Pre-judgment Interest
The CCRA has recently dealt with a number of issues involving the tax treatment of pre-judgment interest on wrongful dismissal awards. We understand that, while a wrongful dismissal award would be taxed as a retiring allowance, it is the administrative position of the CCRA that the associated pre-judgment interest would not be subject to tax.
Question 1
What is meant by pre-judgment interest?
Response 1
Sometimes, pre-judgment interest is referred to as either pre-judgment interest or pre-settlement interest. Pre-judgment interest means an amount, classified as interest by the courts or under the terms of the settlement agreement, that is interest payable for the time between the emergence of the cause of action and the date of the award or settlement.
Question 2
What is the CCRA’s current administrative position on the tax treatment of pre-judgment interest?
Response 2
Our current position is that pre-judgment interest is generally taxable as interest income if it is in the nature of interest. The courts have described interest in general terms as “the return or consideration or compensation for the use or retention by one person of a sum of money, belonging to… or owed to, another”. It is a question of fact whether an amount paid under the terms of a court order or settlement agreement constitutes interest income. In our view, where an award for damages is made either by a court or by means of an out-of-court settlement which includes an amount that is explicitly identified to be interest on all or a portion of the award, such amount normally constitutes interest income in the hands of the recipient for all purposes of the Act.
However, there is currently an administrative exception for pre-judgment interest related to awards for personal injury or death, wrongful dismissal, and retroactive worker’s compensation payments. Accordingly, pre-judgment interest on such awards is not subject to tax.
Question 3
What is the CCRA’s rationale for not taxing pre-judgment interest on taxable wrongful dismissal awards?
Response 3
The CCRA issued a press release on April 26, 1985, which stated that pre-judgment interest received in respect of damage awards did not have to be included in income. The CCRA applied this administrative position to awards for personal injury or death, wrongful dismissal, and retroactive worker’s compensation.
Question 4
What changes will the CCRA make to its administrative position on pre-judgment interest?
Response 4
Our administrative position is mainly based on the principle that the taxation of pre-judgment interest should follow the tax treatment of the associated award. We also feel that pre-judgment interest that is in the nature of interest should generally be taxed as such. In order to be consistent with both the underlying reason for our administrative position and legal principles, we will be changing our policy to exclude pre-judgment interest on wrongful dismissal awards from the administrative exception and, therefore, tax it as interest income. Essentially, our new position will be that all pre-judgment interest, which is explicitly identified as interest in the court order or settlement agreement, will be taxed as interest income, but the exception for pre-judgment interest on awards for personal injury or death, or retroactive worker’s compensation will remain in place. This new position will be effective for court orders, or settlement agreements dated on or after January 1, 2004.
Our new administrative position continues to recognize that pre-judgment interest on non-taxable awards related to personal injury or death, or retroactive worker’s compensation payments will not be subject to tax.
Question 5
How can this new position be justified in light of the decision of the Tax Court in Dr. Syed Ahmad 12 case?
Response 5
In this case, the appellant worked for Atomic Energy Canada Limited (“AECL”) as a nuclear researcher for 20 years from 1967 to 1987. In 1984, he was demoted by AECL due to the interference of AECL’s major customer, Ontario Hydro. He subsequently brought an action against Ontario Hydro for inducement of breach of contract. In 1987, he was wrongfully dismissed by AECL, and received $102,000 as a settlement. In 1993, the Ontario Superior Court ordered Ontario Hydro to pay the appellant general damages of $488,525, libel damages of $40,000, pre-judgment interest of $388,212, and post-judgment interest of $199,371. This judgment was upheld by the Court of Appeal for Ontario in 1997. In reassessing the taxpayer for 1997, the CCRA included in his income the general damages and interest (other than approximately $45,000 of interest relating to the libel damages).
The court found that the general damages did not constitute a retiring allowance because they were not paid in respect of the loss of an office or employment. The damages represented compensation for the destruction of the appellant’s career as a nuclear researcher due to the tort of inducement of breach of contract, and not merely for the loss of a particular job. Accordingly, the damages were found to be not taxable.
As for the taxation of the pre-judgment interest, the court found that the appellant did not have any right to a principal amount prior to judgment, and no interest could accrue until the judgment was rendered. Therefore, the amount labelled pre-judgment interest in this case formed part of the award and was not, in fact, interest.
This case was decided on its particular facts and, in our view, is not inconsistent with our policy on pre-judgment interest. Essentially, the court found that the portion of the award stated to be “pre-judgment interest” in this case was not in the nature of interest. Since the court also found that the award did not fall within the definition of “retiring allowance”, the portion of the award identified as pre-judgment interest was not subject to tax.
Where pre-judgment interest is paid on an award for wrongful dismissal, the amount will normally be taxed as interest income. However, if the facts indicate that the portion identified as “interest” is not in the nature of interest, then it will be considered to form part of the overall award, and be taxed as a retiring allowance.