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Is Compensation Taxable?

First of all, the word surrogatum or surrogacy is strong, but it accurately defines the core concept of the principle. Here is an example:

The rule in a country is that only the king and queen’s son can be the next king. A king had an infertility problem so he secretly asked one of the handsome guards to help. The queen got pregnant and gave birth to a boy, and the prince boy would be able to take over the throne when he grew up.

Similarly:

  • A labour worker was injured because of the negligence of his employer. The employer compensated him for all the wages during the worker’s temporary leave. This compensation is taxable because the salary he deserved was equally taxable anyway if he were not injured.
  • Due to the bank’s negligence, an investment income that a VIP investor should have earned was not earned. To keep the VIP client the bank paid some compensation to the investor. This compensation is also taxable because the capital gain was taxable in nature in the first place.

In the early 1990s, the BC provincial government wanted to build a national park. During the land acquisition several land owners were compensated but one of them, Frank Beban Logging Ltd, was not. The company argued and then received the government payment of $800,000 although the BC government was not obligated to pay. Afterwards, the logging company did not file a tax return on the money, CRA came in, no agreement between the 2 parties so they went to court.

The judge conducted two tests:

  1. The Surrogatum Principle test: whether the compensation can be treated equivalently with damages awarded. The answer is “no” to this question
  2. The Cranswick’s 7-question test: it appears all answers were likely to be “no”

Thus, the court concluded that the $800,000 received by the logging company was a windfall and tax-free. Frank Beban Logging Ltd v Canada [1998]

In conclusion:

  • Since there is compensation, there must have been some losses in the first place. The compensation should also be taxed as long as the original loss should have been taxed. This is the “surrogacy principle”;
  • Compensation for personal’s psychiatric and physical injuries, i.e. pain, destress, inconvenience, loss of amenity, and negative impact on family members due to vehicle accidents and work-related injuries, are regarded as general damages. These compensations are not taxable generically speaking;
  • For the compensations or settlements on (wrongful) employment dismissal, please refer to this blog article for their tax considerations.