How to treat payments received as damages in a lawsuit—whether as a result of a judgment or pursuant to a settlement—can be a vexing question. The Supreme Court of Canada provided some guidance in Tsiaprailis v. Canada, [2005] 1 S.C.R. 113, 2005 SCC 8. The Tax Court applied Tsiaprailis recently in Bourgault Industries Ltd. v. The Queen, 2006 TCC 449. Justice Woods, in the latter case, characterized the analysis as follows:
[33] In determining whether a settlement payment is income or capital to a recipient, the principle that is generally applied is referred to as the surrogatum principle. It provides that the settlement will have the same character as the interest that is settled: The Queen v. Tsiaprailis [supra].
[34] The surrogatum principle was recently described by Sharlow J.A. in Transocean Offshore Ltd. v. The Queen, [2005 FCA 104], at para. 50:
… the answer to that question requires the application of a judge-made rule, sometimes called the “surrogatum principle”, by which the tax treatment of a payment of damages or a settlement payment is considered to be the same as the tax treatment of whatever the payment is intended to replace. Thus, an amount paid as a settlement or as damages is income if it is paid as compensation for lost future rent … It is a capital receipt if it is compensation for a diminution of capital of the recipient …
