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canadian tax journal / revue fiscale canadienne (2010) vol. 58, n o 3, 577 - 608 577 Taxing Personal Injury Damages: Tax Policy Analysis from the Canadian Perspective Tamara Larre* PRÉCIS Même si l’Agence du revenu du Canada (ARC) maintient que les dommages-intérêts pour préjudice corporel sont exonérés d’impôt, elle n’a donné que peu d’explications sur sa position. La pratique de l’ARC qui consiste à ne pas ajouter ces sommes reçues dans le calcul du revenu fait en sorte qu’il est peu probable que les tribunaux puissent se prononcer sur la question du traitement légal adéquat des dommages-intérêts pour préjudice corporel. Le présent article analyse les conséquences pour la politique fiscale de l’imposition de chacun des types suivants de dommages-intérêts pour préjudice corporel : la perte de capacité de travailler, le dommage non pécuniaire et le coût des soins de santé futurs. L’article propose que les dommages-intérêts pour la perte de capacité de travailler et les dommages-intérêts pour dommage non pécuniaire devraient être pleinement imposables puisqu’ils sont perçus au mieux comme le remplacement d’une immobilisation ayant un coût de base minime. L’article montre aussi que l’on obtient une meilleure équité à la fois horizontale et verticale si les dommages-intérêts pour le coût des soins de santé futurs sont pleinement imposables, compte tenu du crédit d’impôt qui est actuellement accordé pour les frais médicaux. La question du regroupement des revenus n’est pas jugée comme étant assez significative pour justifier le traitement d’un gain en capital, même si l’exonération de la moitié des revenus est plus viable sur le plan politique que l’étalement du revenu sur les années suivantes. En conclusion, si l’exonération fiscale actuelle des dommages-intérêts pour préjudice corporel est maintenue, il y aurait tout lieu de la justifier en tant que dépense fiscale plutôt que par d’autres explications liées à la politique fiscale. ABSTRACT The Canada Revenue Agency (CRA) maintains that all personal injury damages are exempt from income tax, but has provided little explanation for its position. The CRA’s practice of * Of University of Saskatchewan College of Law (e-mail: [email protected]). I am indebted to my thesis supervisor, Lisa Philipps, for her insight, guidance, and support. I also would like to thank Neil Brooks, Jinyan Li, David Duff, Kate Sutherland, Ken Cooper-Stephenson, Alan Macnaughton, and the anonymous reviewer of this article for their comments and suggestions, and Emily Luther for her excellent research assistance. I presented papers on this topic at a number of conferences, and I thank the conference participants for their feedback. Any shortcomings in this article are my own doing.
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canadian tax journal / revue fiscale canadienne (2010) vol. 58, no 3, 577 - 608

577

Taxing Personal Injury Damages: Tax Policy Analysis from the Canadian Perspective

Tamara Larre*

P R É C I S

Même si l’Agence du revenu du Canada (ARC) maintient que les dommages-intérêts pour préjudice corporel sont exonérés d’impôt, elle n’a donné que peu d’explications sur sa position. La pratique de l’ARC qui consiste à ne pas ajouter ces sommes reçues dans le calcul du revenu fait en sorte qu’il est peu probable que les tribunaux puissent se prononcer sur la question du traitement légal adéquat des dommages-intérêts pour préjudice corporel. Le présent article analyse les conséquences pour la politique fiscale de l’imposition de chacun des types suivants de dommages-intérêts pour préjudice corporel : la perte de capacité de travailler, le dommage non pécuniaire et le coût des soins de santé futurs. L’article propose que les dommages-intérêts pour la perte de capacité de travailler et les dommages-intérêts pour dommage non pécuniaire devraient être pleinement imposables puisqu’ils sont perçus au mieux comme le remplacement d’une immobilisation ayant un coût de base minime. L’article montre aussi que l’on obtient une meilleure équité à la fois horizontale et verticale si les dommages-intérêts pour le coût des soins de santé futurs sont pleinement imposables, compte tenu du crédit d’impôt qui est actuellement accordé pour les frais médicaux. La question du regroupement des revenus n’est pas jugée comme étant assez significative pour justifier le traitement d’un gain en capital, même si l’exonération de la moitié des revenus est plus viable sur le plan politique que l’étalement du revenu sur les années suivantes. En conclusion, si l’exonération fiscale actuelle des dommages-intérêts pour préjudice corporel est maintenue, il y aurait tout lieu de la justifier en tant que dépense fiscale plutôt que par d’autres explications liées à la politique fiscale.

A B S T R A C T

The Canada Revenue Agency (CRA) maintains that all personal injury damages are exempt from income tax, but has provided little explanation for its position. The CRA’s practice of

* OfUniversityofSaskatchewanCollegeofLaw(e-mail:[email protected]).Iamindebtedtomythesissupervisor,LisaPhilipps,forherinsight,guidance,andsupport.IalsowouldliketothankNeilBrooks,JinyanLi,DavidDuff,KateSutherland,KenCooper-Stephenson,AlanMacnaughton,andtheanonymousreviewerofthisarticlefortheircommentsandsuggestions,andEmilyLutherforherexcellentresearchassistance.Ipresentedpapersonthistopicatanumberofconferences,andIthanktheconferenceparticipantsfortheirfeedback.Anyshortcomingsinthisarticlearemyowndoing.

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not including such receipts in income makes it unlikely that Canadian courts will have the opportunity to fully consider the proper legal treatment of personal injury damages. This article examines the tax policy implications of taxing each of the following types of personal injury damages: loss of working capacity, non-pecuniary damages, and cost-of-care awards. It is argued that damages for loss of working capacity and non-pecuniary damages should be fully taxed, since they are best viewed as replacing capital assets with low basis. It is also shown that horizontal and vertical equity may be better achieved if damages for cost of care are fully taxed, given the existing medical expense tax credit. Income-bunching concerns are not considered significant enough to justify capital gains treatment, although a one-half exemption would be more politically viable than forward averaging. In conclusion, if the current tax exemption for personal injury damages is maintained, it must be justified as a tax expenditure rather than on other tax policy grounds.

KEYWORDS: DAMAGES n TAXATION n TAX POLICY

C O N T E N T S

The Taxation of Personal Injury Damages: The Need for Clarification 578Introduction 578Background 579

The Current Law 579The Debate 582Calculating Personal Injury Damages 584

Tax Policy Analysis 587The “In Lieu of” Approach 587Neutrality: The Behavioural Effects of Taxing Damages 589Equity and Simplicity: The Pragmatic Application of Income Theory 591

Damages for Cost of Care 592Damages for Loss of Working Capacity 596Non-Pecuniary Damages 600Deduction of Legal Fees 602The Capital Gains Preference 602Bunching and Income Averaging 605

Unresolved Issues and Concluding Remarks 607

THE TA X ATIO N O F PER SO N A L INJURY DA M AGE S: THE NEED FO R CL A RIFIC ATIO N

Introduction

Scholars intheUnitedStateshavebeendebatingthetaxationofpersonal injurydamages for half a century, and published articles have revealed theoretical andconceptualdifficultieswiththeexistingtaxexemptionforpersonalinjurydamages.However, the issue of how personal injury damages should be taxed has beenlargelyignoredinCanada.1TheCanadaRevenueAgency(CRA)hasofferedvery

1 Seetheliteraturereviewunder“Background”below.

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littleexplanationforitslongstandingviewthatpersonalinjurydamagesarenottax-able.2GiventheCRA’sposition,itseemsunlikelythatthecourtswillencountertheopportunitytoclarifythepropertreatmentofsuchdamagesundertheIncomeTaxAct;3therefore,theuncertaintyinthecurrentlawwouldbebestresolvedthroughanamendmenttotheAct.Theissue,then,isthecontentofthislegislativeclarifica-tionoramendment.Thepurposeofthisarticleistoanalyzethisissue,withaviewtoencouragingfurtherpolicydiscussiononhowpersonalinjurydamagesshouldbetaxedinCanada.

WhiletherehavebeennumerousAmericanarticlesonthetaxationofpersonalinjurydamages,myanalysisseekstoextendthisliteratureinseveralways.First,Iassess and analyze each type of personal injury damages, including the seldom-consideredcategoriesoflossofhomemakingcapacityandcostofcare.Thissystematicapproachensuresthatalltypesofdamagesarefullyconsidered.TheAmericanlitera-turehastendedtofocusondiscreditingthepotentialjustificationsforthecurrentexemption,andhasnotfocusedonprescribingtheappropriatetaxtreatment.Inthisarticle,Idrawattentiontolargelyneglectedmattersthatmustbeconsideredbeforechangescanberecommended,includingtheamountofbasisintheassetsdisposedof,theavailabilityofthemedicalexpensetaxcreditwhereacost-of-careawardisgranted,andwhetherthecapitalgainspreferenceshouldextendtopersonalinjurydamagesiftheyaretaxed.AnotherimportantcontributionofthisarticleisthatitaddressestheCanadiancontext,includingpublicinvestmentinhumancapitalandCanadian lawrelating to thecalculationofdamages, the taxationofmedicalex-penses,andthedeterminationofbasis.

Thearticleisdividedintothreeparts.Intheremainderofthisfirstpart,Isetoutbackground information on how personal injury damages are currently taxed inCanada,reviewtheexistingliteratureontaxingpersonalinjurydamages,andsum-marizehowthevariouscategoriesofdamagesarecalculatedunderCanadianprivatelaw.Inthesecondpart,Iapplythetraditionaltaxevaluativecriteriaofequity,neu-trality,andsimplicitytopersonalinjurydamages.Iconcludethatthemostattractiveoption,fromataxpolicyperspective,istotaxpersonalinjurydamages.Inthethirdpart,Isetoutmyconclusion,andpointoutthatthenextstageofanalysisshouldbetodeterminewhetherthetaxexemptioncanbejustifiedasataxexpenditureaimedatfurtheringthegoalsoftortlaw.

Background

The Current LawAlthoughthisarticleisconcernedwithhowpersonalinjurydamagesshould betaxed,asopposedtohowtheyaretaxed,thecurrentlawisbrieflyconsideredhereinorderto

2 SeeCanadaRevenueAgency,Interpretation BulletinIT-365R2,“Damages,SettlementsandSimilarReceipts,”May8,1987,paragraph2.Alsoseeinfranote6andtheaccompanyingtext.

3 RSC1985,c.1(5thSupp.),asamended(hereinreferredtoas“theAct”).Unlessotherwiseindicated,statutoryreferencesinthisarticlearetotheAct.

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providecontextanddemonstratetheneedforlegislativeclarification.4BecausethereisnoprovisionintheActspecificallydealingwiththetaxationofpersonalinjurydam-ages,theirtaxtreatmentdependsontheapplicationofthegeneralrulesintheAct.5

TheCRAhasrepeatedlystateditspositionthatpersonalinjurydamagesarenotsubjecttotax.IntheoriginalversionofIT-365,“Damages,SettlementsandSimilarReceipts,”6issuedin1977,theDepartmentofNationalRevenue(asitthenwas)indi-catedthatdamagesrelatingtoapersonalinjuryactionwereexemptfromtax,withtheexceptionofspecialdamagesforpre-triallossofearnings.Thatpositionchangedinlaterversionsofthebulletintoexemptalltypesofpersonalinjurydamages,7likelyinresponsetothe1978decisionoftheFederalCourtinD Cirella v. The Queen,8discussedbelow.TheCRAhasconfirmeditspositionmorerecentlyinanumberoftechnicalinterpretations,butithasnotofferedanexplanationfortheexemption.9

Cirellaistheonlytaxcasedirectlyonpoint.Inthatcase,theFederalCourtTrialDivision held that personal injury damages for out-of-pocket expenses, loss ofpre-trial income, and general damages were not taxable since they did not fallwithinthemeaningofemploymentincomeintheAct.TheFederalCourtreasonedthatthedamageswerenotincomefromasourceandwerecapitalinnature,partlyasaresultofitsconclusionthatdamagesforlostearnings(bothpre-andpost-trial)compensatedforlostearningcapacity.TheFederalCourt’sdecisionwasinlinewiththeSupremeCourtofCanada’sobitercommentsinits1966decisioninThe Queen v. Jennings et al.,10thatdamagesforlossoffutureearningswerecompensationforalostcapitalasset(earningcapacity)andthereforewerenotsubjecttotax.

The reasoning in Cirella is consistent with the surrogatum principle, whichcourtshaveusedtodeterminetheappropriatetaxtreatmentofreplacementpay-ments.11 In Tsiaprailis v. The Queen, the Supreme Court of Canada articulated atwo-stepprocessforapplyingthesurrogatumprincipletoresolvetheissueoftheappropriatetaxtreatmentofasettlementpayment:“(1)[W]hatwasthepayment

4 Foradescriptionofthetaxationofdamagesingeneral,seeJoelA.Weinstein,“Damages,Fines,andPenalties:AnUpdate,”inReport of Proceedings of the Fifty-Second Tax Conference,2000ConferenceReport(Toronto:CanadianTaxFoundation,2001),7:1-33.

5 Anarrowexceptionisprovidedforinparagraphs81(1)(g.1)and(g.2),whichprovidethatincomeearnedondamageawardsisexemptfromtaxifpaidtoplaintiffsunder21yearsofage.

6 DepartmentofNationalRevenue,Interpretation BulletinIT-365,“Damages,SettlementsandSimilarReceipts,”March21,1977,paragraph5.

7 See,forexample,IT-365R2,supranote2.

8 [1978]CTC1(FCTD);rev’g.[1976]CTC2292(TRB).

9 See,forexample,CRAdocumentnos.2006-0187391E5,February5,2007,and9932545,January10,2000.

10 [1966]SCR532.

11 ThesurrogatumprincipleoriginatedinthecaseofLondon & Thames Haven Oil Wharves Ltd. v. Attwooll,[1967]2AllER124(CA).Foradiscussionofthesurrogatumprinciple,seeMarthaO’Brien,“Surrogatum,Source,andTsiaprailis:IsThereaPrincipledBasisfortheTaxTreatmentofReplacementPayments?”(2006)vol.54,no.4Canadian Tax Journal862-906.

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intendedtoreplace?And,iftheanswertothatquestionissufficientlyclear,(2)wouldthereplacedamounthavebeentaxableintherecipient’shands?”12Ineffect,thecourtsinCirellaandJenningsappliedthesurrogatumprincipletocharacterizethenatureof the damages by determining whether the damages replaced lost income or adamagedordestroyedcapitalasset.Asnotedabove,inbothcases,thecourtscon-cludedthatpersonalinjurydamagesforlossofearningsreplacedacapitalasset.

ItisnotablethatthecourtinCirelladidnotconsiderwhetherthedispositionofthecapitalassetcouldleadtoacapitalgain.Thetaxationyearreassessedinthatcasewas1972,thesameyearinwhichcapitalgainsbecametaxable.Arguably,thetran-sitionalruleinincometaxapplicationrule26(1)couldhavebeenappliedtoarguethatthedamagesshouldnotbesubjecttothenewregime.Therulestatesthattheprovisions imposing tax on capital gains apply only to “dispositions of propertymadeafter1971,”andinCirellatheaccidentleadingtothedamages(andthereforethedispositionofproperty)occurredin1968.WhateverthereasonforexcludingthisanalysisfromthedecisioninCirella,itiscertainlyrelevanttodiscussthepossibilityoftaxingpersonalinjurydamagesasacapitalgain.

Assumingthatthereisadispositionofcapitalpropertyuponpersonalinjury,thetaxpayer’scost(orbasis)ofthatassetwouldhavetobedeterminedinordertocalcu-latethecapitalgainorloss.Althoughtheliteratureonhumancapitaldiscussedlaterinthearticlesuggestsapositivebasis,itisextremelydifficulttoascertaintheexactamountofbasisinaperson’sworkingcapacityorcapacitytoenjoylife,andasare-sult,itwouldbenearlyimpossibleforacourttodeterminetheamountofagainorlosswithanyprecision.ThispracticaldifficultymaybeoneexplanationfortheCRA’sdecisionnottoimposetaxonpersonalinjurydamages,and,alongwiththegeneralstateofuncertaintywithrespecttotheapplicationoftheActtopersonalinjurydam-ages,itisapersuasivereasonforlegislativechange.

Theliteraturediscussingthetaxationofpersonalinjurydamagesisreviewedinthenextsectionofthearticle.MostofthepublishedarticlesonpointoriginateintheUnitedStates,where,unlikeinCanada,thelawonthetaxationofpersonalinjurydamageshasbeencodified, in section104(a)(2)of the InternalRevenueCode.13Commentatorshavespeculatedthatthepolicyunderlyingthepredecessortosec-tion104(a)(2)wasthatpersonalinjurydamagesshouldnotbetaxedbecausetheyareareplacementofcapital.14In1996,section104(a)(2)wasamendedaspartofthe

12 [2005]DTC5119,atparagraph15(SCC).InTsiaprailis,theamountinquestionwasintendedtoreplacepastdisabilitypayments,whichwouldhavebeentaxableinthehandsofthetaxpayer.Therefore,thedamagesrepresentingcompensationforlostpastbenefitsweresubjecttotaxundersubparagraph6(1)(f )(ii).

13 InternalRevenueCodeof1986,asamended(hereinreferredtoas“theIRC”).

14 SeeLauraSagerandStephenCohen,“DiscriminationAgainstDamagesforUnlawfulDiscrimination:TheSupremeCourt,Congress,andtheIncomeTax”(1998)vol.35,no.2Harvard Journal on Legislation447-508,at452;andJ.MartinBurkeandMichaelK.Friel,“TaxTreatmentofEmployment-RelatedPersonalInjuryAwards:TheNeedforLimits”(1989)vol.50,no.1Montana Law Review13-47.

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SmallBusiness JobProtectionActof1996torestrict theexemptiontopersonalinjurydamagesforphysicalinjuries.15The1996changeshavebeencriticizedasbeingarbitrary,16unjustifiable,17andeven“invidious,”18butthusfar,theyhavewithstoodconstitutionalscrutiny.19

The DebateTheAmericanliteraturehasexaminedanumberofthepossiblejustificationsforexemptingpersonal injurydamagesfromtax.Inthissection,I introducethekeyargumentsthatappearinthedebate.Theliteraturethatitisrelevanttothepolicyanalysiswillbediscussedinmoredepthinthenextpartofthearticle.

NumerousAmericanauthorshaveexaminedthepossibilitythattheexemptioncanbejustifiedonhumanitariangrounds,basedonsympathyandpityforinjuredplaintiffs.Forexample,Yoriotakesnoteofthe“emotionalandtraditional”factorsthatmayunderlietheexemptioninIRCsection104(a)(2).20Heconcludesthatthisexplanationis“neitherlegallynorlogicallyconvincing,”sincesomedamagesthatareexemptdonotevokesympathy,whileotherdamagesthatarenotexemptcouldinvolveanemotionallyupsettinginjury.21Similarly,SagerandCohendismissthisjustificationbecausetheexclusionappliestominorinjuries.22Thehumanitarianjus-tificationhasalsobeendismissedonthegroundsthatitiscontrarytothegoalsofdisabilitypolicy.23Sinceithasbeendiscreditedintheliterature,sympathyisnot

15 Pub.L.no.104-188,110Stat.1838.IRCsection104(a)(2)currentlyreadsasfollows:Ingeneral.Exceptinthecaseofamountsattributableto(andnotinexcessof )deductionsallowedundersection213(relatingtomedical,etc.,expenses)foranypriortaxableyear,grossincomedoesnotinclude...

(2) theamountofanydamages(otherthanpunitivedamages)received(whetherbysuitoragreementandwhetheraslumpsumsorasperiodicpayments)onaccountofpersonalphysicalinjuriesorphysicalsickness.

16 SeeSagerandCohen,supranote14,at507. 17 See,forexample,KarenB.Brown,“NotColor-orGender-Neutral:NewTaxTreatmentof

EmploymentDiscriminationDamages”(1998)vol.7,no.2Southern California Review of Law and Women’s Studies223-68;andNicholasM.Whittington,“AgainsttheGrain:AnInterdisciplinaryExaminationofthe1996FederalStatutoryChangestotheTaxabilityofPersonalInjuryAwards”(1997)vol.37,no.1Washburn Law Journal153-86.

18 SagerandCohen,supranote14,at507. 19 InMurphy v. IRS,theCourtofAppealfortheDistrictofColumbiaoverturneditsoriginal

decisionthatsection104(a)(2)wasunconstitutionaltotheextentthatitrequiredthatpersonalinjurydamagesrelatingtonon-physicalinjuriesbetaxed:493F.3d170(DCCir.CA2007);vacating460F.3d79(DCCir.2006);rev’g.362F.Supp.2d206(DCCir.2005).

20 EdwardYorio,“TheTaxationofDamages:TaxandNon-TaxPolicyConsiderations”(1977)vol.62,no.4Cornell Law Review701-36,at706,citingBertramHarnett,“TortsandTaxes”(1952)vol.27,no.4New York University Law Review614-46,at626.

21 Yorio,supranote20,at707. 22 SagerandCohen,supranote14,at496-97. 23 TamaraLarre,“PitytheTaxpayer:TheTaxExemptionforPersonalInjuryDamagesasa

DisabilityPolicy”(2007)vol.33,no.3Queen’s Law Journal217-47.

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consideredinthisarticleasaplausiblejustificationforexemptingpersonalinjurydamagesfromtax.

Anotherquestionthatarisesfromtheliteratureiswhetherthe“inlieuof ”orsubstitutionapproachshouldbefollowedwhenanalyzingtheissueofwhethertheexemptionshouldbemaintained.Yorio,forexample,hasarguedthat“damagesin-tended to compensate for losses that the taxpayer would have enjoyed tax-freeshouldalsobetax-free.”24WhileYorioconcludedthatsubstitutionreasoningdoesnotsupporttheexemptionfordamagesforlossofearnings,Brookshasarguedtothecontrary.25 In thesoleCanadianacademicarticleonthetaxationofpersonalinjurydamages,Krishnauses“inlieuof ”reasoningtoconcludethatcompensationforlossofamenitiesoflifeshouldbeexemptbecausepersonalamenitiesarenotordinarilytaxed.26Whilethistypeofreasoningisusedrelativelyofteninthelitera-ture,ithasbeenquestionedbysomecommentators,suchasCochran.27Inthesecondpartofthisarticle,Iexaminethissubstitutionreasoningandexplainwhyitispref-erabletoapplytheprinciplesofequity,neutrality,andsimplicityinthiscontext.

Athirdpotentialjustificationfortheexemptionthatisexaminedintheliteratureisthatdamagesforlossofearningscanbeconsideredareturnofcapital.ThisisconsistentwiththeviewofthecourtinCirella.Thereappearstobeageneralcon-sensusintheliteraturethatifthedamagesreplaceacapitalasset,thentheamountshould,intheory,betaxedtotheextentthattheamountexceedsbasis.28Thereisdisagreement,however,overwhetherornotpersonalinjurydamagesreplaceacapitalasset.Someauthors,suchasYorioandCochran,havenotviewedlossofearningsasareturnofcapital,whileothers,suchasStephan,usetheconceptofhumancapitaltoarguethatdamages for lossofearningsdo, in fact,compensate fora lostcapitalasset.29Ifpersonalinjurydamagesforlossofearningsdocompensateforthelossofacapitalasset,thebasisoftheassetmustbedeterminedinordertocalculatethegain.Stephanarguesinsupportofapresumptionthatbasisisequaltothedamagesreceived,resultinginnotaxablegain.30Inthenextpartofthisarticle,IexaminewhetherStephan’sreasoningcanbetransferredtotheCanadiancontext.Whilethefocusof the literaturehasbeenondamages for loss of earnings, I also examine

24 Yorio,supranote20,at713.

25 JenniferJ.S.Brooks,“DevelopingaTheoryofDamageRecoveryTaxation”(1988)vol.14,no.4William Mitchell Law Review759-806.

26 VernKrishna,“TaxationofPersonalInjuryAwards:AWiryMethuselah”(1976-77)vol.3,no.2Dalhousie Law Journal385-439.

27 Seeinfranote28andthediscussioninthetextbelowatnote61.

28 See,forexample,Yorio,supranote20,at712;MarkW.Cochran,“ShouldPersonalInjuryDamageAwardsBeTaxed?”(1988)vol.38,no.1Case Western Reserve Law Review43-65,at45;andPaulB.StephanIII,“FederalIncomeTaxationandHumanCapital”(1984)vol.70,no.7Virginia Law Review1357-1428,at1388.

29 Ibid.

30 Stephan,supranote28,at1395.

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whethernon-pecuniarydamagesandlossofhomemakingcapacityshouldbeviewedascompensationforalostcapitalasset,andwhetherthesedamagescanleadtoacapitalgain.Ialsoarguethattheliteratureplacesundueemphasisonthedistinctionbetweenincomeandcapitalinthiscontext.

Many authors have also considered whether income-bunching problems canjustifytheexemption.Yoriowasparticularlysympathetictothisargumentbecauseinthecaseofpersonalinjurydamages,therealizationisforced.31Otherauthors,including Krishna, have suggested that bunching problems should be addressedthroughincome-averagingrules,suchasthoseexistingatthetimeKrishnawrotehisarticle.32Iconsiderthebunchingargumentandpotentialsolutionslaterinthisarticle.

Afinalconsiderationthatoftenarisesintheliteratureistheinteractionbetweentaxationandthepurposeoftortdamages.Forexample,Yorioconsideredtheimpactoftaxingpersonalinjurydamagesontheplaintiff,33andCochranconsideredissuessuchaseconomicincentivestobecomeanaccidentvictim,punitiveeffectsontort-feasors,andtheregulatory functionof thetortsystem.34 Inthefinalpartof thisarticle,Iraisetheneedforfurtherandmorecompletestudyoftheimpactoftaxingpersonalinjurydamagesonthegoalsoftortlaw—anendeavourthatisbeyondthescopeofthisparticulararticle.

Calculating Personal Injury DamagesTheprimarygoalofpersonalinjurydamagesistofulfillthecompensatoryprinciplebyputtingtheplaintiffbackinthesamepositionthatsheorhewouldhavebeeninhadtheinjurynotoccurred.35Thisisachievedbyawardingdamagesundernumer-ouscategories,or“heads,”tocompensateforthedifferenttypesoflossessustainedbytheplaintiff.In1978,theSupremeCourtofCanadareleasedthreecases,oftenreferredtoas“thedamagestrilogy,”thatprovidedthefoundationforthemoderncharacterizationandcalculationofpersonalinjurydamages.36Fourheadsofdamagesemergedfromthesecases:(1)specialdamages,(2)lossoffutureearningcapacity,(3)allowanceforfuturecare,and(4)non-pecuniarydamages.37Thepurposeofeachoftheseheadsofdamagesandtheapplicablemethodofcalculationarerelevanttothetaxpolicyanalysisthatfollows,andthereforearedescribedbelow.

31 Yorio,supranote20,at718.

32 Supranote26,at435.

33 SeeYorio,supranote20,at733.

34 SeeCochran,supranote28,at59-64.

35 SeeKenCooper-Stephenson,Personal Injury Damages in Canada,2ded.(Scarborough,ON:Carswell,1996),9.

36 Andrews v. Grand & Toy Alberta Ltd.(1978),83DLR(3d)452(SCC);Thornton v. School District No. 57 (Prince George)(1978),83DLR(3d)480(SCC);andArnold v. Teno(1978),83DLR(3d)609(SCC).

37 SeeThornton,supranote36.

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Special DamagesSpecialdamagescompensatetheplaintiffforpre-trialpecuniarylossesandcanbedividedintotwocategories:(1)pre-triallossofworkingcapacity,whichcompensatestheplaintiffforlostearningsandareducedabilitytoperformhomemakingtasks;and (2) pre-trial cost of care, which compensates the plaintiff for out-of-pocketmedical and care expenses related to the injury.38 Interest is awarded on specialdamagestoaccountforinflationandlostinvestmentopportunitybetweenthetimethatthelossorexpensewasincurredandthetimeofthetrial.39

Future Loss of Working CapacityDamagesforlossoffutureearningsanddamagesforlossofhomemakingcapacityarenowviewedassubheadsundertheumbrellaoffuturelossofworkingcapacity.40Damagesforlossofhomemakingcapacity,arelativelynewcategory,41areintendedtocompensatetheplaintiffforadecreasedabilitytoperformmanualandmanage-menttasksinthehome.42Courtsusuallycalculatethesedamagesbydeterminingthecostofhiringsomeonetoperformtheservicesthattheplaintiffcannolongerperform and then applying a discount rate in accordance with provincially pre-scribedrules.43

Thecalculationofdamagesforlossoffutureearningsisusuallyverycomplex,becauseofthelargenumberoffactorsanduncertaintiesthatmustbetakenintoaccount.Tomaketheawardsasaccurateaspossible,thecourtsusuallyemploytheactuarialmethodofassessmentthroughmathematicalcalculations,expertactuarialandeconomicevidence,andstatisticalevidenceandprobabilities.44Theanticipatedlostearningsstreamisdiscountedtoitsnetpresentvaluebyapplyingaprescribeddiscountrate,asdescribedabove.

38 Cooper-Stephenson,supranote35,at126.

39 Ibid.,at83.Theinterestawardedonspecialdamagesisgovernedbytheapplicableprovincialstatute,whichinmostcasesstipulateshowinterestshouldbecalculated:see,forexample,Ontario,CourtsofJusticeAct,RSO1990,c.C.43,sections127to130;BritishColumbia,CourtOrderInterestAct,RSBC1996,c.79,section1;andSaskatchewan,Pre-judgmentInterestAct,SS1984-85-86,c.P-22.2.

40 Cooper-Stephenson,supranote35,at102.Cooper-Stephenson’sdamagesschemewascitedwithapprovalinTaylor v. Hogan(1998),160Nfld.&P.E.I.R.93(Nfld.CA).Athirdsubheadunderlossofworkingcapacity,damagesforlossofsharedfamilyincome,isnotconsideredinthisarticlebecausethenatureofthissubheadisstillsomewhatuncertain.

41 ThissubheadofdamageswasfirstrecognizedinCanadiancaselawinFobel v. Dean(1991),83DLR(4th)385(Sask.CA).SeealsoMcTavish v. MacGillivray et al.,2000BCCA164;Brouwer v. Grewal(1995),30Alta.LR(3d)244(QB);andCarter v. Anderson(1998),168NSR(2d)297(CA).

42 SeeCooper-Stephenson,supranote35,at312.

43 See,forexample,thefourcasescitedinnote41,supra.Forexamplesofprovincialrulesgoverningthediscountrate,seeBritishColumbia,LawandEquityAct,RSBC1996,c.253,section56andBCReg.352/81;Ontario,RulesofCivilProcedure,RRO1990,Reg.194,rule53.09;andSaskatchewan,TheQueen’sBenchRules,rule284B(1)(b).

44 SeeCooper-Stephenson,supranote35,at56-65.

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Personal injury damages strive to fully compensate plaintiffs so that they arereturnedtotheirpre-injuryposition.Inlightofthiscompensatoryprinciple,onemightassumethatcourtswouldconsidertheimpactoftaxwhencalculatingdam-agesforlossofearnings.Forexample,ifaplaintiffwouldhavepaidtaxonhisorherfuture employment income, but does not have to pay tax on damages replacingthoseearnings,theamountofemploymentincomelostwouldbecalculatednetoftax.45Ontheotherhand,agross-upwouldbeaddedtotheawardinordertoaccountfortaxthatmustbepaidoninterestearnedonalump-sumaward.InJennings,46however, theSupremeCourtofCanadarejected thisapproachanddecided thatcourtsshouldnotconsidertaxwhencalculatingdamagesforlossofearnings.Asdiscussedabove, thecourt reasoned, inobiter, thatdamages for lossof earningscompensatetheplaintiffforlostearningcapacity,acapitalasset,whichwouldnotbesubjecttotax.Thecourtalsoobservedthattakingthistaxwindfallintoaccountwhendeterminingdamageswouldgreatlycomplicatethedamagescalculationprocess.

ThecourtinJenningsopinedthatwhencalculatingdamages,itwasnotitsconcernthatthegovernmentdidnotimposetaxondamageawards.ThecourtreaffirmedthispositioninCunningham v. Wheeler:“[T]axationofdamagesforlostincomeisaquestionwhichshouldbelefttothelegislatureswhichcan,iftheywish,readilypassamendmentstomakedamagesforlostincometaxable.”47Parliamentwasinvitedtoconsidertheissueasamatteroftaxpolicy,butasofyetithasfailedtotakethecourtuponthisinvitation.

Future Cost of Care

Damagesforfuturecostofcarecompensatetheplaintiffforexpensesthatsheorhewillhavetoincurpost-trial,includingmedicalcare,personalcare,andotherrelatedexpenses.Futurecost-of-careexpensesmaybeawardedforbothcapitalandongoingexpensesthattheplaintiffisexpectedtoincurasaresultoftheinjury.48Toarriveatthefinalaward,anticipatedexpensesarediscountedtopresentvalue49anddamagesaregrossedupinordertoaccountfortaxthatwillneedtobepaidontheinvest-mentincomeearnedonthelump-sumaward.50

Non-Pecuniary Losses

Asthelabelsuggests,non-pecuniarydamagesareintendedtocompensatetheplain-tifffornon-economiclosses.InAndrews v. Grand & Toy Alberta Ltd.,51theSupreme

45 ThisistheapproachtakenbytheBritishcourts:seeBritish Transport Commission v. Gourley,[1956]AC185,at206(HL).

46 Supranote10.

47 [1994]1SCR359,at418.

48 SeeCooper-Stephenson,supranote35,at104and409-10.

49 Ibid.,at455-56.

50 See,forexample,Watkins v. Olafson,[1989]2SCR750.

51 Supranote36.

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CourtofCanadaheld thatnon-pecuniarydamages shouldbe calculatedusing afunctional approach.This approachaims toprovide ameasureof solace for theplaintiff ’smisfortunebyawardingfundstomaketheplaintiff ’slifemoretolerableandpleasurable.Thecourtwasconcernedthatextravagantnon-pecuniaryawardscouldcreateasignificantburden,notonlyontortfeasorsbutalsoontherestofso-ciety,sincetortawardsareoftenwidelydistributed.Therefore,thecourtinAndrewsimposedacaponnon-pecuniarydamagesintheamountof$100,000,whichcourtshaveincreasedtomatchinflation.

Inpractice,courtshavenotrequiredplaintiffstoprojectexpendituresforwhichnon-pecuniarydamageswillbeused.Instead,courtsusuallysetnon-pecuniarydam-agesbylookingtothesizeofawards insimilarcases.52Asaconsequenceofthisglobal approach, neither discount rates nor tax gross-ups are directly employedwhendeterminingthevalueofnon-pecuniaryawards.53

TA X P O LIC Y A N A LYSIS

Theappropriatetaxtreatmentofpersonalinjurydamagesisessentiallyaquestionofhowtodefinethetaxbase.Taxpolicyanalystshavedevelopedaframeworkofcriteria for evaluating the revenue-raising provisions in income tax legislation,whichincludesthecriteriausedhere:equity,neutrality,andsimplicity.Ialsocon-sidertheequalityimplicationsofparticularpoliciesthroughout.54Sincemyanalysisrevealstensionbetweenthegoalsofequityandsimplicity,Iconsidersolutionsthatbalance the concerns relating to these two criteria. I conclude that equity itselfwouldrequirethatallpersonalinjurydamagesbetaxedtotheextentthatthedam-agesexceedtherelevantcosts,butthatsomecompromiseisnecessaryinordertosimplifythecomputationofnetincome.

The “In Lieu of ” Approach

Somescholarswritingontheappropriatetaxtreatmentofpersonalinjurydamageshaveappliedwhatisreferredtohereasthe“inlieuof ”principle.Brookshasde-scribedthislineofreasoningasfollows:“Paymentstocompensatepeopleforthelossofvaluetheyotherwisereceivetaxfreeshouldalsobetaxfree.”55Theprinciplehasalsobeenstatedinthereverse:replacementsoftaxablevaluesshouldbetaxable.56

52 SeeCooper-Stephenson,supranote35,at482-83.

53 See,forexample,Tucker (Public Trustee of ) v. Asleson(1991),62BCLR(2d)78(SC);rev’d.onothergrounds78BCLR(2d)173(CA).

54 Younghasarguedthattaxprovisionsshouldbeevaluatedfortheireffectonsubstantiveequality:seeClaireF.L.Young,“(In)visibleInequalities:Women,TaxandPoverty”(1995)vol.27,no.1Ottawa Law Review99-127.

55 Supranote25,at761.

56 Numerouscommentators,includingYorio,supranote20,at707,andSagerandCohen,supranote14,at474,haveappliedthisreasoningtotheissueofthetaxationofpersonalinjurydamagesforlossofearnings.

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Theapproachtakenunderthe“inlieuof ”principleistoimaginethattheinjuryhad not occurred and to determine whether the thing that the damages replacewouldbetaxed.

“Inlieuof ”reasoningusedatthetimeofdeterminingwhethersomethingistax-ableas“income”shouldnotbeconfusedwithasimilartypeofreasoningusedbythecourtstofillingapsthatexistinthelegislation,asisdonethroughthesurrogatumprinciple.Whereanitemhasnotbeenspecificallyconsideredbylegislators,courtsoftenusethesurrogatumprincipletotaxareceiptthatmayhaveotherwise“fallenthrough the cracks” of the source-based definition of income in paragraph 3(a).However,wherepolicyreformisbeingconsidered,afullanalysisshouldbeem-ployedbypolicymakers,andthereisnoneedtouseatoolsuchasthesurrogatumprincipletopreventtaxerosion.

Inthecaseofdamagesforlossofhomemakingcapacityandnon-pecuniarydam-ages,theapplicationof“inlieuof ”reasoningresultsintheconclusionthattheyshouldbeexempt sincehomemakingproducesnon-taxable imputed incomeandenjoymentoflifeisnon-taxablepsychicincome.Ontheotherhand,the“inlieuof ”principlecannotbeappliedinameaningfulwaytodamagesforcostofcarebecausetheycompensatefortheacquisitionofadditionalexpensesratherthanlostincomeoradestroyedasset.Theapplicationof“inlieuof ”reasoningtodamagesforlossofearningsislesssettled.Somecommentators,suchasYorio,haveused“inlieuof ”reasoningtoarguethatdamagesforlossofearningsshouldbetaxedbecausetheyreplace income that would have been subject to tax.57 Conversely, Brooks hasarguedthatdamagesforlossofearningsshouldnotbetaxedbecausetheyreplaceearningcapacity,whichproducesnon-taxableimputedincome.58“Inlieuof ”rea-soninghasthereforebeenusedbothtosupportanargumentthatdamagesforlossofearningsshouldbetaxedandtosupporttheopposingargumentthattheyshouldbeexempt.

Whilethe“inlieuof ”lineofreasoningappearstohaveanintuitiveappeal,59commentatorsalmostinvariablyemploythisapproachwithoutexplainingitssuperi-orityoverthemoreusualandacceptedpracticeofconsideringfactorssuchasequity,neutrality,andsimplicity.Intuitionisnotasufficientreasontousesubstitutionrea-soningwhendetermininghowpersonalinjurydamagesshouldbetaxed;theremustbeamorerationalexplanation.Itisarguedherethatnosuchexplanationexists.

Theuseof“inlieuof ”reasoningtoincludeareceiptinincomecanplayaroleindiscouragingtaxavoidancewherethetaxpayeriseasilyabletoconverttaxable

57 Yorio,supranote20,at714.

58 Supranote25,at776.

59 Halperinstates,“Intuitively,Ibelievemostofuswouldconcludethatsuchrecoveriesorbenefitsfromthedealer,atortfeasororaninsurancecarriershouldnotbetaxableto[theplaintiff ].Afterallheisnobetteroffthanthosewhodidnotsufferaloss.”DanielHalperin,“ValuingPersonalConsumption:CostVersusValueandtheImpactofInsurance”(1992)vol.1,no.1Florida Tax Review1-50,at4-5(emphasisadded).

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incomeintodamages.Mannsexplainsthatwithoutsubstitutionreasoning,aland-lordcouldconvertrentalincomeintoawindfall“throughthemereexpedientfilingoflawsuitsorassertingclaims.”60Thisisespeciallyaconcernincontractlaw,wherethepartiesareabletosetthetermsofbreach.However,theconversionofincomeisnotapressingconcerninthecaseofpersonalinjurydamages,wheretheplaintiffhasaveryrestrictedabilitytomanipulatethesituationinordertocreateanaction-ableloss.

Afewcommentatorshavearguedagainsttheuseof“inlieuof ”reasoning.Cochran,forexample,challengestheconclusionthatifdamagesareawardedtocompensatefornon-taxableincome,thedamagesshouldalsobenon-taxable.Heexplains:

Itisgenerallyagreedthatimputedincomeescapestaxationforpracticalratherthanlogicalreasons.Specifically,difficultyindefiningandvaluingimputedincomearethemainobstaclestoitstaxation.Itappearsthattheseobstaclesareremovedwhenim-putedincomeisreducedtocash.Thus,whiledamageawardssometimesrepresentasubstitutefornon-taxableimputedincome,itdoesnotfollowthatsuchawardsshouldbeexcludedfromgrossincomeonthatbasis.61

Similarly,Dodgearguesthat“[t]hetaxCodewouldbewhollyunderminediftrans-actionsinvolvingmaterialwealthcouldbeconvertedbyamagicwandintonon-materialephemera.”62

Onemightassumethattheapplicationofthe“inlieuof ”principlewillalwaysyield the sameresultsas theapplicationofequity,neutrality, andsimplicity,andtherefore“inlieuof ”reasoningcouldbeusedasatypeofshortcutfordeterminingthe appropriate tax treatment of replacement payments such as personal injurydamages.However,theanalysisinthisarticlewillshowthatthisisnotnecessarilythecase.Theredoesnotappeartobeaconvincingreasonforapplying“inlieuof ”reasoninginsteadofthecriteriaofequity,neutrality,andsimplicity.

Neutrality: The Behavioural Effects of Taxing Damages

Itiswellacceptedthattaxpolicyanalysisshouldconsidertheeconomicimpactofaparticulartaxpolicy.Thecriterionofneutralityisusuallyconcernedwithinterfer-encewiththefreemarket.However,inthecaseoftaxingpersonalinjurydamages,thismaynotbeparticularlyrelevant,sincethetortlawhasalreadyinterferedwiththe freemarket through the impositionofdamages. Instead,efficiencyconcerns

60 PhilipF.MannsJr.,“RestoringTortiouslyDamagedHumanCapitalTax-FreeUnderInternalRevenueCodeSection104(a)(2)’sNewPhysicalInjuryRequirement”(1998)vol.46,no.2Buffalo Law Review347-91,at348.

61 Cochran,supranote28,at48-49.

62 JosephM.Dodge,“MurphyandtheSixteenthAmendmentinRelationtotheTaxationofNon-ExcludablePersonalInjuryAwards”(2007)vol.8,no.4Florida Tax Review369-428,at425.AlthoughDodge’scommentsweremadeinrelationtostatutoryinterpretationbythecourtsinMurphy,supranote19,theyapplyequallyinthetaxpolicyforum.

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mayariseherebecauseofthewaytheimpositionoftaxcaninterferewithtortlaw,which,accordingtoscholarssuchasPosner,shouldanddoesstrivetoachievetheoptimallevelofdeterrenceandoverallreductionofthecostofaccidents.63Theim-positionof taxwillchange thecostof theaccident, toeither theplaintiffor thetortfeasor,dependingonwhetherthedamagesawardisgrosseduptotakethetaxesintoaccount.Thiswill,atleastintheory,affecttheavoidancemeasurestakenbythepersonbearingthetaxburden.Assumingthattortlawiscapableofhavingthede-terrenteffectclaimedbyPosnerandothers,thequestioniswhetherthisresultsinthe appropriate levelofdeterrence forpotential tortfeasors and in avoidancebypotentialplaintiffs.Generally,potentialtortfeasorswillbeencouragedtotaketheappropriateprecautionsifdamagesaresetattheamountofthesocialloss.64

The current tax exemption combined with the existing gross compensationapproachtocalculatingthelossofearningsshouldachievethecorrectlevelofde-terrence,becausethetortfeasormustpaytheentiresocialloss,includinglosttaxrevenues.65Sincetheplaintiffreceivesawindfallasaresultofthegrosscompensa-tionapproach,itmaybearguedthattheplaintiffisnotreceivingtheappropriateincentivetoprotecthimselforherselffrominjury.Iftaxisimposedondamagesforlostearnings,itispossiblethatcourtswillrespondbycalculatingdamagesnetoftaxthatwouldhavebeenpaidontheearnings,andthengrossinguptheawardtomaketheplaintiffwhole.Thiswouldsolve theproblemof theplaintiffnot takingad-equatemeasurestoavoidtheinjury,butitcouldleadtooverdeterrencebecauseofbunchingconcerns.Thisproblemwillberesolvedforthemostpartifaveragingisallowed,asrecommendedlaterinthisarticle.

Inthecaseofnon-pecuniarydamages,itismoredifficulttoestablishthecorrectlevelofdeterrenceandavoidance.Atatheoreticallevel,thecaponnon-pecuniarydamageawardslikelyresultsinunderdeterrenceandoveravoidance.Itispossiblethatmoreefficientdeterrencemayresultiftheawardsaretaxedandgrossedupfortax.However,itisuncertainwhetheragross-upwouldoccur,giventhereluctanceofthecourtstoincreasenon-pecuniarydamageawards.

It alsoappears that thecorrect levelofdeterrenceandavoidance is currentlyachievedforcostofcareandlossofhomemakingcapacity,sincetheentiresocialcostisbeingbornebythetortfeasorandthereisnowindfalltotheplaintiff.Iftaxisimposedandthereisagross-upofthedamages,overdeterrencemayoccur.Giventheuncertaintyofwhetherdamagesawardswouldbegrossedupandtheuncer-taintyoftheactualimpactonprecautionsresultingfromanincreaseintortdamages,

63 See,forexample,RichardA.Posner,Economic Analysis of the Law,5thed.(NewYork:AspenLaw&Business,1998),209;WilliamM.LandesandRichardA.Posner,The Economic Structure of Tort Law(Cambridge,MA:HarvardUniversityPress,1987),14;andGuidoCalabresi,The Costs of Accidents: A Legal and Economic Analysis(NewHaven:YaleUniversityPress,1970),26-27.

64 See,forexample,StevenShavell,Economic Analysis of Accident Law(Cambridge,MA:HarvardUniversityPress,1987),143.

65 Ibid.

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deterrence-related arguments only weakly justify the exemption for cost-of-careandlossofhomemakingcapacitydamages.

Equity and Simplicity: The Pragmatic Application of Income Theory

Afairtaxsystemandsocialjusticedemandthatpersonsinsimilarcircumstancesbetreatedalikeunderthelaw.Intermsoftaxlaw,thisrequiresthatindividualsinsimilarcircumstancesbearthesameamountoftax,aprinciplereferredtointaxdiscourseashorizontalequity.Therelatedprincipleofverticalequityrequiresthatpersonsindifferentsituationsbearappropriatelydifferenttaxburdens.

Themostwidelyacceptedresponsetothequestionofwhatcircumstancesshouldberelevantwhencomparingtaxpayersandtheirrelativeburdensunderanincometaxsystemisthattaxpayersshouldbecomparedonthebasisoftheirabilitytopayasmeasuredbyincome.66Itisthereforenecessarytodefineincomeinordertoapplytheconceptofequity.Haigdescribedincomeas“themoneyvalueofthenetaccre-tiontoone’seconomicpowerbetweentwopoints intime.”67BuildingonHaig’swork,Simonsproducedwhatisperhapsthemostwell-knowndefinitionofincome.Underthisdefinition,referredtoastheHaig-Simonsaccretiondefinition,incomeisdefinedas“thealgebraicsumof(1)themarketvalueofrightsexercisedincon-sumptionand(2)thechangeinthevalueofthestoreofpropertyrightsbetweenthebeginning and end of the period in question.”68 While perhaps not all scholarswouldagreethattheHaig-Simonsdefinitionofincomeistheideal,nootherfullydevelopedandwidelyacceptedtheoryofincomehasemergedintheliterature.Forthisreason,theHaig-Simonsdefinitionisrecognizedbymanytaxscholarsasthestartingpointfordiscussionsoftaxreformandpolicy.69Thisarticle,too,willusetheHaig-Simonsdefinitionwhenapplyingtheconceptoftaxequity.

Formanyreasons,mostofwhichareeitherpracticalorpoliticalinnature,theActhasnotfullyadoptedtheHaig-Simonsdefinitionofincome.Forexample,inordertoresolve“thetwinproblemsofvaluation...andliquidity”inherentinan

66 See,forexample,PeterW.Hogg,JoanneE.Magee,andJinyanLi,Principles of Canadian Income Tax Law,5thed.(Toronto:Carswell,2005),27;andCanada,RoyalCommissiononTaxation,Report of the Royal Commission on Taxation(Ottawa:Queen’sPrinter,1966),vol.3,16-17(hereinreferredtoas“theCarterreport”).

67 RobertMurrayHaig,“TheConceptofIncome—EconomicandLegalAspects,”inRichardA.MusgraveandCarlA.Shoup,eds.,Readings in the Economics of Taxation(Homewood,IL:RichardD.Irwin1959),59.

68 HenryC.Simons,Personal Income Taxation(Chicago:UniversityofChicagoPress,1938),50.

69 See,forexample,LouisKaplow,“HumanCapitalUnderanIdealIncomeTax”(1994)vol.80,no.7Virginia Law Review1477-1514;andStanleyA.Koppelman,“PersonalDeductionsUnderanIdealIncomeTax”(1988)vol.43,no.4Tax Law Review679-730,at682-83.EventheCartercommissionusestheHaig-Simonsdefinitionasitsstartingpoint:Carterreport,supranote66,vol.3,at39.

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unrealizedaccrualsystem,70mostincometaxsystemshavefollowedtherealizationprinciple.OnceitisacknowledgedthattheActdoesnotadheretotheHaig-Simonsdefinitionofincome,itisimpossibletoignoretherealitiesofourtaxsystem.Bittkerusedtheconceptof“secondbest”todescribehowtaxpolicyshouldbeanalyzed.“The‘best’practicalprogram,onthistheory,wouldnotbetheonethateliminatedthemost‘preferences,’buttheonewhosetaxburdendistributionwastheclosesttotheideal.”71Theideaofsecondbestprovidesthattheappropriatetaxtreatmentofanamountcannotbedeterminedonlybyreferencetothe“firstbest”Haig-Simonsconceptofincome;rather,thenecessarydeviationsfromthe“firstbest”rulepresentintheexistingsystem(forexample,therealizationprinciple)shouldbeacknowledged.72

Thetaxpolicycriterionofsimplicityrequiresthatpracticalmattersbeconsid-ered.Whilethefirststageofanalysisistodeterminetheidealtaxtreatmentofaparticularitembyreferencetoanormativetheoryofincome,itisequallyimportanttoaddresspragmaticconcernssuchasadministrativeandcompliancecosts,com-prehensibility,certaintyofapplication,andlikelihoodofavoidanceorevasion.Itwillbecomereadilyapparentthattaxingpersonalinjurydamagesaccordingtotheidealpresentsseriousimpracticalities,andalargeportionoftheanalysisinthisarticleisdedicatedtoaddressingthoseimpracticalitiesinthefairestmannerpossible.

In thediscussion that follows, Iwill analyzewhether tax equity requires thatpersonalinjurydamagesbetaxed,usingtheHaig-Simonsdefinitionofincomeastheideal.Theprimaryquestionthatmustbeanswerediswhetherornotthedamageswouldconstituteincome.Whereitisimpracticaltoimplementtheidealtaxtreat-ment,administrativeconcessionsarediscussed.Thefollowinganalysisleadstotheconclusionthatdamagesforcostofcarearenotincome,butthattaxingcost-of-careawardsmaybethemostequitableinlightoftheexistingtaxcreditformedicalex-penses.Iarguethatlossofworkingcapacityandnon-pecuniarydamagesareincometotheextentthattheyexceedtheplaintiff ’sbasisinworkingcapacityandcapacitytoenjoylife,respectively,butthereareinsurmountablebarrierstocalculatingbasis.Iconcludethatthebestsolutionistoassumeabasisofnil,andthereforetaxthedam-ages.Ithenconsiderwhethercapitalgainstreatmentisjustifiedandhowbunchingconcernsshouldbeaddressed.

Damages for Cost of CareClearly,thereceiptofdamagesforcostofcareleadstoanincreaseinwealthundertheHaig-Simonsdefinitionofincome.Thequestioniswhetherthereisadecrease

70 DavidJ.Shakow,“TaxationWithoutRealization:AProposalforAccrualTaxation”(1986)vol.134,no.5University of Pennsylvania Law Review1111-1205,at1113.

71 BorisI.Bittker,“A‘ComprehensiveTaxBase’asaGoalofIncomeTaxReform”(1967)vol.80,no.5Harvard Law Review925-85,at983-84.

72 SeealsoJ.GregoryBallentine,“ThreeFailuresinEconomicAnalysisofTaxReform,”inProceedings of the Seventy-Ninth Annual Conference on Taxation(Hartford,CT:NationalTaxAssociation—TaxInstituteofAmerica,1986),3-6.

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inwealthwhentheplaintiffincursthecost-of-careexpenses.Thiswillnotbethecaseiftheexpensesrepresentconsumption.Iftheexpensesarenotconsumption,anargumentcanbemadethatthereisnonetdecreaseinwealth,andthereforethedamagesshouldnotbesubjecttotax.

Theappropriatetaxtreatmentthereforedependsonone’sinterpretationoftheconsumptionelementofthedefinitionofincome.73Threeleadingscholars,Andrews,Kelman,andSurrey,haveattemptedtoclarifythedefinitionofconsumptionanditsapplicationtomedicalexpenses.Itisclearthatthereisnoconsensusonthedefinitionofconsumption.Andrewsequatesconsumptionwiththoseexpensesthatrepresentanincreaseinwell-being,andthereforearguesthatmedicalexpensesarenotcon-sumption.74Kelmanappearstobelievethatconsumptionincludesallmoneythatthetaxpayerhasvoluntarilydisposedof(presumablyexcludingbusinessexpenses).75Sincehemaintainsthatmedicalexpendituresarevoluntarilyincurred,76itfollowsthattheyshouldbeincludedinincomeasconsumption.Surreyviewsconsumptionasallexpendituresunrelatedtoearningincome.77Hisopinionisthatmedicalex-pensesarecorrectlyclassifiedastaxexpenditures,andconsequentlytheirdeductionisnottheoreticallynecessaryinordertoarriveatnetincome.78

Canadianpolicymakersappeartosupporttheview(atleasttoalimiteddegree)thatmedical expensesdonot represent consumption. Initially introduced in theformofadeduction,thecurrentmedicalexpensestaxcredit(METC)allowsforacreditequalto15percentofeligiblemedicalexpensesbeyondacertainthreshold.Thethresholdin2010isequaltothelesserof$2,024and3percentofthetaxpayer’sincomeforthetaxationyear.79Themostpersuasivereasonforthethresholdisthatit represents theaverageamountofmedicalexpenses incurred in theyearbyall

73 Itisinterestingtonotethattheanalysisofcost-of-careawardsunderaconsumptiontaxwouldbethesameasthatcontainedinthisarticlesincetheprimaryconceptualissueundertheaccretiondefinitioniswhethertheexpecteduseisconsumption.Theanalysisoftheothertypesofdamagesunderaconsumptiontaxwouldbesignificantlydifferent.Underaconsumptiontax,damagesforlossofworkingcapacitywouldbetaxedonlywhenconsumed.Non-pecuniarydamages,ontheotherhand,arebasedonamountsthattheplaintiffcouldspendtomakelifemorepleasurable.Therefore,anargumentcouldbemadethatnon-pecuniarydamagesshouldbetaxedunderaconsumptiontax,butthepaymentoftaxshouldbespreadouttocorrespondtotheyearsoverwhichtheconsumptionwilloccur.

74 WilliamD.Andrews,“PersonalDeductionsinanIdealIncomeTax”(1972)vol.86,no.2Harvard Law Review309-85.

75 MarkG.Kelman,“PersonalDeductionsRevisited:WhyTheyFitPoorlyinan‘Ideal’IncomeTaxandWhyTheyFitWorseinaFarfromIdealWorld”(1979)vol.31,no.5Stanford Law Review831-83,at835.

76 Ibid.,atnotes87and101.

77 StanleyS.Surrey,Pathways to Tax Reform: The Concept of Tax Expenditures(Cambridge,MA:HarvardUniversityPress,1973),121.

78 Ibid.,at21-22.

79 Section118.2.

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taxpayers;therefore,thecreditisintendedtoofferreliefonlytothosewhoincurextraordinaryexpenses.80Thefederalgovernment’sdecisiontoconvertthedeductiontoacreditappearstobeinconsistentwiththeideathatmedicalexpensesarenotconsumption,sincetheamountofthecreditisrestrictedbythelowestmarginalrateoftax.However,Duffpointsoutthatthemovetoacreditsystemmayhavebeenpoliticalinnature.81Therefore,theconversionofthedeductiontoacreditshouldnotrefutethepropositionthatourtaxsystemacceptsthatatleastmanymedicalexpensesarenon-discretionary,non-consumptionitemsandshouldnotbetaxed.Inthefollowinganalysis,Iadopttheviewthatmedicalexpensesarenotconsumption,whichappearstobemostconsistentwiththeAct.

Theconceptofequitystrivestoensurethatthetaxburdenisappropriatelyequal(inthecaseofhorizontalequity)ordifferent(inthecaseofverticalequity).TheMETCcanaffectthetaxburden,andthereforeitsimpactmustbeconsidered.Intheexamplesbelow,Icomparethetaxburdensofplaintiffsinreceiptoffuturecost-of-careawardswiththetaxburdensofuncompensatedinjuredtaxpayersanduninjuredtaxpayers.Threealternativetaxtreatmentsofmedicalexpensesareappliedinanattempttodeterminethemostequitablesolution.Underthefirstscenario,cost-of-careawardsarenottaxedandtheMETCisstillavailabletotheplaintiff.Underthesecondscenario,cost-of-careawardsarenottaxedbuttheMETCisnotavailabletotheplaintiff.Underthethirdscenario,cost-of-careawardsaretaxedandtheMETCisavailabletotheplaintiff.Itbecomesclearfromtheseexamplesthatinequitieswillbepresentunderallthreealternativetaxtreatments.

Assumethattherearetwotaxpayers,AandB,eachwithanetincomeof$50,000(nottakingintoaccountcost-of-careexpenses,cost-of-careawards,ortheMETC),and each with $20,000 of “extraordinary” medical expenses (that is, expenses inexcessofthethreshold)thatqualifyfortheMETCundersection118.2.Aissuccess-fulinherpersonalinjuryactionintheyearoftheinjuryandrecovers$20,000asacost-of-careaward,butBdoesnotreceivepersonalinjurydamages.Itisindisput-able that thecost-of-careaward is anaccretion towealth, thereby increasingA’sincomeby$20,000.However,assumingthatmedicalexpensesarenotconsumption,theincomeofbothtaxpayerswilldecreaseby$20,000.Theresultisthat,intheory,afterconsideringmedicalexpensesanddamagesawarded,A’sincomewillbe$50,000andB’sincomewillbe$30,000.

Underthefirstscenario,cost-of-careawardsareexemptandtheMETCisavail-abletothetaxpayerreceivingthedamages.Thisis,infact,theCRA’sinterpretationoftheapplicationoftheMETCtofuturecost-of-careawards.82TheresultisthatA

80 Carterreport,supranote66,vol.3,at213;andDavidG.Duff,“DisabilityandtheIncomeTax”(2000)vol.45,no.4McGill Law Journal797-889.

81 Duff,supranote80,at821-22.

82 Subsection118.2(1)affordstaxpayersacreditfortheir“medicalexpenses,”butparagraph118.2(3)(b)excludesamountsforwhichthetaxpayerisentitledtobereimbursed,unlessthereimbursementisrequiredtobeincludedinincomeandisnotdeductible.Sincecost-of-care

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andBwillbothpaytaxon$50,000ofincomeandwillbothbeentitledtothesameMETC.Therefore,theywillpaythesameamountoffederaltax,eventhoughitisindisputablethatA’sincomeis$20,000greaterthanB’s.Itisalsoclearthathorizon-talinequitiesmaycurrentlyexistifonecomparestaxpayerswhoincurextraordinarymedicalexpenseswith thosewhodonot.Consider taxpayer C,whose income is$50,000andwhodoesnotincuranyextraordinarymedicalexpenses.Althoughintheorytheirincomesarethesame,CwillpaymoretaxthanA.ThisisbecausethetaxsystemrecognizesA’smedicalexpensestwice—firstintheformofanexclusionfromincomeandsecondthroughtheMETC.

Inthesecondscenario,cost-of-careawardsremaintax-exemptbutrecipientsarenotpermittedtousetheMETCforthereimbursedexpenses.Underthisscenario,AwillpaymoretaxthanBbecausetheMETCisnolongeravailabletoA.However,verticalinequitywillstillexistbecausethevalueoftheMETCtoBwillbelessthanthe$20,000deductionavailabletoA.ThisisbecausethevalueoftheMETCtoBwillbelessthana$20,000deduction.TherearenoinequitiesbetweenAandChere,sincebothwillbetaxedon$50,000andneitherwillqualifyfortheMETC.So,whilesomeinequitiesareresolvedunderthisscenario,othersarenot.Asapracticalmatter,itwouldbedifficulttodisallowtheMETCrelatingtothefuturecostsforwhichthetaxpayerhasbeencompensatedsinceitwouldbenearlyimpossibleinmanycasestoidentify which medical expenses actually incurred by the injured taxpayer werefactored into the damages calculation. This problem would not exist for specialdamagesreimbursingthetaxpayerforexpensesalreadyincurred.

Underthethirdscenario,cost-of-careawardsaretaxedandthetaxpayerreceivingtheawardispermittedtotaketheMETC.A’staxableincomewillbe$20,000greaterthanB’s,andtherefore(assumingthattheprogressivetaxratesare“correct”),verticalequitywillbeachieved.However,therewillbeinequitabletreatmentasbetweeninjured taxpayers and uninjured taxpayers. A will pay more tax than C since theMETCwillbenefitAonlytotheextentofthelowestmarginalrate.

Allthreeofthescenariosconsideredgiverisetoinequities.However,inthecaseofthethirdscenario,theinequitymaybeviewedasanintentionalchoicebypolicymakers.ThisinequitabletreatmentofinjuredanduninjuredtaxpayersresultsfromtheMETCbeingintheformofacreditratherthanadeduction;theinequityexistswhetherornottheinjuredtaxpayeriscompensatedthroughacost-of-careaward.Presumably,theuseofacreditwasanintentionalchoicemadebythefederalgov-ernment.Ifitcannotbejustifiedonpolicygrounds(asmanywouldargue),thenthe

awardsarecurrentlynotincludedinincome,onecouldarguethattheyareareimbursementofmedicalexpenses,whichshoulddisqualifythoseexpensesfrombeingclaimedundertheMETC.However,thiswouldraisedifficultieswithidentifyingtheparticularmedicalexpensesforwhichtheplaintiffiscompensatedthroughthecost-of-careaward.ThispracticalconcernmayhaveinfluencedtheCRA’sopinionthatfuture-carecostsarenotconsideredreimbursementsofmedicalcostsforthepurposesofparagraph118.2(3)(b):seeCRAdocumentno.9421975,“ReimbursementofMedicalExpenses,”November23,1994.FromthisitcouldbeinferredthattheMETCwouldbeavailabledespitethereceiptofafuturecost-of-careaward.

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resultinginequitieswouldbebetterresolvedbyallowingadeductionformedicalexpensesthanbyignoringcost-of-careawardsfortaxpurposes,whichgivesprefer-entialtreatmenttosuccessfultortplaintiffs.

Asaresultoftheforegoingdiscussion,thereissomesupportforarguingthattaxingcost-of-careawardsisthepreferablealternative.However,cost-of-careawardswillgiverisetoincome-bunchingconcernswheretheawardislarge.Sincebunch-ingisaproblemwithotherheadsofdamagesaswell,itwillbeconsideredseparatelybelow.

Damages for Loss of Working CapacityTheliteraturehasraisedtheissueofwhetherdamagesforlossofearningscompen-sateforthelossofacapitalassetorincome.TherearestrongargumentstosupportthereasoningofthecourtsinJenningsandCirellathatdamagesforlossofearningscompensateforthelossofthecapacitytoearn,acapitalasset.Whilethosecasesdidnotaddress thepossiblecapitalgainsconsequencesof thisfinding, thebasiccharacterizationof thedamages as replacementof capital iswell foundedand issupportedbysomeoftheliteratureonhumancapital.83Whiledamagesforlossofhomemakingcapacityhavenotbeendiscussedintheliterature,itisalsoappropriatetoextendtheanalysisfordamagesforlossofearningstoconcludethatdamagesforlossofhomemakingcapacitycompensateforalostordamagedcapitalasset.Inbothcircumstances,theveryabilitytoearnincomeorperformhouseholdtaskshasbeenwhollyorpartiallydestroyed,andthistendstosupporttheconclusionthattherehasbeendamagetoacapitalasset.Inthediscussionthatfollows,Iusetheterm“earn-ingcapacity”todescribetheassetconnectedtodamagesforlossofearningsandtheterm“homemakingcapacity”todescribetheassetconnectedtodamagesforlossofhomemakingcapacity.Attimes,thesetwoassetsarereferredtotogetheras“workingcapacity.”Whilesomemaytakeissuewithviewingthesedamagesascompensationforcapitalassets,Iarguebelowthatthedistinctionbetweenincomeandcapitalhereisnotasimportantasitismadeouttobeintheliterature.

Inanarticleonthetaxationofhumancapital,Stephandiscussesthetaxexclusionforpersonalinjurydamages.Hebeginsbydefininghumancapitalasthe“presentvalue of the flow of future satisfactions that an individual can command in thecourseofhislife.”84Heexplainsthathumancapitalisacquiredatbirththroughbio-logicalandsocialinheritance,oftenreferredtoasendowment;throughindividualaction, such as education, on-the-job training, migration, and health care; andthroughexogenouschanges,includingtechnologicalorsocialtransformation.Heassertsthat,intheory,increasesinfutureearningpowershouldproducetaxliabil-itiesanddecreasesinfutureearningpowershouldproducetaxdeductions.85

83 See,forexample,Stephan,supranote28andthediscussionbelow.

84 Ibid.,at1358.

85 Ibid.,at1358-60.

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Inthecaseofpersonalinjurydamagesforlossofworkingcapacity,itappearsthatthereisnonetincreaseinwealth.TheaccumulationaspectoftheHaig-Simonsformulatakesintoaccount“thechangeinthevalueofthestoreofpropertyrightsbetweenthebeginningandendoftheperiodinquestion.”86Simonswasconcernedwiththeabilitytomeasurechangesinwealthinconsistentunits.Inhisview,incomehastodowith“rightswhichcommandprices(ortowhichpricesmaybeimputed),”87anditis“measuredaccordingtoobjectivemarketstandards.”88Earningcapacityiscapableofbeingmeasuredaccordingtoobjectivemarketstandards,notbecauseitmaybetransferredorsold,butbecauseitsexpectedincomestreamhasamarketvalue.Homemakingcapacityalsocanbemeasuredusingobjectivemarketstandards,be-causethereisamarketforhomemakingduties.Sinceworkingcapacityiscapableofbeingobjectivelymeasuredintermsofmarketvalue,decreasesinthevalueofwork-ingcapacityasaresultoftheinjuryshouldbereflectedintheaccumulationpartoftheHaig-Simonsdefinitionof income. Ifdamagesareawarded, therewillbeanoffsettingincreaseinwealthinthetaxationyearinwhichthedamagesarereceived.Thus,therewillbenonetaccretiontowealthasaresultoftheinjuryifdamagesinanamountequaltothelossofworkingcapacityarereceivedintheyearoftheinjury.

However, income may arise under our tax system without a net accretion towealth,becauseoftherealizationprinciple.ThedifferencebetweentheHaig-Simonsdefinitionof incomeand incomeunder therealizationprinciple is the timingofincomeinclusions.AlthoughtheremaynotbeanetaccretiontowealthundertheHaig-Simonsdefinitionwhendamagesfor lossofworkingcapacityarereceived,theremayneverthelessbeincomeunderarealizationsystemowingtolatentgainsthatwouldhavealreadybeentaxedhadthetaxsystemfullyimplementedtheHaig-Simonsconceptofincome.ThisexplainsStephan’sargumentthatconversionofacapital asset (including human capital) produces income to the extent that theamountrealizedexceedsadjustedbasis.89

Itisworthnotingherethatthesameconclusionisreachedevenifworkingcap-acityisnotrecognizedasanasset.Ifdamagesforworkingcapacityareviewedasreplacingincomeratherthanacapitalasset,theresultwillbesimilar,ifnotthesame:damageswillrepresentincome(oraloss)totheextentthatthedamagesexceed(orareexceededby)undeductedexpensesincurredtoearnthatincome.Thatis,ifwork-ingcapacityisnotrecognizedasanasset,thecoststhatwouldhaveotherwisebeenclassifiedasinvestmentscreatingbasisshouldbeviewedinsteadasdeductiblecurrentexpenses.Thepracticalissuessurroundingthedeterminationofbasisanddeduct-ibleexpenseswillbeconsiderednext.

Stephandiscussesthetaxpayer’sbasisinthetwocomponentsofhumancapital,endowment and accumulation. He argues that endowment could be treated the

86 Simons,supranote68,at50.

87 Ibid.,at49.

88 Ibid.,at51.

89 Stephan,supranote28,at1388.

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sameasinheritancesundertheIRCbyallowingbasistobesteppeduptoitsvalueatbirth.90Oneargumentinfavourofusingabasisofnil,however,wouldbetoavoidthedifficultiessurroundingthecalculationofdepreciationofbasis.Stephanarguesthatthisproblemcanbedispensedwithbyassumingthateveryonewouldhavethesamedepreciationdeductioneachyearandallowingnodeduction,orbyonlyrec-ognizinglargevariationsresultingfromdisruptionsinlifepatterns.91

Ontheotherhand,Stephandoesacknowledgethatpersonalinjurydamagesmayleadtoagaininsomecases,especiallywherehumancapitaliscreatedbysubsidiesorforgoneearnings,whichdonotincreasebasis.Stephanpointsoutthatthedilemmaisthatidentifyingthegainportionofadamageawardwillusuallybeprohibitivelycostly;thus,“thechoiceisbetweenovertaxationandundertaxation,andonecanonlyguesswhichruleerrsmorefrequentlyormoredramatically.”92Heconcludesthatbyusingthebasis-firstapproach,whichtheUSCongressappliesforpartialliquidationsinothercontexts,thepresumptionofnogainproducesfewer“wrong”results.

Twoadministrativelyfeasibleoptionsfordealingwiththedifficultiesofdetermin-ingbasisaretoassumeeitherthatthebasisisnilorthatitisequaltothedamagesawarded.Stephan’sargumentthatoverinclusionastheresultoftaxingpersonalinjurydamagesismorelikelythanunderinclusioninthecaseofnottaxingdamagesisbasedontwoimportantassumptionsthatdonottranslatetotheCanadiancontext.First,Stephanfavoursabasis-firstapproachforcomputinggainsonapartialdistribution,whichheconcludesisconsistentwithUSlaw.InCanada,however,theActcallsforaprorataallocationofbasis.93Second,StephanobservesthataddingthevalueoftheendowmentatbirthtobasiscouldbeanextensionoftheruleintheIRCthatallowsastep-upofbasisininheritedpropertytoitsvalueatthetimeofthepreviousowner’sdeath.94However,thistaxadvantageclearlyignorestheaccretiontowealthexperi-encedbytherecipientoftheproperty.InCanada,astep-upinbasisisallowedforinheritedproperty,95butthisisbecauseaccruedgainsaretaxeduponthepreviousowner’sdeath.96Sincethereisnopreviousownerofendowment,asimilarreasoncan-notbeextendedtoallowastep-upofbasisinendowmenttofairmarketvalueatbirth.

AlthoughtheCarterreportdidnotconsiderthetaxationofpersonalinjurydam-ages,somecommentsmadeinthereportsupporttheconclusionthatbasisinworkingcapacityislikelytobelow.Aspartofthediscussionofthepossibilityofdepreciatinghumancapital,thereportstates,“Whilenoonewoulddenythatraisingahumanbeing involves costs, the costs usually are borne by the parents and society as a

90 Ibid.,at1389.

91 Ibid.,at1390-91.Stephandoesnotgiveexamplesofwhathewouldconsiderlargevariationswarrantingspecialrecognition.

92 Ibid.,at1395.

93 Paragraph53(2)(d).

94 IRCsection1014.

95 Paragraph70(5)(b)oftheAct.

96 Subsection70(5).

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whole,andwouldnothavebeenbornebytheindividualclaimingthededuction.”97ThisleadstotwootherpointsthatmaydistinguishCanadafromtheUSsituationanalyzedbyStephan.ThefirstpointisthatinCanada,alargeproportionofmed-icalexpensesispaidforbythegovernment.Thesecondpointisthattaxcreditsareallowedforeducation.

Thepreferableapproachistoassumenobasisinworkingcapacity.Oneadvantageofthisapproachoverassumingthatbasisisequaltothedamagesawardedisthatitremovestheneedtoallowfordepreciationofbasis,aswellastheneedtocalculatealosswhereworkingcapacityisdisposedofwithoutadequatecompensation.Therearealsomoreprincipledreasonstosupportthisapproach.Thefollowingfactorsindicatethatataxpayer’sbasisinworkingcapacityisverylow:

n Theendowmentportionofworkingcapacity,whichislikelyasignificantpor-tionofthevalueofworkingcapacity,shouldnotbeincludedinbasisbecausethetaxpayerwillnothavepersonallyinvestedinherorhisendowment.

n Manyoftheothercontributorstothevalueofworkingcapacity,mostnotablyeducation andhealth care, are largelygovernment-provided and thereforeshouldnotbeaddedtobasis.

n Increasestoworkingcapacitythatoccurasaresultofworkexperienceandon-the-jobtrainingdonotrequireadditionalinvestmentandthereforeshouldnotbeaddedtobasis.

n Where education, health care, and migration services and costs are notgovernment-sponsored, deductions or credits may be available under theAct.98To theextent that thesedeductionsorcredits areavailable tooffsetprivatecosts,theamountsshouldnotbeaddedtobasis.99

n Damagesoftencompensateforonlyapartialdispositionofworkingcapacity,andundertheproportionateallocationrule,basisattributabletothedisposed-ofportionisrestricted.100

97 Carterreport,supranote66,vol.3,at43.Itisnotablethatthereportdidnotrejectthenotionofhumancapital,butinsteadfoundthatdepreciationofhumancapitalwasnotwarrantedbecauseofthelackofbasisandadministrativeproblemsinseparatinginvestmentfrompersonalconsumption.

98 Tuitionandeducationcreditsareprovidedundersubsections118.5(1)and(2);creditsforinterestonstudentloansareavailableundersection118.62;and,asdiscussedabove,amedicalexpensecreditisprovidedundersection118.2.Movingexpensesmaybedeductedwheretherequirementsinsubsection62(1)or(2)aremet.

99 Thecreditsshouldbeconvertedintodeductionstodeterminetheamountthatshouldnotbeincludedinbasis.Whenfulldeductionisnotallowed,someoftheamountexcludedcouldbeattributedtoconsumption.Admittedly,manylegitimatecostswillstillnotbedeductible,includingforgoneearningswhilepursuingpost-secondaryeducation,andtheseintheoryshouldbeaddedtocost.However,theargumentisnotthatcostisequaltonil,butthatassuminganilbasisispreferabletobasisequaltothedamagesawarded.

100 Paragraph53(2)(d).

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n Manyoftheexpendituresrelatingtoone’sbodyareinthenatureofmainten-anceandrepairs.101

Anotherimportantfactor isthatthedistributiveeffectsoftaxingdamagesforlossofworkingcapacityarepreferabletothedistributiveeffectsofnottaxingdam-ages.Individualswithahighlyvaluedearningcapacityincomparisontobasisareaffordedthegreatestbenefitfromtheexclusion.Brookspointsoutthatthreeofthefourcomponentsofhumancapital—leisure,opportunity,andchoice—aregreaterin persons with material assets.102 These factors are probably also correlated tootherdimensionsofsocialprivilege,suchasgenderandrace.Therearelikelyalsosocioeconomic and racial barriers to another major generator of human capital,post-secondaryeducation.103Thus,thefailuretotaxpersonalinjurydamagesforlossofearningsbenefitsthewealthymorethanthepoorandmayreinforceracial,gender,andsocioeconomicinequalitiesinsociety.Further,underprogressiverates,thosewithhigherincomeswillbenefitmorefromtheexclusion.Thesedistributivecon-cernsfurtherstrengthenthecasefortaxingdamagesforlossofworkingcapacity.

Non-Pecuniary DamagesNon-pecuniarydamagescompensatetheplaintiffforthelossoftheabilitytoenjoyapain-freelife.Likedamagesforlossofworkingcapacity,thesetooarebestviewedascompensationforthelossofacapitalasset,whichIwillrefertoas“capacitytoenjoy life.”When forced to choose, it seemsmore appropriate to conceptualizenon-pecuniarydamagesascompensationforthelossofacapitalasset.Theplaintiffhasnotjustlostparticularenjoyments,but,instead,hisorherveryabilitytoenjoylifehasbeendamaged.104

ApplyingtheHaig-Simonsdefinitionofincome,itisclearthatthereceiptofacash award for non-pecuniary damages will increase the plaintiff ’s wealth. Thequestion,then,iswhethertherehasbeenacorrespondingdecreaseinwealthcausedbythelossofabilitytoenjoylife.Whileitisdifficulttoattachamarketvalueto

101 DouglasA.Kahn,“TaxationofDamagesAfterSchleier—WhereAreWeandWhereDoWeGofromHere?”(1995)vol.15,no.3Quinnipiac Law Review305-42,at310-11.

102 JenniferJ.S.Brooks,“TaxationandHumanCapital”(1996)vol.13,no.2American Journal of Tax Policy189-213.Brooksdoesnotarguethatthefourthfactor,ability,isconnectedtomaterialcapital.

103 Schultzpointsoutthattherearemanyhindrancestofreechoiceofprofessions,includingracialandreligiousdiscrimination,whichkeepinvestmentinhumancapitalbelowtheoptimallevel:TheodoreW.Schultz,Investment in Human Capital: The Role of Education and of Research(NewYork:FreePress,1971),17.Itisalsoprobablethatinmanycasespost-secondaryeducationincreasesaperson’sworkingcapacitybyanamountgreaterthanthatperson’sinvestmentbecauseofgovernmentsubsidiesforeducationalinstitutionsandtaxcreditsforeducationexpenses.

104 Thetortsystemhasassumedthatthereisalossofabilitytoenjoylifethroughtheawardingofnon-pecuniarydamages.However,cautionshouldbeexercisedtoensurethatthisassumptionisnotmadeautomaticallyforallpersonswithdisabilities:seeinfranote105andtheaccompanyingtext.

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capacitytoenjoylife,courtsdoattempttovaluetheplaintiff ’sloss.Asnotedabove,Simonswasconcernedwiththeabilitytoattachavaluetochangesinwealth.Inthecaseofawardsfornon-pecuniarydamages,thedifficulttaskofvaluinglostenjoy-mentoflifenolongerfallsontheshouldersoftaxadministratorsorthetaxpayer.Itappearsthatusingthenon-pecuniarydamagescalculatedbythecourtasthevalueofthetaxpayer’sdecreaseinwealthwouldresultinamoreaccurateandjustcalcula-tionofthetaxpayer’schangeinwealththanignoringtheinjurytothecapacitytoenjoylifealtogether.Therefore,themostreasonableapplicationoftheHaig-Simonsdefinitionofincomeresultsinaconclusionthatnon-pecuniarydamagesdonotleadtoanetaccretiontowealth.

Asinthecaseofdamagesforlossofworkingcapacity,oncetherealizationprin-cipleistakenintoaccount,itisclearthatnon-pecuniarydamageswillresultinataxablegain(oraloss)totheextentthatthedamagesexceed(orareexceededby)thetaxpayer’sbasisinthelostasset,capacitytoenjoylife.Theamountofincomeorlosswillbethesameevenifonedoesnotacknowledgethelossofacapitalasset,since costs thatwouldhaveotherwisebeen viewed as creatingbasis in the assetshouldinsteadbeconsidereddeductibleexpenses.

Littlehasbeenwrittenonhowtodetermineorestimatebasisincapacitytoenjoylife,andthistaskisnolesscomplicatedthaninthecaseoflossofworkingcapacity.Thefeasibleoptionsarethereforetoassumethatbasisisequaltothenon-pecuniarydamagesawardedorthatitisequaltonil.Itislikelythataplaintiff ’sbasisincap-acitytoenjoylifewouldbeevenlowerthanherorhisbasisinworkingcapacity,sincemanyofthegeneratorsofcapacitytoenjoylifeeitherarenotmonetaryex-pendituresmadebythetaxpayerorareconsumption.Thevalueofanindividual’scapacitytoenjoylifecouldbeincreasedby

n endowment(includingone’sdispositionorpersonality),whichisnotcreatedthroughmonetaryinvestment;

n building relationships with others, otherwise referred to as social capital,whichlikelywouldnotbecreatedthroughmonetaryinvestment;

n investinginworkingcapacity,whichlikelyhasalowbasis,and,evenifitispartially created through theplaintiff ’s investment, shouldnotbedouble-countedhereascreatingbasisincapacitytoenjoylife;

n investinginphysicalcapital, includingone’shealth,whichisunlikelytobecreatedthroughinvestmentsthatcreatebasisbecauseanyexpendituresshouldbeconsumption;

n investinginadesirablesocial,physical,andeconomicenvironment,forwhichrelatedexpensesrepresentconsumptionorseparateassets(forexample,one’sresidence)andthereforeshouldnotcreatebasisincapacitytoenjoylife;

n accretionstowealth,whichcannotcreatebasisbecausewealthcreatesincometotheextentthatitisaccumulatedwithintheparticulartaxationperiodundertheHaig-Simonsdefinitionofincome;

n othertypesofconsumption,whichcannotcreatebasisbecauseconsumptioncreatesincomeundertheHaig-Simonsdefinitionofincome;and

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n thecapacityofotherstoenjoylife,whichisunlikelytobecreatedthroughmonetaryinvestmentbytheindividual.

Itisalsoimportanttonotethatthedisabilityliteraturecautionsagainsttheas-sumption that persons with disabilities are no longer able to enjoy life.105 Thisreasoningleadstoanargumentthatitwouldbepresumptuoustoconcludethattheplaintiffhaddisposedofallofherorhiscapacitytoenjoylifeasaresultoftheinjury.Infact,itispossibletoarguethatincertaincases,capacitytoenjoylifeincreasesasaresultoftheinjurywheretheplaintiffisnolongerabletowork,sinceheorshedoesnothavetoenduredissatisfactionsrelatingtothejobandhasincreasedtimeforleisure.106Therefore,justasinthecaseoflossofworkingcapacity,thelossofenjoymentoflifewillusuallybeapartialdispositionofthatasset,andonlyapro-portionateamountofanybasisshouldbeallocatedtothepartdisposedofasaresultoftheinjury.

Onthebasisoftheforegoingdiscussion,itislikelythataplaintiff ’sbasisinthedisposed-ofportionofcapacitytoenjoylifeislow,andthereforeanassumptionthatthisbasisisnilwouldbemoreaccuratethananassumptionthatitisequaltothedamagesawarded.Therefore,thebestsolutiontotheproblemofdeterminingbasisistoassumethatitisnil,resultinginanincomeinclusionequaltotheamountofthenon-pecuniarydamagesawarded.

Deduction of Legal FeesTheconclusionthatdamagesforlossofworkingcapacityandnon-pecuniarydam-agesshouldbefullytaxedislargelybasedontheinabilitytoidentifyamountsthatwouldincreasebasisinthedamagedassetsortheexpensesrelatedtoearningthedamages.Legalfeesincurredtorecoverthedamagesareonetypeofexpensethatiseasilyidentifiable.Whetherthedamagesrepresentincomeorcapital,legalexpensesincurredforrecoveringdamagesshouldbedeductibletotheextentthattheyarenotreimbursedbythedefendantbecausetheyareacostnecessarytorecoverthedamagesandarenotpersonalconsumption.107

The Capital Gains PreferenceIhavearguedthatdamagesforlossofworkingcapacityandnon-pecuniarydamagesbetweenincomeandcapitalisimportantbecauseofthepreferentialtreatmentgiven

105 See,forexample,SallyFrenchandJohnSwain,“WhoseTragedy?TowardsaPersonalNon-TragedyViewofDisability,”inJohnSwain,SallyFrench,ColinBarnes,andCarolThomas,eds.,Disabling Barriers—Enabling Environments,2ded.(London:SAGEPublicationsLtd.,2004),34-40,at34.SeealsoDanielGilbert,Stumbling on Happiness(Toronto:VintageCanada,2007).

106 Itshouldbeemphasizedthatthiswillcertainlynotbethecaseforallinjuredplaintiffs.Wherethereisanon-pecuniary“upside”totheinjury,non-pecuniarydamagesshouldbereduced:seeCooper-Stephenson,supranote35,at287-88.

107 Krishnaadvocatesforthedeductionofnetlegalexpensesinproportiontotaxabledamages:seesupranote26,at433.

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tocapitalgains.Sincethisissuehasbeenneglectedintheliteraturetodate,inthissectionIexaminewhetherthepreferenceshouldbeextendedtodamagesforlossofworkingcapacityandnon-pecuniarydamagesiftheyaretaxed.

AlthoughthereshouldbenocapitalgainspreferenceundertheHaig-Simonsideal,thespecialtreatmentofcapitalgainsisoftenexplainedasnecessaryinordertocorrectproblemsresultingfromdeviationsfromtheidealthatexistinourtaxsystem.Whetherornotareceiptisaffordedspecialtaxtreatmentasacapitalgainshoulddependonwhetherthepolicyreasonsforthepreferenceapplytotheparticu-lartypeofreceipt.108Iexplorethesereasonsbelowandconcludethattheydonotprovideasoundpolicyreasonforextendingthecapitalgainspreferencetopersonalinjurydamages.

Thefourmostfrequentlyofferedpolicyreasonsforthereducedrateoftaxoncapitalgainsare109

1. toreduce“lock-in”effects, 2. toprovideeconomicstimulation, 3. toadjustforinflationaryeffects,and 4. toalleviateincomebunching.

It should be noted that these policy justifications are contested, and there is noconsensus among commentators about the true justification for the preferentialtreatment of capital gains. Instead of entering into this debate, I consider herewhetheranyofthesefourreasonscouldsupportextendingthecapitalgainsprefer-encetopersonalinjurydamages.

Withrespecttothefirstreason,somecommentatorshavearguedthatthetaxa-tionofcapitalgainscreatesadisincentivetosell,causinganeconomicallyinefficientlock-ineffect.110The theory is thatgrantingcapitalgainspreferential treatmentdecreasesthiseffect,whichsomehavearguedhastheadditionaladvantageofin-creasingoveralltaxrevenuesfromdispositionsdespitethelowertaxrate.111Whether

108 Thatis,thedefinitionofcapitalgainorcapitalassetshouldcoincidewiththepurposebehindthepreferentialtreatmentofcapitalgains:see,forexample,CalvinH.Johnson,“SeventeenCullsfromCapitalGains”(1990)vol.48,no.10Tax Notes1285-99.

109 SeeJosephByronCartee,“AHistoricalEssayandEconomicAssayoftheCapitalAssetDefinition:TheTaxpayerandCourtsAreStillMindfullyGuessingWhileCongressDoesn’tSeemTo(Havea)Mind”(1993)vol.34,no.3William & Mary Law Review885-931,atnote13.

110 SeeNoelB.CunninghamandDeborahH.Schenk,“TheCaseforaCapitalGainsPreference”(1993)vol.48,no.3Tax Law Review319-80,at344.

111 SeeJohnson,supranote108,at1285.Althoughsomehavearguedthatthislock-ineffectiscausedbybunching,amoreaccurateexplanationisthatthenetpresentvalueoftaxthatwillbepaidonfutureinvestmentincomeislessthanthetaxthatwillbepaidonthecapitalgainiftheassetissoldimmediately.(Popkinentertainsthisideabutconcludesthatthisisnot,infact,thereasonforthepreference:WilliamD.Popkin,“TheDeepStructureofCapitalGains”(1983)vol.33,no.2Case Western Reserve Law Review153-207,at161.)Thus,thelock-ineffectisasdependentonthetimevalueofmoneyasontheprogressiveratestructure.Usingthislogic,

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therationalebehindthelock-inargumentistoincreasemarketefficiencyortoin-creasegovernmentrevenue,itisclearthattheargumentdoesnotextendtocasessuchaspersonalinjurydamageswherethetaxpayercannotvoluntarilyrealizethegainontheasset.

A second argument for the preferential treatment of capital gains is that theeconomywillbenefitfromincreasedeconomicrisktakingandpersonalinvestmentbytaxpayers.112Althoughincreasedinvestmentinworkingcapacityorcapacitytoenjoylifemaybedesirable,preferentialtaxtreatmentofinvoluntarydispositions(includingpersonalinjurysituations)willnotstimulatesuchinvestmentbecausethedispositionisnotintentional.Therefore,economicstimulationcannotjustifytaxingpersonalinjurydamagesatpreferentialcapitalgainsrates.

Athirddefenceofthecapitalgainspreferenceisthatitservestooffsettheeffectsofinflationoncapitalvalues.Wherethevalueofanassetincreasesasaresultofinflation,therewillbenocorrespondingincreaseinthetaxpayer’sbasisinthatasset,anduponrealization,thetaxpayerwillexperienceagainexceedinghisorherrealincreaseinwealth.Itisarguedthatincreasesinthemonetaryvalueoftheassetat-tributableonly to inflation shouldnotbe taxed; therefore, the lower tax rateoncapitalgainscanbeseenasacrudemechanismtoadjustforinflation.113

Botha taxpayer’smarket earnings and thevalueofhomemaking serviceswillincreasewithoverallpricelevels;therefore,thevalueofworkingcapacitywillin-creaseoveran inflationaryperiod.Asaresult,partofa taxpayer’sgainuponthedispositionofworkingcapacitywilloftenbeattributabletoinflationandwillnotrepresentatrueaccretiontowealth.Anargumentcouldbemadethatthevalueofcapacity to enjoy life will also increase as a result of inflation because the valueofleisure,whichisacomponentofenjoymentoflife,isbasedonitstradeoff,work.Inflationaryincreasesinthevalueofearningsandhomemakingserviceswillcreateacorrespondinginflationaryincreaseinthevalueofcapacitytoenjoylife.However,inflationisunlikelytocausesignificantproblemsinthecaseofthedispositionofworkingcapacityandcapacitytoenjoylifebecause,asalreadydiscussed,thetax-payer’sbasisinthedestroyedcapitalassetislikelytobequitelow.Itisbasis,andnotproceeds,thatshouldbeindexedforinflationinorderforthetaxpayer’staxburdentostayconstantintermsofrealdollars.114Whiletaxpayersshouldbeabletoindextheirbasisinworkingcapacityorcapacitytoenjoylifeifdispositionsaretaxed,thefailuretoaccountforinflationisnotapressingconcernherebecausebasisislow.Further,theindexingoftaxbracketsandcreditsundertheActshouldhelptoallevi-ateinflationaryconcerns.

thelock-inargumentsareconcernedwiththebunchingoffutureincome(thatis,incomethatwouldhavebeenearnediftheassethadnotbeensold)asaresultofsellingtheassetratherthanbunchingofaccumulatedgains:seePopkin,supra.

112 Popkin,supranote111,at196.

113 Hogg,Magee,andLi,supranote66,at293.

114 SeeReedShuldiner,“IndexingtheTaxCode”(1993)vol.48,no.3Tax Law Review537-660,at550-51.

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Thefourthreasoncommonlyofferedtosupportthepreferenceforcapitalgainsisthatitisnecessarytocounteractthenegativeeffectsofincomebunchingresultingfromtheprogressiveratestructure.Supportersof thisargumentposit thatsincecapitalgainsoftenhaveaccruedoveranumberofyears,itisunfairtotaxthematahighermarginalratethanifthegainshadbeenincludedinincomeintheyearstheyaccrued.Therefore,thepreferentialtaxrateforcapitalgainscanbeexplainedasanunrefinedaveragingmechanism.115Theproblemofbunchingandthepossibilityofincomeaveragingarediscussednext.

Bunching and Income AveragingTherearetwoseparatebunchingconcernsthatcouldariseifpersonalinjurydamagesaretaxed.Thefirstconcernrelatestotherealizationprinciple.Progressivetaxratesoftenresultinalargeramountoftaxbeingpaidwhenagainisrealizedthanwouldhavebeenpaid if thegainhadbeentaxedas itaccrued.TheCartercommissionpointedoutthatthisresultis“grosslyunfair.”116Thisisthebunchingargumentthatsomecommentatorsuse to support thecapitalgainspreference,asnotedabove.Whilethereissomelimitedsupportforprovidingincome-averagingreliefforper-sonalinjurydamagesonthesegrounds,thereareanumberofreasonstosuggestthattheseconcernsareinsufficienttojustifyeitheracompleteexemptionorcapitalgainstreatment.First,therealizationprinciplecreatesabenefitthatwouldatleastpartiallyoffsetthisdisadvantagebyallowingthetaxpayertodefertaxonthegainsuntilthedispositionoftheasset.Second,itispossiblethatmarginalrateswillhavedecreasedoverthetimethatthetaxpayerheldtheasset.Third,itislikelythatin-creasesinthevalueofworkingcapacityandcapacitytoenjoylifedonotoccurevenly,andconsequentlythetaxpayermayhavebeenpushedintoahightaxbracketevenifgainsweretaxedastheyaccrued.117

Amorecompellingbunchingargumentarisesbecauseweimposetaxonanan-nualbasis,andthereforetaxpayerswithfluctuatingincomesmaypaymoretaxthanthosewhoseincomesremainconstant.Thiscreatesaninequitableresultbecause,inthewordsoftheCarterreport,

[t]hereisnothingsacrosanctaboutthemeasurementofincomefortaxpurposesonanannualbasis.Thechoiceofthecalendaryearastherelevanttimeperiodisamatterofconventionandconvenienceratherthanprinciple.118

115 Popkinentertainsthisideabutconcludesthatthisisnot,infact,thereasonforthepreference:supranote111,at154ff.SeealsoCunninghamandSchenk,supranote110,at328.

116 Carterreport,supranote66,vol.3,at242.

117 Forexample,significantincreasesinthevalueoftheassetscouldoccuruponendowment.Also,Beckerhasdemonstratedthattheincentivetoinvestinhumancapitallessensasageincreases:GaryS.Becker,Human Capital: A Theoretical and Empirical Analysis, with Special Reference to Education,2ded.(NewYork:NationalBureauofEconomicResearch,1975),64.

118 Supranote66,vol.3,at241.

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Inthecaseofpersonalinjurydamages,theinjusticehereisthattheplaintiffwilloftenbe taxedatahigher rateunderourannual taxationsystemthanheor shewouldbeifwechosealongertimespanasthetaxationperiod.Thisproblemcouldbeaddressedbyallowingincomeaveragingoverseveraltaxationyears.

Incomebunchingisaproblemformanytaxpayers,notjustthosereceivingper-sonalinjurydamages.ThecommonoccurrenceofincomefluctuationwasareasonfortheCarterreport’srecommendationthatincomeaveragingbeavailabletoalltaxpayers.119SeveralformsofaveragingruleshaveexistedintheActovertheyears,butalmostallhavebeenrepealed.IntheNovember1981federalbudget,themin-isteroffinancedescribedthe“patchwork”systematthattime(whichconsistedofgeneral averaging, income-averaging annuity contracts, and reserves for capitalgains)ascostlyandineffective.120Theministerthereforeannouncedthatallthreeofthesesystemswouldbewithdrawnandreplacedbyanewsystemofforwardav-eraging.Thisnewaveragingsystemwasrepealedin1988.Theministeroffinanceatthattimerationalizedthedecisionbyexplainingthatforwardaveragingwasusedbyfewtaxpayers,mostofwhomwereinhightaxbrackets,andthatitsrepealwouldsimplifytheAct.121Healsoexplainedthattaxrateshadbeenlowered,andthenum-beroftaxbracketswasreducedfrom10to3.Blockaveraging,whichwasavailabletofarmersandfishermen,wasalsoeliminatedatthattime.

Afullandcompleteanalysisofaveragingalternativesisbeyondthescopeofthisarticle,122andislikelyunnecessaryfromapracticalperspective.GiventhehistoryofincomeaveragingundertheAct,itseemsveryunlikelythatincomeaveragingwouldbepermittedifpersonalinjurydamagesbecametaxed.Theadministrativeconcernssurroundingaveragingsystemsaresignificant,andtheloweringofratesandflatteningoftheratestructurehavereducedtheimpactofincomebunching.TheCartercommissionandtheministeroffinancebothexpressedconcernsrelat-ingtoapiecemealapproachthatfavouredcertaintypesoftaxpayers.Here,allowingspecialtreatmentforpersonalinjurydamagesseemsunlikely,withoneexceptiondiscussednext.

Oneexistingaveragingschemecouldbeextendedtoapplytopersonalinjurydam-ages.123Sections110.2and120.31allowrecipientsofcertainlump-sumpayments

119 Ibid.,at255.

120 Canada,DepartmentofFinance,1981Budget,TheBudgetinMoreDetail,November12,1981,35.

121 Canada,DepartmentofFinance,Supplementary Information Relating to Tax Reform Measures(Ottawa:DepartmentofFinance,December16,1987),49.

122 Foramorecompleteanalysis,seeRichardGoode,“Long-TermAveragingofIncome,”inHenryJ.AaronandMichaelJ.Boskin,eds.,The Economics of Taxation(Washington,DC:BrookingsInstitution,1980),159ff.

123 Thiscouldbedonebyamendingthedefinitionof“qualifyingamount”insubsection110.2(1)toincludeanamountthatisreceived,asaresultofsettlementorcourtorderinrespectofapersonalinjurydamagesclaim,asspecialdamagesrelatingtoalossorcostincurredbetweenthetimeofinjuryandthetimeofsettlementorcourtorder.

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tospreadthosepaymentsbacktotheyearstowhichthepaymentsrelate.Specialdamagesrelatingtopre-trialorpre-settlementlossescouldbeincludedinthisre-gimefairlyeasily.However,asFrankovichaspointedout,theexistingsectionsofferlittlereliefbecausetheyeffectivelysubjecttheinterestelementofthelump-sumpayments to double taxation.124 If the government enacts Frankovic’s suggestedrevisions,includingspecialdamagesforpersonalinjurydamagesinthisaveragingsystemwouldbeadvisablesinceitwouldofferatleastpartialbunchingreliefwitharelativelylowadministrativecost.

Eveniftheregimeinsections110.2and120.31isamendedtooffersomebunch-ingrelief,bunchingconcernsmaystillexistinsomecasesfortheremainingdamages.Itcouldbearguedthatonlyhalfofthedamagesshouldbeincludedinincomebyextendingcapitalgainstreatment.Whilethisoptionwouldbeadministrativelylesscomplex than averaging, in my opinion bunching concerns are not significantenoughtojustifyaone-halfexclusion.Asalreadyexplained,thebunchingproblemsheredonotrelatetothoseusedtojustifycapitalgainstreatment;rather,theyareofthetypethatareexperiencedbyalltaxpayerswithincomesthatfluctuate.However,fromapractical standpoint,policymakersmaydecidethatofferingcapitalgainstreatmentfortheremainingdamagesmaymaketheintroductionoftaxonpersonalinjurydamagesmorepalatableandthusmorepoliticallyfeasible.

UNRE SO LV ED ISSUE S A ND CO NCLUDING REM A RK S

TheissueofhowpersonalinjurydamagesshouldbetreatedfortaxpurposeshasbeenlargelyignoredinCanada.TheCRAhasnotfullyexplaineditspositionthatpersonalinjurydamagesshouldnotbetaxed,perhapsbecausetheproperapplicationoftheActtotheissueisuncertainorevenimpossible.Thereisaneedforlegislativeinterventiontoclarifythelaw.Thisarticlehasattemptedtoshedsomelightonthecontentofthislegislativeclarificationbyapplyingthecriteriaofequity,neutrality,andsimplicitytothequestionofhowpersonalinjurydamagesshouldbetaxed.

The application of these traditional criteria results in a conclusion that taxshouldbeimposedonallofthecategoriesofpersonalinjurydamages:lossofwork-ingcapacity,non-pecuniarydamages,andcost-of-careawards.Theimpositionoftaxonthesetypesofdamageswouldresultinanestimated$21millioninfederaltaxrevenuesalone.125Horizontalandverticalequityarebettermetifcost-of-caredam-agesaretaxed,assumingthattheexistingMETCremainsunchanged.Damagesforlossofworkingcapacityandnon-pecuniarylossshould,intheory,betaxedonlyto

124 JosephFrankovic,“TheTaxationofRetroactiveLump-SumPayments:ThePracticeandthePolicy”(2010)vol.58,no.1Canadian Tax Journal1-23.

125 Thisestimateisbasedontheprojectedcostofexcludingsuchpaymentssetoutinthefederaltaxexpenditurebudgetfor2009.Asimilaramountisspentthroughthepersonalpoliticaldonationtaxcredit.SeeCanada,DepartmentofFinance,TaxExpendituresandEvaluations2008(Ottawa:DepartmentofFinance,2008),16-18.

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theextentthatthedamagesexceedinvestmentinthedamagedassets,workingcap-acity,andcapacitytoenjoylife.However,determiningtheinvestment,orbasis,intheseassetsisnearlyimpossible,sothecriterionofsimplicitydemandsthatamorerealisticsolutionbefound.Ithasbeenarguedthatthebestalternativeistofullytaxdamagesforlossofworkingcapacityandnon-pecuniaryloss,sincebasisinthere-latedassetsislikelytobequitelow.Anaveragingrulecouldbejustifiedonequitygrounds,althoughfullaveragingisunlikely.Ifpersonalinjurydamagesremainex-empt,thepolicymustbejustifiedasataxexpenditure.

Theanalysisinthisarticledoesnotcompletelyanswerthequestionofwhetherandhowpersonalinjurydamagesshouldbetaxed.ManyprovisionsintheActinten-tionallydeviatefromthebenchmarknormativetaxbaseinordertoachievenon-taxobjectives.Itispossiblethattheexemptionforpersonalinjurydamagescouldbejustifiedasassistingtortlawwithmeetingitsobjectives.Tortlawseekstoachieveanumberofobjectives,includingcompensation,deterrence,correctivejustice,anddistributivejustice.Atfirstglance,itmayseemthattaxingpersonalinjurydamageswould interfere with the compensation goal of damages. However, whether fullcompensationoccursisdeterminedbywhethercourtswouldgrossuptheawardsiftheyweretaxed.Thisraisestwoquestions:whetheraddingthiscomplexityisac-ceptableandwhetherincreasingawardsisdesirablefromadistributiveperspective.Oncetheseissuesarefullyconsidered,itwillbepossibletoarriveataconclusiononhowpersonalinjurydamagesshouldbetaxed.


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