By Alan Caplan
Edmonton Sun Freelance

Disability benefits paid by an insurance company are taxable or non-taxable depending on how the policy was paid.

Generally, if the policy premium is deductible for tax purposes, the periodic benefit is taxable when received. If the premium isn't deductible, the benefits aren't taxable either. Most of the policies with taxable benefits are employer-sponsored. That is, the employer pays all or part of an employee's disability insurance cost. It follows that the premium is a deductible expense for the employer and the benefit, if and when the employee collects it, will be taxable.

Normally, personally owned disability policies, personally paid, produce non-taxable benefits.

According to the Supreme Court of Canada in a recent decision, the original characteristics of the policy govern taxation - even if an insurance company decides you're not entitled to any more benefits and you sue and win cash settlement, or the company wants to settle instead of paying over an undetermined number of years.

Proving that the future just doesn't seem what it used to be, the case initially dates back to 1984 when Mrs. T was injured in a car accident.

She subsequently claimed long-term disability benefits under her employer-sponsored insurance plan and it paid her until May 1993 when the insurer, Manulife, decided she was no longer entitled to the benefit. Mrs. T went to court to have the policy (and the payments) reinstated.

Manulife's and Mrs. T's lawyers exchanged letters and eventually settled for a lump sum of $105,000, which was broken into three parts: the past benefits she was owed, 75% of the future value of future payments and about $6,500 for costs, disbursements and GST.

Mrs. T included the value of her past benefits on her 1996 tax return, but not the amount of the future benefits or the costs.

Revenue Canada reassessed her for the whole $105,000, adding the full amount to her income in one year.

Proving once more that a woman scorned can be a formidable force, she fought back and eventually the case wound up before the Supreme Court. Her reasoning was that the Income Tax Act provides that period payments on account of disability are taxable.

In the Tax Court of Canada, she won handily; the TCC reasoning that this was a lump-sum payment, not periodic payments, and none of the settlement was taxable.

It was a moral victory for Mrs. T, but that was not to last.

Revenue Canada took the case to the Federal Court of Appeal, which disagreed with the TCC and took the position that part of the settlement included an amount for past benefits owing that would have otherwise been paid periodically under the policy, and therefore should be taxable.

Although she won a partial victory with the original decision, Mrs. T took it to the SCC.

There, her lawyers argued that the sum she received wasn't really from the disability plan, but represented an agreement to end a court dispute, which isn't taxable.

However, the majority of the Supreme Court Justices ruled (a minority disagreed) that the amount for past disability payments was taxable and Mrs. T couldn't assert Manulife's liability under the policy and "then argue that the payment does not flow from the obligations... of the policy."

You can't suck and blow at the same time.

Mrs. T refiled her 1996 return, adding to the rest of her income for that year the lump sum received for past benefits (which, in this case was the largest proportion of the settlement). The result was that she paid in large part at the top marginal tax rate.

It's a note to lawyers and others involved in such lawsuits: be aware of the tax consequences of the structure of a settlement.