TaxMatters@EY – March 2023

Alan Roth, Toronto

Background

Class action lawsuits have become more common in Canada in recent years. These lawsuits allow one or more plaintiffs to seek justice on behalf of a larger group from a defendant(s) that is accused of harming the group in some way through, for example, negligence or misconduct. Any settlement payments or other remedies obtained are shared among the group.

Class action lawsuits in Canada have occasionally resulted in some large settlement agreements, such as the 2006 Residential School Settlement Agreement of $1.9 billion. The tax treatment of amounts received under a class action settlement agreement was the subject of a recent Canada Revenue Agency (CRA) document.

When damages are paid to settle a legal action, the courts have generally looked to the nature of the income or property the payment is intended to replace to determine the tax treatment of the payment. In applying this so-called surrogatum principle, the Tax Court of Canada in Lavoie v the Queen1 concluded that settlement payments made to a registered retirement savings plan (RRSP) annuitant as a result of losses suffered by the RRSP should be treated for tax purposes as taxable benefits received by the annuitant out of or under the RRSP.2 If a settlement does not replace a source of income and satisfies certain other criteria, it may be treated as a tax-free windfall.3

Subsection 146(8) of the Income Tax Act (the Act) requires benefits (as defined in subsection 146(1)) a taxpayer receives out of or under an RRSP to be included in the taxpayer’s income for a taxation year, subject to a few exceptions.4 Subsection 146.3(5) provides for a similar income inclusion for tax purposes for benefits a taxpayer receives out of or under a registered retirement income fund (RRIF), other than certain amounts that are already included in computing income for tax purposes under other provisions of the Act.5 The financial institution making a payment out of or under an RRSP or RRIF is required to withhold and remit tax to the CRA on the payment on account of the payee’s related tax liability under paragraphs 153(1)(j) and 153(1)(l) of the Act, respectively.6

Tax treatment of class action settlements

In a scenario described in CRA document 2021-0911101E5, a settlement payment was made by a financial institution pursuant to a court order to settle a class action lawsuit for actionable losses suffered in connection with an investment held in a registered plan like an RRSP or a RRIF.

The CRA was asked what the tax treatment of the settlement payment is if the payment is either:

• Made directly to the registered plan that suffered the loss
• Made directly to the registered plan’s controlling individual (the annuitant) and then subsequently returned to either the same or another registered plan of the annuitant

The CRA responded by noting that its longstanding position is that a settlement payment made directly to the registered plan that suffered the loss is not considered to be a contribution, premium or gift to the plan and, therefore, the payment will not result in an income inclusion to the plan’s annuitant. The CRA also confirmed that the same tax consequences would apply if the settlement payment is made directly to the annuitant and that individual returned it to the registered plan in a reasonable period of time, which the CRA considers to be the later of six months from the time the individual receives the payment and the end of the taxation year in which the payment was received.

If the registered plan that suffered the loss no longer exists or has matured, the payment may be made to another registered plan of the same type for the same annuitant. But if the annuitant who receives the settlement payment chooses to retain the payment, then the CRA would consider the payment to be a benefit received by the individual under the plan and, therefore, the amount would have to be included in the individual’s income for tax purposes under subsection 146(8) of the Act if it’s an RRSP, or under subsection 146.3(5) if it’s a RRIF. If the annuitant receives a settlement payment in respect of a tax-free savings account (TFSA), the amount would be non-taxable since withdrawals from a TFSA are not subject to tax.

Reporting

If the settlement payment is made directly to the registered plan, nothing needs to be done since the payment is not taxable and is not considered a contribution to the plan.

If the settlement payment is made directly to the annuitant of the plan, the financial institution making the payment has to withhold and remit tax on the payment, even if the plan’s annuitant subsequently returns the payment to the plan or another plan of the same type. The financial institution has to file a T4RSP or T4RIF slip reporting the gross amount of the benefit and the tax withheld, which the annuitant has to report on their income tax return.

If the payment is returned to the plan or to another RRSP or RRIF of the same annuitant, it would not result in an income inclusion as noted above. Instead, the individual would be able to claim a deduction for the amount returned on line 23200, “Other deductions,” of their income tax return for the payment year, effectively offsetting the income inclusion.

If the settlement payment is returned to the plan after the end of the taxation year in which the payment was received and the annuitant’s income tax return for the year has already been filed, the individual can request an adjustment to their return to deduct the repayment amount on line 23200 of the return.

Finally, the CRA noted that if the payment was made to the annuitant in respect of a TFSA , no amount would need to be reported on the individual’s income tax return since TFSA distributions are not taxable.

Example

Susan is a Canadian resident who holds a self-directed RRSP, administered by her investment bank, that contains investments in the common shares of several publicly traded companies. The RRSP account for which she is the annuitant held shares in a well-known software company for many years. In 2018, the company became embroiled in a large financial scandal, and by the end of that year the RRSP’s shares in the company were worthless.

In 2019, a few of the largest shareholders filed a class action lawsuit on behalf of all those who owned shares in the company as of June 2018. In 2021, an agreement was reached to settle the lawsuit, and payments were made in December of that year pursuant to the terms of the settlement agreement. The RRSP’s share of the settlement was $50,000, which was paid directly to Susan.

When the payment was made, Susan’s investment bank withheld and remitted tax of $15,000 to the CRA, equal to 30% of the settlement payment. Tax was withheld because the settlement payment was made directly to the plan annuitant. In February 2022, the bank issued a T4RSP slip to Susan reporting the $50,000 settlement payment as taxable income received out of her RRSP and the $15,000 of tax withheld.

Susan’s 2021 T1 personal income tax return, which she filed in April 2022, correctly included the $50,000 settlement as taxable RRSP income and also reported the amount of tax withheld. In May 2022, Susan returned the settlement payment to her RRSP account. The repayment was made within the CRA’s reasonable period of time threshold as it was made less than six months following the December 2021 receipt of the settlement amount. Since Susan had already filed her 2021 T1 return by the time she repaid the settlement amount, she filed an adjustment to her return claiming a deduction of $50,000 on line 23200, effectively offsetting her income inclusion for the settlement payment.

If Susan’s total income tax payments for the 2021 taxation year — from all amounts withheld at source plus any payments she made through instalments or on the filing of the original T1 — exceed her revised income tax payable amount based on the adjustment filed, the excess payments may be refunded to her.

Conclusion

In summary, the tax consequences of receiving a payment as settlement for a class action lawsuit filed for losses sustained by a registered plan like an RRSP or RRIF are fairly straightforward. But there are a few steps that both the annuitant and plan administrator need to take where payments are made directly to the annuitant to avoid any adverse tax consequences.

Winnie Szeto, Toronto, and Gael Melville, Vancouver

In this recent case, the Tax Court of Canada held that a payment received by a taxpayer in respect of the termination of his employment was not earned income for the purpose of calculating his registered retirement savings plan (RRSP) deduction limit. As a result, the taxpayer overcontributed to his RRSP and he was liable for Part X.1 tax, interest and penalties on the excess.

The RRSP rules

An RRSP is a savings vehicle, registered with the government of Canada, that receives preferential tax treatment under the Income Tax Act (the Act).1 Contributions to an RRSP are tax deductible in the year of contribution. Also, investment income earned from investments held in an RRSP can grow tax free so long as the funds remain in the RRSP. Investment income earned in an RRSP will only be taxed when it is withdrawn.

There is a limit on the amount that can be contributed to an RRSP in any given year, also known as the RRSP deduction limit or contribution room. While several amounts are considered in the calculation of this limit, an individual’s contribution to an RRSP generally cannot exceed 18% of their earned income in the previous year, up to an annual dollar limit, plus any unused RRSP deduction room at the end of the previous year. Of particular relevance to this case is the calculation of earned income for purposes of determining an individual’s deduction limit.

The most important point for the purposes of this case is that an individual’s contribution to an RRSP cannot exceed 18% of their earned income in the previous year.

If an individual contributes more to their RRSP than their RRSP deduction limit allows by more than $2,000 (on a cumulative basis), an excess contribution will result. The excess contribution is subject to a penalty tax (also known as Part X.1 tax), which is equal to 1% of the excess contribution amount per month, until the excess is withdrawn.

Facts

The facts of this case are simple. In 2013, the taxpayer’s employment was terminated by his employer. With the assistance of a lawyer, he succeeded in negotiating a payment from his former employer of approximately $165,000 in respect of his termination. He received the payment in 2014 and reported it in his 2014 tax return as taxable income. In February 2015, the taxpayer made a contribution of $24,270, representing approximately 14.7% of his termination payment, to his RRSP. In 2018, the Canada Revenue Agency (CRA) assessed the taxpayer Part X.1 tax, interest and penalties in respect of his 2015 taxation year on the basis that he overcontributed to his RRSP. The taxpayer appealed the assessment to the Tax Court of Canada.

Tax Court decision

At trial, the judge noted that the first issue in this case was whether the taxpayer overcontributed to his RRSP. There was also a second issue in respect of the correct computation of tax, but we won’t concern ourselves with that issue in this commentary since it merely dealt with factual errors.

The judge first considered that the definition of RRSP deduction limit in subsection 146(1) of the Act, among other things, limits a taxpayer’s RRSP contribution to a maximum of 18% of the taxpayer’s earned income in the preceding taxation year. Therefore, if the termination payment from the taxpayer’s employer constituted earned income, there would be no overcontribution.

Earned income, as defined in subsection 146(1), includes a taxpayer’s income from employment. According to subsection 5(1) of the Act, “a taxpayer’s income for a taxation year from… employment is the salary, wages and other remuneration… received by the taxpayer in the year.”

The taxpayer argued that the termination payment was part of his employment remuneration, and that if the payment was not remuneration and not earned income, the amount should not have been taxed in the first place.

The judge disagreed with the taxpayer, referring to the decision of the Federal Court of Appeal in the Queen v Atkins2 and noting that it was well established that such termination payments were not part of employment income. This principle still stands because the Atkins case was never overturned and Parliament did not amend the tax laws to overrule the decision.

With respect to whether the termination payment should have been taxable, the judge noted that the amended definition of retiring allowance in subsection 248(1) of the Act means an amount received in respect of a loss of employment, whether or not the amount was received as, on account of or in lieu of payment of damages or pursuant to an order or judgment of a competent tribunal. Furthermore, subparagraph 56(1)(a)(ii) provides that a retiring allowance must be included in computing a taxpayer’s income. Read together, the two provisions result in the termination payment being taxable.

And finally, the judge noted that section 56 is in Part 1, Division B, Subdivision D, “Other Sources of Income,” of the Act. Based on this, the judge concluded that the termination payment was other income and not employment income. Therefore, the payment did not constitute earned income for the purpose of calculating the taxpayer’s RRSP deduction limit for the year and he had overcontributed.

Although the taxpayer lost with respect to the overcontribution issue, the judge allowed the appeal in part so that the Part X.1 tax, interest and penalties could be recomputed correctly.

Lessons learned

Familiarize yourself with the RRSP rules and be aware that Part X.1 tax, as well as late-filing penalties and interest, may result from excess contributions. Although subsection 204.1(4) of the Act allows you to request a waiver of Part X.1 tax, such waiver is at the CRA’s discretion and is based on what it views as a reasonable error. As a result, you should exercise caution when contributing to RRSPs and seek professional tax advice as appropriate.

Tax Alerts – Canada

Tax Alert 2022 No. 12 – Yukon budget

Tax Alert 2022 No. 13 – Proposed EIFEL rules
On February 4, 2022, the Department of Finance released for public comment draft legislative proposals and accompanying explanatory notes to implement most of the remaining measures from the 2021 federal budget. Included in these measures are rules aimed at limiting the amount of interest and other financing expenses that businesses may deduct for income tax purposes based on a proportion of earnings, as previously announced in the budget. These new rules are described as the excessive interest and financing expenses limitation (EIFEL) rules.

Tax Alert 2022 No. 14 – Canadian sanctions related to Russia: update
Following the February 24, 2022 announcement of additional sanctions under the Special Economic Measures (Russia) Regulations and the Special Economic Measures (Ukraine) Regulations, from March 3 to 10, 2022, Canada further amended the Special Economic Measures (Russia) Regulations and removed Russia and Belarus from entitlement to most-favoured nation tariff treatment.

Tax Alert 2022 No. 15 – New Brunswick budget

Tax Alert 2022 No. 16 – Québec budget highlights

Tax Alert 2022 No. 17– Québec budget

Tax Alert 2022 No. 18 – Saskatchewan budget

Tax Alert 2022 No. 19 – Nova Scotia budget

Tax Alert 2022 No. 20 – Canadian sanctions related to Russia: further update
Following the 10 March 2022 announcement of additional sanctions under the Special Economic Measures (Russia) Regulations (Regulations), from 14 March 2022 to 24 March 2022, Canada further amended the Regulations by adding 175 individuals and prohibiting the export of certain goods and technologies described in the Restricted Goods and Technologies List.

Tax Alert 2022 No. 21 – Ontario increases and extends nonresident speculation tax
On 30 March 2022, Ontario filed Regulation 240/22, which implements amendments to increase the nonresident speculation tax rate to 20% (from 15%) and extend the application of the tax provincewide. As well, tax rebates for international students and foreign nationals working in Ontario have been eliminated.

Summary

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