Do I Pay Taxes on my Settlement?

By Matt Lalande in Questions on January 18, 2025

When it comes to case settlements, the tax implications largely depend on the nature of the compensation being provided to the plaintiff. As a law firm specializing in five key areas—complex personal injury, denied long-term disability, wrongful death, legal representation for hurt children, and employment law—we understand the importance of clarifying the tax treatment of settlements and awards for our clients. While the tax rules may vary for other areas of law, we will focus on providing insight into the taxation of settlements and awards within our practice areas. It is crucial for plaintiffs to understand the tax consequences of their compensation to ensure they receive the full benefits of their settlement or award. By working closely with our clients and staying up-to-date on the latest tax regulations, we strive to provide comprehensive guidance on this complex topic.

Personal Injury Law and Wrongful Death

General Damages for Pain and Suffering

General damages, also known as non-pecuniary damages, are not taxable in Canada due to a combination of court decisions and the interpretation of the Income Tax Act by the Canada Revenue Agency (CRA). The same principle applies to damages paid for wrongful death under the Family Law Act.

The leading authority on this matter is the Supreme Court of Canada’s decision in Cirella v. The Queen, [1978] 1 S.C.R. 1, which established the principle that general damages awarded for personal injury are not taxable. The court held that general damages are not considered income under the Income Tax Act, as they are not a gain or a benefit, but rather a compensation for a loss of amenities and enjoyment of life.

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The court’s reasoning was based on the interpretation of the definition of “income” in the Income Tax Act. The act does not specifically include general damages as a type of taxable income. The court concluded that Parliament did not intend to tax general damages, as they are not a gain or a benefit in the ordinary sense of the word.

Following the Cirella decision, the CRA issued Interpretation Bulletin IT-365R2, which confirms that awards for personal injury, including general damages, are not taxable. The bulletin states:

“An award of damages for personal injury (other than for punitive or exemplary damages or interest) received as a lump sum is not taxable to the recipient, regardless of when the injury occurred. This includes damages for both pecuniary and non-pecuniary losses, such as amounts for loss of future earnings, loss of earning capacity, pain and suffering, and loss of enjoyment of life.”

The tax-free treatment of general damages has been consistently applied by the courts and the CRA since the Cirella decision. This principle ensures that plaintiffs who receive compensation for non-pecuniary losses are not further burdened by taxation on those amounts, recognizing that general damages are intended to compensate for intangible losses rather than provide a financial gain.

Loss of Income

In Canada, the tax treatment of awards or settlements for future loss of income is governed by the Income Tax Act and the interpretation of this act by the courts. The leading case on this matter is the Supreme Court of Canada decision in Tsiaprailis v. Canada, [2005] 1 S.C.R. 113, 2005 SCC 8.

In Tsiaprailis, the Supreme Court held that a lump-sum award for future loss of income in a personal injury case is not taxable. The court distinguished between awards for past loss of income (which are taxable) and awards for future loss of income (which are not taxable).

The court’s reasoning was based on the interpretation of paragraph 3(a) of the Income Tax Act, which states that a taxpayer’s income from an office or employment includes “salary, wages and other remuneration, including gratuities, received by the taxpayer in the year.” The court held that an award for future loss of income does not fall within this definition because it is not “received” in the year, but rather represents a future entitlement.

Following the Tsiaprailis decision, the Canada Revenue Agency (CRA) updated its policies to confirm that awards for future loss of income are not taxable. In its Interpretation Bulletin IT-365R2, the CRA states:

“An award of damages for personal injury (other than for punitive or exemplary damages or interest) received as a lump sum is not taxable to the recipient, regardless of when the injury occurred. This includes damages for both pecuniary and non-pecuniary losses, such as amounts for loss of future earnings…”

Therefore, the key authority in Canada for the tax-free treatment of awards or settlements for future loss of income is the Supreme Court’s decision in Tsiaprailis v. Canada, as interpreted and applied by the CRA.

Long-Term Disability Settlements

The tax treatment of long-term disability (LTD) awards in Canada depends on the specific circumstances of the policy and how the premiums were paid. LTD benefits can be either taxable or non-taxable, depending on who paid the premiums and how they were treated for tax purposes.

Non-taxable LTD benefits:
If the employee paid the LTD premiums with after-tax dollars, meaning the premiums were not deducted from their taxable income, then the LTD benefits received are generally not taxable. This is because the employee has already paid taxes on the money used to pay the premiums.

Taxable LTD benefits:

If an employer paid the LTD premiums and did not include the premium amounts as a taxable benefit in the employee’s income, then the LTD benefits received are generally taxable. This is because the employee has not paid taxes on the money used to pay the premiums.

If the employee paid the LTD premiums, but the premiums were deducted from their gross income before taxes (i.e., with pre-tax dollars), then the LTD benefits received are generally taxable. In this case, the employee has not yet paid taxes on the money used to pay the premiums.

It’s important to note that if you settle your long-term disability benefits, it is generally only the arrears (i.e. payment from the denial/cut-off date) are taxable.

Employment Law Settlements

Termination in Lieu of Notice

When an employee is terminated without cause, they are entitled to receive either working notice or pay in lieu of notice. The pay in lieu of notice, often referred to as a severance package, is meant to provide the employee with financial support during the notice period as if they had continued working for the employer.

Sections 3(a) and (b) of Canada’s Income Tax Act “ITA” sets out the definition of “income,” stating that each taxpayer’s income for the year typically includes the total amount from each office, employment, business, property, and from capital gains. Furthermore, section 5 of the ITA states that “income from an office or employment” is the salary, wages, and other remuneration received by the taxpayer in the year.

Therefore, salary, wages, and other remuneration are taxable at the employee’s normal withholding rate based on the employee’s tax bracket and are subject to deductions such as Employment Insurance (“EI”) premiums and Canada Pension Plan (“CPP”) contributions.

Retirement Allowance

A retirement allowance may be payable when an employee retires or their employment is terminated, serving as either recognition of long service or compensation for the loss of their position. Payments tied to termination, settlements, or damages for wrongful dismissal often qualify, provided they meet specific criteria. To be considered a retirement allowance, the payment must directly relate to the loss of employment, not be speculative or contingent, and the employment relationship must end on a specific date within a reasonable timeframe. Courts assess eligibility by asking whether the payment would have been received without the termination and whether its purpose is to compensate for the loss. Payments such as statutory severance or damages in lieu of reasonable notice generally qualify, whereas salary continuation, accrued benefits, and retention bonuses are excluded as employment income.

The retirement allowance withholding tax rate varies based on the payment amount. For amounts up to $5,000, the rate is 10% (5% in Quebec). Payments exceeding $5,000 but not more than $15,000 are subject to a 20% rate (10% in Quebec), while amounts over $15,000 are taxed at 30% (15% in Quebec). This flat rate withholding ensures the tax is pre-collected, although the ultimate tax liability will depend on the employee’s annual income and tax bracket. Employers must report the allowance on a T4A slip and ensure withholding at the applicable rate.

Over $60M in Settlements and Verdicts since 2003

At Lalande Personal Injury Lawyers, we take pride in being trusted Hamilton personal injury lawyers who have been fighting for justice since 2003. Over the years, we’ve helped our clients recover more than $60 million in settlements and verdicts in personal injury, disability, and employment law cases. Whether you’re dealing with a life-changing injury, a denied disability claim, or unfair treatment at work, we are here to provide compassionate and experienced legal representation. If you believe you have a case, call us today—we’re ready to help you secure the compensation you deserve.

Call our Hamilton Personal Injury, Disability and Employment Lawyers today, no matter where you are in Ontario, at 1-844-LALANDE or local throughout Southern Ontario at 905-333-8888. Alternatively, you can contact us online, confidentially, by filling out a contact form. You may also have a social worker or nurse practitioner reach out to us on your behalf if you can’t.

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