commercial context, damages and settlement payments are generally received as either business income or as a capital receipt. If a payment is received as business income, the payment should be fully included in computing the recipient’s taxable income. For the payor, if the payment is treated as a business expense, it should be fully deductible in computing the payor’s taxable income from that business.

If the payment is instead characterized as a capital receipt, only one-half of the capital gain should generally be included in the recipient’s income; however, this is not always the case. For example, an indemnity payment received by a purchaser under a share purchase agreement may reduce the purchaser’s adjusted cost base in the purchased shares, as discussed below. For a payor, the treatment of a payment that is made on account of capital will depend on the circumstances.

In other contexts, it is possible for payments to be made as compensation for reputational damage, suffering, injury or death; such payments are generally non-taxable windfalls and not included in the recipient’s income.

As a numerical example, consider a settlement payment of $100,000. If the payment is treated as business income to the recipient, the payment is fully included in the recipient’s income. Assuming the payment is subject to a corporate tax rate of 26.5%, the tax payable by the recipient on the payment is $26,500, leaving only $73,500 of after-tax proceeds available to the recipient. However, if the payment is treated as a capital receipt that gives rise to a $100,000 capital gain, only half of the payment (i.e., $50,000) is included in the recipient’s income. Accordingly, the recipient pays $13,250 of tax on the payment (i.e., 26.5% of $50,000), leaving $86,750 in after-tax proceeds. From the payor’s perspective, a settlement payment on income account may be fully deductible, contrarily to a payment on capital account.

Securing the Appropriate Outcome

In some cases, there might be potential for flexibility in the tax characterization of damages, settlement and indemnity payments. In the case of damages imposed by a court, the judgment typically outlines the purpose for which they are paid. This being the case, at the outset of litigation, it can be beneficial to consider the tax characterization of the damages sought. Initial pleadings can guide the court’s ultimate determination of the tax characterization of such payments for tax purposes. Letters between the parties and their lawyers, side agreements and testimony may also prove influential.

In the context of a settlement, when applicable, it may be advantageous for the recipient of a settlement payment to ensure that the settlement agreement includes language indicating that the payment is compensation for the loss of a capital asset. Alternatively, if the payment pertains to both damage to capital property and loss of income, the settlement agreement could specify the allocation of the payment as between being on account of income and on account of capital. However, there are limitations on the extent to which a payment can be characterized in a settlement agreement. The nature of the settlement payment depends not only on its language, but also on the totality of the circumstances. In such context, to ensure that a taxpayer receives a specific after-tax amount, contractual provisions providing for a gross-up for potentially applicable taxes could be negotiated. Basically, the tax authorities (and courts) will determine for themselves what the damage payments are for, but properly structured documentation can help shape how the payments are treated. However, the form of the transaction entered into cannot be completely inconsistent with its true business substance, taking into account the nature and the source of the claim in issue.

Indemnities in Share Purchase Agreements

Most standard share purchase agreements include indemnity provisions requiring the vendor to compensate the purchaser for breaches of representations and warranties or other covenants in the agreement.

The tax implications of a vendor receiving an indemnity payment under a share purchase agreement will depend on whether the recipient is the target entity or the purchaser. If the indemnity is paid to the target corporation, the tax authorities could take the position that the full amount should be included in the target corporation’s income in the year that it is received. If the indemnity is paid to the purchaser, the amount received should be treated as a downward adjustment to the adjusted cost base to the purchaser of the shares purchased; in other words, no immediate income inclusion results therefrom to the extent the damages are related to the shares acquired. For greater clarity and to remind the parties how to proceed when an indemnity has to be paid in a share purchase agreement context, the agreement should explicitly provide that indemnity payments will be made to the purchaser (not the target) as an adjustment to the purchase price. Often such a clause is included in the share purchase agreement.

If the receipt of the indemnity payment reduces the cost of the shares of the target held by the purchaser, then the purchaser should only be “taxed” on the indemnity payment in the year it disposes of the shares of the target corporation in the form of a greater gain or lesser loss. The capital gain or loss realized on the sale of the shares of the target should be subject to a 50% inclusion rate provided they qualify as capital property, and 50% of capital losses can be applied against capital gains under certain circumstances.

From the vendor’s perspective, an indemnity payment made in respect of a sale of a capital property is generally treated as a reduction to the vendor’s proceeds of disposition (resulting in a lesser gain or greater loss), if it is paid or payable on or before the vendor’s tax return filing-due date for the taxation year in which the sale takes place. If the indemnity is paid or payable after this time, it is deemed to be a capital loss of the vendor. Because a taxpayer is only permitted to carry back net capital losses for three years, the vendor should not be permitted to carry back any net capital loss arising from the indemnity payment to offset any capital gain realized on the sale, if the indemnity is not paid or payable for more than three years after the year of sale. However, in such a situation, the vendor should be entitled to carry back the net capital loss to offset any other capital gains realized in the three preceding taxation years, or to carry forward such net capital loss to offset any capital gains realized in subsequent taxation years.

GST/HST Considerations

The net value of indemnities and settlement payments can also be impacted by indirect tax considerations. Under Part IX of the Excise Tax Act (Canada), the goods and services tax (“GST”) or harmonized sales tax (“HST”) is generally required to be collected on the supply of taxable goods and services in Canada. In the commercial context, if a purchaser of goods or services pays GST/HST in the course of its commercial activities, it can generally recover the GST/HST paid in the form of an “input tax credit” in its GST/HST return for the reporting period in which the tax became payable or was paid.

In certain circumstances, indemnities and settlement payments can be deemed to include GST/HST, even if the agreement or judgment is silent as to whether the parties intended for the payment to be made inclusive or exclusive of GST/HST. This deeming rule applies where three requirements are met:

1. the parties entered a contract for the provision of a taxable supply in Canada;
2. there was a breach, modification or termination of that contract; and
3. as a result of such breach, modification or termination, the purchaser of the supply made a compensation payment (e.g., a damages payment) to the supplier otherwise than as consideration for the taxable supply.

Where this rule applies, the payment is deemed to be inclusive of GST/HST such that a portion of the compensation payment is made on account of GST/HST. Accordingly, the purchaser may be able to claim an input tax credit in respect of the portion of that payment that is deemed to be GST/HST; however, the amount of the payment received by the supplier should then be less than it would have been had this deeming rule not applied, since GST/HST is deemed to be included in the payment.

Because section 182 only applies in respect of payments made under a contract for a taxable supply from the purchaser to the supplier, but not to payments made from the supplier to the purchaser, it is often possible to structure the contract (or the settlement agreement) to mitigate its application. Additionally, as we alluded to earlier when discussing income taxes, the terms of the contract in question (or the settlement agreement) may be drafted to provide that the quantum of any such compensation payments will be grossed up such that the recipient is made whole for any applicable GST/HST. A payor, on the other hand, may wish for the settlement payment to be inclusive of GST/HST, and negotiate the drafting of the settlement agreement with this in mind. This is a critical point to consider whenever making payments to which section 182 might apply, especially when acting for the recipient of the payment.