This type of settlement is typically meant to compensate victims for losses caused by the accident, such as medical expenses, pain and suffering, and lost income.
The CRA usually follows the “surrogatum principle,” which looks at whether a settlement payment takes on the characteristics of what it is meant to replace. For example, if a business sues someone over revenue it lost due to a breach of contract, then the purpose of the settlement award would be to replace the lost business income. That award would be taxable because the income it replaces would have been taxable.
However, laws governing the CRA have a special exception for personal injury payments. As long as the award is for special damages like loss of future earnings or general damages like loss of earning capacity, you typically do not have to pay taxes on compensation received in this kind of settlement.
This means that even if you would normally have to pay taxes on the earnings that the personal injury settlement is replacing, you do not have to pay taxes on the compensation you receive through your settlement for lost wages. It doesn’t matter whether a judge or jury awards the compensation or you reach a settlement out of court – these payments are usually not taxable.
In addition, even if a government entity like a province or territory is the party paying you for injuries after a motor vehicle accident or criminal act, these payments still are not taxable by the CRA.
If the settlement includes something other than special or general damages, then you might have to pay taxes on it. For example, if it includes terms like a guaranteed severance payment or other compensation that could be considered employment income, then that part of the settlement might be taxable.