Principal Issues: [TaxInterpretations translation]
What tax treatment should be given to interest received and legal costs incurred in settling a dispute for which damages have been awarded?
Position: Interest is taxable and legal fees are generally non-deductible.
Reasons: The interest received constitutes actual interest under paragraph 12(1)(c) and cannot be associated with an amount received for damages for injury or death referred to in paragraph 4 of IT-365R2. The legal fees were not incurred for the purpose of deriving income from business or property.
November 27, 2002
XXXXXXXXXX Tax Services Office Headquarters Lucie Vermette, CGA Attention: XXXXXXXXXX (613) 957-2092
2002-014920
Tax treatment of interest received and legal fees incurred as part of a settlement for damages
This is in response to your letter of June 25, 2002, in which you requested our opinion on the above subject. We apologize for the delay in responding to your request.
FACTS
XXXXXXXXXX taxpayers filed an action against corporations which XXXXXXXXXX.
The taxpayers were successful and were awarded an amount for property damages to defray the costs of re-doing the XXXXXXXXXX and an amount for damages for harm and inconvenience suffered during the years they had to live in their damaged home while waiting for a settlement.
The calculation of the amounts for material damages was based on the appraisals by a construction firm and the addition of certain other costs, such as the XXXXXXXXXX.
The amounts for damage and inconvenience represented, per house, an amount of $XXXXXXXXXX for the period of XXXXXXXXXX plus $XXXXXXXXXX per year until the date when the XXXXXXXXXX were replaced or the problem rectified.
The taxpayers also received pre-judgment interest (from the date the case arose to the date of the order) and post-judgment interest, and also incurred legal fees.
According to the information obtained, it appears that only one of the plaintiffs made a claim for damages for personal injury for mental suffering and obtained an amount for general damages and an amount for special damages for loss of income during the years XXXXXXXXXX.
QUESTION
You wish to know the tax treatment of interest received and legal fees incurred.
OUR COMMENTS
First, we would like to clarify that this opinion deals solely with the tax treatment of the interest received and legal fees incurred in the above lawsuit, and not with the tax treatment of the damage amounts received in settlement of the litigation. Furthermore, we understand that the majority of plaintiffs received damages in respect of their personal residence. These amounts are generally non-taxable, and we have oriented our analysis accordingly. If it turns out that some plaintiffs received damages for rental property or property used in a business, the result of our analysis could be different, particularly regarding legal fees.
Interest
Interest received in settlement of a dispute is generally taxable under paragraph 12(1)(c) of the Income Tax Act (the "Act"). However, paragraph 4 of Interpretation Bulletin IT-365R2 indicates that where an amount in respect of damages for personal injury or death has been awarded by a Court, no part of such amount will be income to the recipient even though the amount includes or is augmented by an amount which, pursuant to the terms of the Court order or the settlement agreement, is referred to as interest. This relief is also applicable to pre-judgment interest in respect of amounts of damages received in litigation settlements for retroactive workers' compensation payments or for wrongful dismissal. Post-judgment interest is taxable in all cases.
Therefore, in the present situation, in order for the pre-judgment interest received not to constitute income to the taxpayers, the compensation would have to have been paid as damages for injury or death, since it is clear that the compensation was not paid for the other two reasons cited above.
We are of the view that the first category of damages received by the taxpayers which is intended to defray the cost of redoing the XXXXXXXXXX does not constitute an amount received as damages for injury or death since this amount is used to defray the expenses incurred or to be incurred to repair the XXXXXXXXXX of their personal residence.
We are also of the view that the compensation received for harm and inconvenience does not constitute an amount received as damages for personal injury or death. Although that amount is intended to compensate the taxpayers for the fact that they had to live for some years in homes with certain defects, it cannot be equated with compensation for injury or psychological suffering, or for death.
However, the amounts for general and specific damages awarded to the taxpayer who made a claim for damages for personal injury for mental suffering could perhaps be considered as damages for personal injury or death, and the pre-judgment interest (if pre-judgment interest was calculated on those amounts) could be non-taxable in accordance with the CCRA's position. However, we are not in a position to confirm the tax treatment of interest for this particular taxpayer, as we do not have all the necessary information.
In conclusion, generally speaking, in the present situation, the pre-judgment interest received by the taxpayers is taxable pursuant to paragraph 12(1)(c), since it does not meet the exceptions set out in the CCRA's position. Post-judgment interest is also taxable under the same provision of the Act. In addition, pre- and post-judgment interest would also be taxable in situations where damages were received in respect of buildings that generated property income or were used in a business.
Legal fees
Except where there is a specific provision in the Act regarding legal fees, such as paragraphs 8(1)(b), 60(o) or 60(o.1), legal fees are deductible only to the extent that they were incurred for the purpose of earning income from a business or property and to the extent that they are not capital expenditures.
In the situation presented, the legal fees incurred were not deductible pursuant to the specific paragraphs cited above. Furthermore, the taxpayers did not incur them for the purpose of earning business or property income, since amounts for damages received in respect of their residence used for personal purposes are not taxable. Consequently, those expenses were not deductible pursuant to paragraph 18(1)(a).
Unlike legal expenses incurred to obtain amounts for damages in respect of their personal residence, legal expenses incurred to obtain amounts for damages in respect of a rental property or property used in a business may be deductible in certain situations. However, we cannot give an opinion in that regard, as each specific situation would have to be analyzed on its own merits.
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the electronic library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
Should you require any additional information regarding this matter, please do not hesitate to contact us.
Best regards,
Ghislaine Landry, CGA
Manager
Individuals, Business and Partnerships Section
Business and Partnerships Division
Income Tax Rulings Directorate
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