Robert Carson ASSOCIATED ECONOMIC CONSULTANTS LTD.

Transcription

1 TAX GROSS-UP AND FUND MANAGEMENT BACKGROUND, METHODS AND CONTROVERSIES Robert Carson ASSOCIATED ECONOMIC CONSULTANTS LTD. June 12, WHAT DOES A TAX GROSS-UP DO? In family compensation matters, sums claimed for future loss of dependency are calculated on aftertax income. When the funds awarded are invested, the income earned is taxable. To permit plaintiffs in family compensation claims to withdraw amounts from their awards which correspond to their annual losses over the period of future loss, and to pay taxes on the income earned from investing the award, it is necessary to increase the size of the award. More recently awards for loss in family compensation claims have come to include, in many instances, significant amounts representing the survivors loss of the value of household or domestic work which was done by the deceased. As domestic work done by family members has value, but does not involve any exchange of time for wages or other forms of taxable compensation, awards for loss of household services are also increased, to offset the taxes that are payable on the investment income which they generate. The calculations which are made to determine the extent to which awards for future loss in family compensation claims must be increased to cover both the withdrawals made to offset losses and the taxes payable on the investment income generated by the award, are called tax gross-up calculations. In personal injury matters, awards for future loss of income are made on the basis of pre-tax income. When the lump sum is invested, the income earned is taxable. However, because the taxes payable on the income earned by investing a future income loss award are at least analogous, if not necessarily very similar in amounts to the taxes that would have been paid if there had been no injury and the income was earned, tax gross-up calculations are not made on awards for future income loss, in personal injury claims. The investment income earned on cost of care awards is also exposed to tax. The investment income from cost of care awards is income that plaintiffs have only as a result of their injuries and the taxes payable on it are taxes that plaintiffs would not otherwise have paid. That is, for the taxes payable on the investment income generated by a cost of care award there is no analogous amount of tax that would have been paid in the absence of the injury, and it is therefore likely that an injured plaintiff who has a cost of care award to invest will have to pay more in tax than would have been paid absent the injury. If the effects of taxation on the income earned from a cost of care award are not offset by a gross-up, the funds may be insufficient both to cover the costs of the plaintiff s care needs, and to pay the additional taxes that he or she would not otherwise have paid. To offset the effects of additional taxation on the income earned by investing a cost of care award, tax gross-up calculations are required.

2 June 12, 2012 Tax Gross-Up and Fund Management Page 2 2. A VERY BRIEF HISTORY OF TAX GROSS-UPS Tax gross-up calculations have, for as long as I have been involved in litigation economics, been a part of the process of arriving at the quantum of damages in family compensation claims. Fortunately, family compensation claims are unusual. When tax gross-up calculations applied only to family compensation claims, the calculations did not present much of a problem, in terms of the demands they placed on the time of judges and lawyers. However, in 1989 the Supreme Court of Canada held, in an Ontario case, Watkins v. Olafson, that a gross up should be awarded on the cost of care component of Mr. Watkins personal injury award. Once gross-ups became accepted components of personal injury awards, in addition to family compensation claims, the number of cases involving them increased substantially. Such calculations are inherently complex, and the substantial increase in their numbers became a source of growing demand for court time spent on a subject that could well be described as opaque, even under the best of circumstances. In 1992 the Law Reform Commission (LRC) of British Columbia received from the Judges Law Reform Committee a suggestion that the LRC undertake an examination of tax gross-up and management fees, with a view to producing standardized assumptions to be used in calculating these components of damage awards. A committee was struck in 1993 and in February 1994, a report was published. The hope, at the time, was that legislation would follow or, somewhat less optimistically, it was wished that the practitioners of the art would follow the recommendations of the committee, thereby avoiding needless conflict. Of course the most optimistic hope was never realized and the fall-back wish was only partially granted. My efforts to count the people in Canada who have worked in the area in the last 20 years have produced a number in the range of 55. This is a non-scientific count consisting of all of those that I have met at conferences or seminars, whom I critiqued, or with whom I have discussed the subject by telephone, in person or by . Not all are still active and it may be that there have been new entrants that I have not yet encountered. From my acquaintanceships with those who do this kind of work I can say that among the several controversies concerning tax gross up calculations there is one which is a uniquely made in British Columbia issue. The matter involves proper treatment of life expectancy in the calculation. It is addressed further in the sections which follow.

3 June 12, 2012 Tax Gross-Up and Fund Management Page 3 3. TAX GROSS-UP LITERATURE AND CASE LAW 3.1 Literature The 1994 B.C. Law Reform Commission report was entitled Report on Standardized Assumptions for Calculating Income Tax Gross-up and Management Fees in Assessing Damages. I refer to the report from this point onward as LRC 133. It is available on the website of the British Columbia 1 Law Institute. It is, as far as I am aware, the only published document of any length which is devoted specifically to the subjects of tax gross-up and fund management. There was a section on tax gross-up in the 1987 Ontario Law Reform Commission s Report on Compensation for Personal Injuries and Death (Ontario Ministry of the Attorney General, 1987). The matter was briefly addressed by Professor Christopher Bruce in his textbook, Assessment of Personal Injury Damages (see the third edition, pages 44 to 47). It is also discussed by Ms. Cara Brown in her Damages Estimating Pecuniary Loss (various sections). In Personal Injury Damages in Canada, (Ken Cooper-Stephenson, Edition 2, 1996), there is a section on the history of tax gross-ups and on certain aspects of the method (see pages 457 to 480). With regard to the preferred actuarial method to account for life expectancy, there is a paper entitled Grossing-Up for Income Tax, written by Mr. Brian Burnell in Mr. Burnell s paper has been circulated among the members of the actuarial profession who are involved in this kind of work and it is known to most or all economists who do the work in B.C. Mr. Burnell was, for several years, the chairman of the Actuarial Evidence Committee of the Canadian Institute of Actuaries. His paper can be found on his website ( 3.2 Case Law B.C. cases in which evidence regarding tax gross-up and fund management has been extensive and in which controversial matters have been raised are listed below. 1. Sammartino v. Hiebert, 1996; 2. Lee (Guardian Ad Litem) v. Richmond Hospital Society, 2002; 3. Li v. Sandhu, 2006; 4. Whetung v. West Fraser Real Estate Holdings, 2008; 1

4 June 12, 2012 Tax Gross-Up and Fund Management Page 4 5. Lines v. Gordon, BCSC 757, 2007; 6. Lines v. Gordon, BCCA, 306, 2007; 7. Hodgins v. Street, 2010; 8. Burnett (Guardian Ad Litem) v. Mohamed, 2010; 9. Sartori v. Gates, 2011; 10. Kirk v. Kloosterman, HOW DO TAX GROSS-UP CALCULATIONS WORK? 4.1 Exhausting Funds Costs of Care and Future Income Loss To understand how tax gross-up calculations work, it is useful to briefly review how claims for future loss of income or future costs of care are calculated, and how the amounts awarded are supposed to provide for funds required, over periods of years, to compensate for future losses or costs. There are four steps involved in calculating the single sum present value of either future losses of earned income, or of future care costs. They are: 1. determine of the annual rate of income loss and/or the annual costs of care imposed by the injury; 2. calculate expected values (losses or costs in each year times the probabilities that future losses will be incurred in each future year, which are probabilities that the plaintiff will be alive to have incurred them); 3. discount expected losses in each year to present values; 4. add the present values of expected yearly losses or costs to produce a single lump sum present value. Future losses or costs are awarded as single sum (also described as lump sum) present values. To function as intended, awards must be invested. The combination of the original sum, and the investment income earned on it, will permit withdrawals to be made over the period of loss, where the amounts that can be withdrawn equal the amounts of earned income found to have been lost or the costs of care found to have been incurred. Invested awards have been described as exhausting funds, as their purpose is to permit plaintiffs to invest the amounts awarded and then to offset their

5 June 12, 2012 Tax Gross-Up and Fund Management Page 5 losses or costs by drawing their funds down to a zero balance over the period of loss which, at the maximum, is the period of life expectancy A Specific Example, Based on an Actual Award In Figure 1, I show an example of the process of calculating the present value of future care costs. The example is based on an award for costs of care made in a matter involving a young adult male plaintiff with a severe spinal cord injury. The vertical bars in Figure 1, including the parts of each bar which are dark, medium and light grey, represent the total costs of all the items of care which the trier of fact accepted as costs incurred by the plaintiff, as a result of his injury. The bars in all three shades of grey represent step 1 in the process outlined in Section 4.1 above. The annual costs of items of care are not constant, which is why the bars in Figure 1 vary in height. The very tall bars represent the periodic replacements (about every 10 years) of specific and very costly items of care. The very tall bar at the left side of Figure 1 represents both costs that will recur from year to year and certain once-only, up front costs. The time frame in Figure 1 is determined by the plaintiff s age (33) and by length of the life table. The life table determines the maximum length of time over which care costs could, potentially, be incurred. Costs potentially continue to the point in time when the probability of survival falls to zero. In British Columbia, most analysts use Statistics Canada s most recent life tables for B.C. residents to take into account life expectancy. For males in B.C., the probability of survival is greater than zero, to about age 106. The bars in Figure 1, including all shades of grey, represent the amounts which were found to be the plaintiff s care needs, if he is alive to need care. If care needs in each year are multiplied by the probabilities that they will be needed, which are the probabilities that the plaintiff will be alive to need care, the effect is to eliminate the part of each bar which is light grey. This corresponds to step 2 in the process set out above. The expected needs, which are the amounts actually claimed and for which provisions have been made in the award, are represented by the dark grey and the medium grey components of the vertical bars. In this example, the plaintiff s life expectancy is 46.9 years, that is, almost to his age 80. In calculating the single sum present value of future costs, life expectancy is built into the calculation as a series of probabilities. As a matter of convenience, survival probabilities can be added so that a period of life expectancy can easily be described, as I have done in this instance to permit me to say that the remaining period of life is 46.9 years. However, that does not mean that the exact time of his death is thought to be predictable. The uncertainty with respect to the time of a plaintiff s death is acknowledged by the use of survival probabilities, as opposed to a certain period of life, in calculating the present values of future income loss and of future costs of care.

6 June 12, 2012 Tax Gross-Up and Fund Management Page 6 I am unaware of any economist or actuary involved in this kind of work, anywhere in Canada, who does not represent life expectancy as a series of survival probabilities when calculating the present value of future income loss and cost of care. There are two ways to take survival into account. One, which may be described as the method of Halley, is based on counts of the numbers of people surviving to generate yearly probabilities of survival. The other, which counts the number of people dying, has been described as the method of De Witt. They are mathematically equivalent in income loss and cost of care calculations. That is, they reflect exactly the same basic notion: that claims are made on the basis of expected costs or losses (losses or costs multiplied by probabilities of being alive to incur them), and not on the basis that costs or losses are incurred with certainty, for any period of time in the future. Looking at each bar in Figure 1, comparing the (combined) medium and dark grey sections to the light grey sections shows that in the later periods (say, after the plaintiff s age 85), expected costs are very much lower than the costs which have not been adjusted to account for the probabilities of need, that is, by the probabilities of survival. Discounting expected costs to present values eliminates the medium grey section of each bar and leaves the dark grey (and the lowest) of the sections of each of the vertical bars in Figure 1. This is step 3. The resulting amounts are the present values of expected care costs in each year. Adding the present values of expected care costs in each year is step 4 in the process set out above. Adding the present values of expected costs results in the single or lump sum present value representing all of the costs in each year, which is the amount awarded for costs of care. In the example, the sum is $2,000,000. To summarize, and referring to Figure 1, identifying care needs and establishing their costs (step 1), reducing costs to expected values, i.e. multiplying by survival probabilities (step 2), discounting expected values in each year to present values (step 3), and summing all years present values (step 4), results in a lump sum present value of future costs of care which, in the example on which Figure 1 is based, amounts to $2,000, The Same Award, but with Less Information The costs of care in Figure 1 vary widely from one year and to the next. The case on which Figure 1 is based is one where the connections between the awards for costs of care and income loss, and the evidence at trial, were quite apparent. However, it is often the case that awards are simply expressed as lump sums, with very little clear connection to evidence that may have been given at trial with regard to specific claims for items of care, their costs, or to annual rates of cost or of income loss. To simplify the information in Figure 1 and to represent cases in which the information conveyed in the award is limited, I have produced Figure 2.

7 June 12, 2012 Tax Gross-Up and Fund Management Page 7 To produce Figure 2, I divided $2,000,000 by the cost of care multiplier to produce an annual cost of care value, $88,899. As in Figure 1, in Figure 2 the annual costs incurred by the plaintiff, if he is alive, are represented by the vertical bars shown in three shades of grey. Unlike Figure 1, in Figure 2 annual costs are set at the average value, $88,899, and so the bars, in all shades of grey, are all of equal height. The light grey sections of each of the bars are the costs that are eliminated when the probabilities of survival are taken into account. Thus, the parts of the bars consisting of dark and medium grey components are the expected costs, which are the amounts for which provision has been made in the award for the plaintiff to withdraw. The dark grey parts of each bar are discounted to present values of the amounts for which provision is made. These values, summed, come to $2,000,000. As the Plaintiff in the reference case was very severely injured, it was determined that he would have no capacity to earn income and his loss of future earnings was assessed to have a present value of $1,240,000. Thus, the total award for future loss, before gross-up and before the matter of fund management was considered, was $3,240,000. The income loss award was considered to have incurred over the period up to the plaintiff s age 70. In the tax gross-up calculation, provision was made for retirement savings, and so some of the fund for income loss was assumed to be set aside so that funds could be drawn down after age 70. If a graph like Figure 2 were to be constructed for the income loss award, its appearance would be similar, and all of the same general principles would apply. 4.2 Concerns about Exhausting Funds Do the Last Years Impart Upward Bias? From time to time concerns have been raised about a disconnect between what is really likely to happen, and extending the calculation of care cost to age 106 (as in the example) or to age 110 (as is the case in matters involving injured women). The shortest answer to such concerns is that a disinterested party (Statistics Canada) made the decision to end their life tables at those ages, that any modification to that decision will be arbitrary and likely to become another point of 2 disagreement between experts. Perhaps a more reassuring response to the concern with regard to overcompensation resulting from the length of the life table can be made by describing effects which including the years at the tail end of the life table actually have on the results of present value calculations. Taking the example on which Figures 1 and 2 are based, and going to the plaintiff s age 85, when there are 21 more years left on the life table, it may be calculated that the estimate of the remaining years of life equals two. From age 90, that falls to one. By taking into account the last 16 or 21 years 2 In some instances, cost of care experts will say that certain items of care are not required beyond a certain age, and some economists make their own assumptions with regard to termination of need, before the end of the period of life expectancy.

8 June 12, 2012 Tax Gross-Up and Fund Management Page 8 on the life table, the actual years of life added are 4%, or 2% of the total remaining period of life expectancy (46.9). Looking at the present values of the funds provided for the period from age 85 onward, just over one percent of the $2,000,000 award is for costs in the last two years of expected life, after age 85. At the age at which the survival probabilities add one year to life expectancy (age 90) the amount set aside in the award for costs of care is about one-half of one percent of the total. The relationship between cost of care funds remaining in an exhausting fund and the number of years of remaining life for the 33 year old male plaintiff with $2,000,000 awarded for cost of care is shown in Figure 3. The vertical bars are the present values of funds remaining in each year. Dollar amounts are shown on the left vertical axis of the figure. Years of life remaining are shown by the downward sloping line. Numbers of years of remaining life are shown on the vertical axis on the right side of Figure Exhausting Funds and Tax Gross-Ups In most instances, investment income earned on an award exceeds the withdrawals made from the award, and typically this continues for quite a few years. The excess income is re-invested and, in effect, becomes part of the capital sum in the next year. However, a point comes when withdrawals exceed investment income. After this point, each subsequent year s withdrawal consists of a larger portion of capital and a smaller portion of investment income. The problem that the tax gross-up is supposed to solve is that, in addition to the expected costs and the expected withdrawals made to offset the expected costs, tax liabilities on the investment income earned by the award add to the amounts which must be withdrawn in each year. If no provision is made to account for the withdrawals that must be made to satisfy the tax authorities and if the plaintiff s withdrawals are in the expected amounts, like those in the dark grey and medium grey areas in Figures 1 and 2, the fund for costs of care will be fully depleted before the end of the period of life expectancy. A tax gross-up calculation determines the amount by which an award for future loss must be increased so that there will be sufficient funds to satisfy the plaintiff s expected needs and the tax authorities expected demands. 4.4 Exhausting Funds and Costs of Fund Management Fund management costs are addressed by Mr. Webster, and so I will not go into much detail about them here. Commercial fund managers base their charges on capital balances, not on income, but nonetheless, calculating the additions that must be made to a capital sum to offset the costs of fund managers fees over a period of loss, has much in common with a tax gross-up calculation. It is also typically the case that commercial fund managers fees are tax deductible, and so their presence will affect (will typically reduce) the result of a gross-up calculation. Fund management fees, at the highest level of need for assistance, add much more to a claim than does a tax gross-up.

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12 June 12, 2012 Tax Gross-Up and Fund Management Page TAX GROSS-UP AND FUND MANAGEMENT FEE CALCULATIONS 5.1 Areas of Common Ground It is generally agreed that although tax gross-ups calculated in personal injury matters are meant only to offset the effects of taxation on the cost of care award, it is necessary to take into account investment income from both the income loss award and the cost of care award, as well as residual earnings, if any, employment earnings if there is no loss of future employment income, and taxable pension income. Income from these sources is described as first dollar income. First dollar income is not subject to any form of gross-up because it is assumed that the taxes paid on it would have been paid, in similar amounts, in the absence of the injury. However, if the true incidence of taxation on the investment income generated from the award for costs of care is to be determined, the first dollar income must be considered, to arrive at the proper estimate of the incremental tax that would be paid on cost of care award investment income. In other words, first dollar income must be considered to correctly calculate the marginal tax rates applying to second dollar (cost of care award) income. Calculations of this form have been described as being stacked, with the bottom of the stack consisting of first dollar income and the top consisting of second dollar income, that is, the income generated from the funds invested from the cost of care award. The stacking, or first dollar - second dollar method of calculation, is widely accepted. There is also general agreement that calculations must be based on nominal, as opposed to real investment income, and that to do so requires an adjustment to the real discount rate (presently 3.5%) to account for price inflation. There has been general agreement that a reasonable estimate of the long term rate of inflation is 2.5%, and there has been general agreement that the long term nominal rate of return on investment can be assumed to be about 6.1%. It is generally agreed that tax brackets, tax deductions and credits, and thresholds for income transfer programs should be indexed to inflation. To summarize, the matters in which there is almost universal agreement in tax gross-up calculations are: 1. the method should be the stacking, or first dollar - second dollar style of calculation; 2. nominal, as opposed to real rates of return should be used to estimate investment income; 3. the nominal rate of return should be estimated on the basis of the real rate of return (the discount rate, determined by regulation, currently 3.5% in B.C.) and an estimate of the long term rate of inflation; 4. for quite some time there has been general acceptance of an estimate of the long term rate of inflation, of 2.5%;

13 June 12, 2012 Tax Gross-Up and Fund Management Page 13 5 it is largely agreed that tax brackets, thresholds for deductions and credits and thresholds for income transfer or income claw-back programs should be indexed to inflation; 6. if there is to be a calculation of fund management costs based on the fees of a private fund manager, it is generally agreed that the costs of fund management should be deducted from taxable income; 7. if funds are to be placed in the hands of the Public Guardian and Trustee, it is generally agreed that fees are not deductible but are, like other future costs of care, subject to gross-up. 5.2 Controversial Matters (Except Life Expectancy) The results of tax gross-up calculations are affected by the ways in which certain provisions in the tax act are applied to the calculation, and also by the treatment of income earned from sources other than the award. Issues that have been prominent in the differences between experts tax gross-up and fund management fee calculations are summarized in the following questions: 1. Is the plaintiff qualified to claim the disability tax credit? 2. If the plaintiff can claim the disability tax credit and has been awarded costs for attendant care, should that care be considered to be full or part time attendant care? 3. If the disability tax credit is claimed, should this benefit the plaintiff (should the disability tax credit be applied to taxes owing on first dollar income) or the defendant (should the credit be applied entirely or in part to taxes on second dollar income)? 4. If the plaintiff is entitled to CPP disability or other taxable wage loss benefits, should the income from these sources be included in first dollar income? 5. Should it be assumed that funds awarded will be shifted into a tax free savings account (TFSA)? 6. Is the plaintiff claiming costs of fund management? 7. If yes to 6, at what level of need? 8. If yes to 6, are the funds likely to be placed either temporarily or permanently in the hands of the Public Guardian and Trustee, or a private trustee? 9. Are Part 7 benefits likely to be paid to cover the costs of some items of care and if so, which items of care and in what amounts?

14 June 12, 2012 Tax Gross-Up and Fund Management Page If there is a high level of need for fund management assistance and if there are minimum fees charged by the fund manager, how should these minimum fees be taken into account in calculating the costs of fund management? 11. What happens if the award, at the outset, is below the fund manager s minimum fee (in which case a financial intermediary will be unlikely to take on the fund manager s role)? 12. In what proportions should the plaintiff be assumed to invest the award in interest bearing securities and/or in other financial instruments that generate dividends and/or capital gains? The matters raised in points 1 to 9 all are strictly legal issues. It follows that the appropriate assumptions are best presented to the expert as instructions. Although the items in the list which I describe as legal issues impose certain technical issues in designing a tax gross-up computer program, they are not matters that are prone to being resolved on economic grounds. What the instructions should be with respect to these matters depends on two things. One is, what does the lawyer think can be proved as a fact about the plaintiff? For example, can it be proved that the plaintiff would or would not be considered to be disabled, as defined for tax purposes? The other is, what arguments is the lawyer prepared to make with respect to matters of fairness? An example 3 of this is the inclusion or exclusion of CPP disability benefits from first dollar income. 5.3 Some Example Calculations To show how some of the issues listed above can affect tax gross-up calculations, I compare calculations made for the example male plaintiff, with his award for income loss and costs of care of $1,240,000 + $2,000,000 = $3,240,000, before gross-up. All calculations described in this section have been made using the survival probability method, as defined in LRC 133 and by the Ontario Law Reform Commission (1987). I assume initially that no assistance with fund management is required, that no use of TFSA s will be made, that attendant care is part time, that the disability tax credit will be claimed exclusively on first dollar income and that CPP disability benefits should be included in first dollar income. The outcome of the calculation is a tax gross-up with a present value of $522, The argument favouring inclusion of CPP disability benefits in first dollar income is that if it is not included, the marginal tax rates applying to second dollar income will be underestimated and the gross-up will not fully offset the effects of taxation on the income earned from the cost of care award. The argument favouring exclusion is that, since CPP disability benefits are ignored (that is, they are not deducted) in arriving at the quantum of income loss, it is unfair to take them into account to increase the tax gross-up.

15 June 12, 2012 Tax Gross-Up and Fund Management Page 15 If TFSA s are assumed to be used at the maximum rate that funds can be transferred into tax free accounts (with the first transfers applying to first dollar income, to the plaintiff s advantage) the result falls to $477,700 (-$45,000). If attendant care is full time and if TFSA s are used to reduce taxes on the award, the result falls further, to $411,100 (-$66,600 or cumulatively, -$111,600). With TFSA s, full time attendant care, disability tax credits not assigned to the plaintiff s advantage and excluding CPP disability income, the result is $361,400 (-$49,700, or cumulatively, -$161,300, that is, 31% less than $522,700). If fund management fees are assumed to be required at the highest level of need described in LRC 133 (level 4), the last of the tax gross-ups described above falls from $361,400 to $272,700. The tax gross-up falls because fund management fees are deductible from taxable income. Based on the fee schedule of a large financial intermediary, management fees are calculated to have a present value of $664,200. Under the circumstances that produce the lowest tax gross-up, the sum of fund management fees and tax gross-up is $936,900. Under the circumstances which produce the highest tax gross-up result, fund management fees are $676,200, the tax gross-up is $394,600, and the sum is $1,070,800. From the highest to the lowest outcome, considering both the tax gross-up and management fees, the difference is $1,070,800 - $936,900 = $133,900, or about 12.5% of the highest amount representing the present values of both tax gross-up and fund management. With regard to management fees, controversy has mostly to do with the need for them, and the extent of the need. With regard to point 10 above, the minimum fund management fee, some experts have referred to these charges as uneconomic when the award approaches the point of exhaustion, and terminate the calculation when the minimum fee comes into effect. However, there is no objective definition of the term uneconomic, in this context, and no consensus with regard to what to do about the problem. In the examples, I have left the minimum fees in the calculations, to the end of the period of life expectancy. 5.4 What Does the Expert Need to Know? In matters that go to trial, it is normally the case that tax gross-up calculations are deferred until the damages with respect to future income loss and costs of care are determined by the court. It is also often the case that a judgment will include findings with respect to the need for assistance with fund management and, perhaps, the level of need. Under these circumstances, the expert needs the reasons for judgment in order to learn as much as can be learned about the sums awarded, and what they are meant to do. In addition to the sums awarded and any information about the award that may be provided in the reasons for judgment, the following information is typically required in a tax gross up calculation: 1. whether the plaintiff receives CPP disability benefits, and if so, how much;

16 June 12, 2012 Tax Gross-Up and Fund Management Page amounts of other non-award, taxable income (pensions, disability benefits other than CPP, investment income from assets held for reasons unrelated to the injury); 3. if the plaintiff is not unable to work, a way to estimate residual earning capacity; 4. whether or not the plaintiff has qualified or is likely to qualify for disability status for tax purposes; 5. whether or not there has been a finding with respect to reduced life expectancy and if so, the background evidence considered by the court to arrive at the finding; 6. whether the plaintiff will be claiming costs of fund management and if so, at what level of need; 7. whether some part of the costs of care will be covered by Part 7 benefits; 8. identification of items of care that may be covered by Part 7 benefits and information with regard to the terms of the coverage (for example, cost limitations that may be imposed on payments for certain goods and services if they are paid through Part 7 s). Because the gross-up calculations are complex and therefore not prone to revision on short notice, it makes sense to address controversial issues by doing with and without calculations. For example, if the plaintiff is receiving CPP disability benefits, because the inclusion or exclusion of them as a component of first dollar income is controversial, it may be advisable to have with and without calculations done to show what is at stake. Tax gross-up and fund management fee calculations are also requested in preparation for mediation. Generally, the information list above pertains but in the absence of a judgment, the expert will need to be instructed with regard to the amounts that are to be claimed for future income loss and for costs of care. 5.5 What Does a Tax Gross-up Look Like? In Figure 4, I show a graphical representation of a tax gross-up, based on future costs of care with a present value of $2,000,000 (costs have an average value of $89,899 per year), simplified as in Figure 2. In this example, income loss is $1,240,000, 50% of care costs are assumed to be claimed for medical expense tax credits, and CPP disability income is included in first dollar income. The vertical bars in Figure 4 show the expected values of future care costs in each year, which are equal to the amounts withdrawn from the award to offset the future costs of care in each year. Each vertical bar shows care costs (dark grey sections) with gross-ups added to each year s cost (light grey sections). Thus, each bar shows the amounts necessary to permit the plaintiff both to withdraw the

17 June 12, 2012 Tax Gross-Up and Fund Management Page 17 amount provided to cover care costs (expected value), and to pay the expected values of income tax incurred on the investment income earned from the cost of care award. Unlike the bars in Figure 2, in Figure 4 the vertical bars are nominal values that is, costs and taxes payable increase with price inflation. For the first 40 years, the effects of inflation outweigh the effects of mortality risk, and dark grey sections of the vertical bars increase in height. After about 40 years, the effects of mortality risk begin to outweigh the effects of inflation, and the dark grey sections of the vertical bars decrease in height. The tax gross-up decreases in both real and in nominal dollar terms in each year and by the plaintiff s age 70, the gross-up adds very little to the sums to be withdrawn. The higher line in Figure 4 shows the investment income generated by the $2,000,000 future costs of care award and by the tax gross-up, $607,200 in the example. The lower line shows the income earned by the cost of care award, excluding income from the tax gross-up amount. Comparing the withdrawals to the income earned shows that for a period of about 12 years (with the gross-up) or for 20 years (without the gross-up) income exceeds withdrawals. This is an artifact of the use of nominal dollars to compare income to the amounts withdrawn. In fact, inflation causes the real value of the capital sum to start falling immediately, as income left in the fund in the early years is insufficient to offset the effects of price inflation. In this style of calculation, which is the survival probability method as defined in LRC 133, the capital sum representing future costs of care is based on probabilities of need and so may be described as a probable amount. That is, it is the best estimate of the probable amount that the plaintiff will need to offset the costs of care which the trier of fact accepted as costs imposed on him by his injury. As withdrawals made from the initial capital sum are also probable amounts, it follows that the balances remaining in the fund in future years are probable amounts. For example, if we look at the present value of the amount remaining in the fund at the plaintiff s age 90, the probable amount is about $10,000. There is no certainty that this amount will remain in a fund, in = 57 years time. It is an estimate of the probable amount remaining, based on the best information we can get about the plaintiff s chances of being alive before, age 90, at age 90, and after. Income earned on probable capital sums will, inevitably, be probable amounts and taxes payable on probable amounts of income are, as well, probable. In other words, the gross-up amounts in Figure 4 (the light sections of the vertical bars) are probable, and not certain amounts.

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19 June 12, 2012 Tax Gross-Up and Fund Management Page THE TREATMENT OF LIFE EXPECTANCY 6.1 Overview of the Literature It is unfortunate that actuaries and economists have been unable to agree upon names for the three widely recognized methods which are used to calculate tax gross-ups and fund management fee expenses. The failure to name the methods, and to agree upon the meaning of the names that have been proposed continues to be a source of confusion, I am sure, to lawyers and judges who must listen to economists and actuaries explain what they have done to arrive at estimates of the present values of tax gross-up and of fund management fees, and compare one expert s results to the work of another. To try to resolve the naming problem I refer first to the paper authored by Mr. Brian Burnell, which he wrote in 2001 to alert his colleagues to concerns with respect to the performance of the methods then in use. Apparently to avoid the naming controversy, Mr. Burnell referred to the three methods which he was comparing as Method 1, Method 2, and Method 3. In Mr. Burnell s Method 1, withdrawals from the fund representing future loss are made with certainty that is, they are the total costs of items of care in each year. They are not the expected values (costs times probabilities of need, i.e. survival). Calculations of this kind have been described as life certain, as annuity certain and as certain withdrawal forms of the calculation. Method 1, which conforms to the term life certain in LRC 133, is used to describe calculations in which withdrawals are assumed to be made with certainty. As the amounts withdrawn in Method 1 exceed the expected values of future losses and costs (they correspond to the vertical bars in Figures 1 and 2, including the sections of each bar in all three shades of grey), withdrawals in each year exceed the amounts for which provisions are made in awards (again, the medium and dark grey sections of the bars in Figures 1 and 2). As fund withdrawals in Method 1 exceed the amounts on which the estimate of loss was based, the method produces balances remaining in the fund in each year which are below the balances that would be in an exhausting fund based on survival probabilities. With lower capital sums remaining in each year income generated by lower balances is of course lower, taxes are lower and estimates of tax gross-up in Mr. Burnell s Method 1 are lower than they are in his other calculations, in Methods 2 and 3. In principle, in a Method 1 calculation, it should be the case that withdrawals continue to the exact age of life expectancy, at which point the fund should be depleted. However, as Method 1 withdrawals exceed the expected values on which the estimate of damages was based, funds run out before the expected age of death is reached. This occurs in Mr. Burnell s Method 1 calculations. For the young male plaintiff who provides our example, the Method 1 tax gross-up calculation terminates about five years before the end of the life-certain period (46.9 years from the start date). The fundamental problem with the Method 1 approach to tax gross-up and fund management calculations is that Method 1 does not operate on the same principle as that used to determine the present value of future damages.

20 June 12, 2012 Tax Gross-Up and Fund Management Page 20 In Mr. Burnell s Method 2, withdrawals are the expected values. Method 2 corresponds to the LRC definition of the survival probability method. Method 2 has been used to generate the example calculations described in Section 5. The fundamental strength of the Method 2 approach to tax gross-up (and fund management) calculations is that it does operate on the same principle as that used to determine the present value of future damages. Mr. Burnell s Method 3 is the most complex approach to the calculation. It uses a different method to arrive at probabilities of need in each year, an approach based on the numbers of deaths, rather than on the numbers of survivors. The approach has been called the undertakers method. In terms of calculating the present value of future damages, Method 3 is mathematically equivalent to Method 2. That is, if applied to exogenously determined sums (as costs of care and income loss are) either Method 2 or Method 3 give exactly the same results. However, while the two forms of calculation do the same things in the calculations of the present values of income loss and costs of care, they do not do not do the same things, nor do they produce the same results, in calculations of tax gross-up and costs of fund management. Method 3 shares a fundamental strength of the Method 2 approach, inasmuch as it does operate on the same (mathematically equivalent) principle as that used to determine the present value of future 5 damages. However, the order in which calculations take place is different in Method 3 tax grossup/fund management calculations, and as a result, Method 3 does not produce the same results in tax gross-up and fund management calculations as Method 2. The Ontario Law Reform Commission (OLRC, Section 3e, pages 144 and 145) discusses methods of determining rates of withdrawal from a fund in a tax gross-up calculation. The first method discussed, and described as the normal practise among actuaries at the time of writing (1986), was based on withdrawals of amounts equal to constant real consumption (page 144). This corresponds to Burnell s Method 1. The second approach discussed by the OLRC corresponds to Burnell s Method 3 and the last, to Burnell s Method 2. The OLRC report rejected the method corresponding to Burnell s Method 3 (on the grounds of its complexity) and recommended an approach in which the rate of withdrawal from the fund for future care in any year should be assumed to equal the expected loss for that year, taking account of the probability of surviving to that year and all contingencies used in the calculation of the present value of the costs of future care. In short, OLRC recommended the use of Burnell s Method 2, the survival probability method. LRC 133 briefly discusses the life certain approach (II E 4. (c)) and endorses the survival probability method (II H 2. (c)). A clear definition of what was meant by the term survival 4 Method 2 calculations have also been said to follow Halley s method of calculating the value of future streams of payments. 5 Following either method to generate a table of year by year present value multipliers yields exactly the same results.

21 June 12, 2012 Tax Gross-Up and Fund Management Page 21 probability method is provided in Appendix C, 9. (2) (a) and (b). The LRC 133 definition corresponds to Burnell s Method 2. Bruce, in edition three of his text, discusses tax gross up briefly, on pages 41 to 47. He endorses a method like Burnell s Method 3. With regard to Method 1, Burnell states: In any case, in the light of these findings, the continued use of Method 1 would not be reasonable, especially in those cases where contingencies other than death are being taken into account. With regard to the choice between Methods 2 and 3, he says: The difference between Method 2 and Method 3 is relatively small in situations where a relatively low tax rate is concerned, and it might be argued that Method 2 could reasonably be used as an approximation to the more theoretically correct Method 3 in those situations. However, as stated above, the difference between these two methods is much more significant in cases where higher tax rates are involved, and Method 2 as an approximation in those cases would be harder to justify. To comment briefly on Mr. Burnell s concerns about high tax rates and the use of Method 2, I note that in personal injury matters, where a high proportion of costs can be claimed for tax credits, there may not be much difference between the outcomes of Methods 2 and 3, particularly for young adult plaintiffs with normal life expectancies. Differences do arise, however, when periods of life expectancy are reduced by age, or by impairment. To summarize, in the literature, two sources (OLRC and LRC 133) support Method 2 (the survival probability method, where withdrawals are expected values), one (Burnell) gives Method 2 a qualified endorsement but expresses a preference for Method 3, and in one (Bruce) there is a clear endorsement of Method 3. In none of the three sources in which Method 1 is discussed, is it the endorsed method. 6.2 Differences in Outcomes Methods 1, 2 and 3 Turning again to the simplified example, an estimate of tax gross-up based on Method 2, with no 6 amount calculated for fund management, is $607,200. Using the more cumbersome Method 3, the result is slightly higher, at $618,600 (+1.9%). Using Method 1 (life certain, or withdrawals made with certainty) the result is $559,300 (-7.9% compared to Method 2, -9.5% compared to Method 3). 6 The tax gross up values have been produced only for the purposes of comparing the methods.

22 June 12, 2012 Tax Gross-Up and Fund Management Page 22 In every case, with a 46.9 year period of life expectancy the differences in outcomes among all three methods were in the range of 2% to 10%. However, as Mr. Burnell s paper indicates, differences in outcomes increase as negative contingencies increase. Mr. Burnell makes his observations with reference to wrongful death calculations and adds negative contingencies (divorce and remarriage). In personal injury matters the same problems arise if plaintiffs are older, and/or if their injuries are of sufficient severity to substantially reduce life expectancy. To put some scale on the differences in results under circumstances in which life expectancy is much lower than 46.9 years, tax gross-up values were calculated on the basis of the same capital sums (costs of care, $2,000,000, income loss, $1,240,000), but for a person with a remaining period of life expectancy of 23.2 years (reduced by about one-half). The Method 2 calculation produced the tax gross-up result of $263,200. The Method 3 calculation produced the result of $316,600 (20.3% above Method 2). The Method 1 calculation produced the result of $232,100 ( 11.8% compared to Method 2, -26.7% compared to Method 3). With a reduced life expectancy, calculation of both tax gross-up and fund management fees based on Method 1 produced a result that was 21.7% below that produced by Method 2 and 26.2% below that of Method 3. The comparisons above conform to Mr. Burnell s finding that as negative contingencies increase, differences between the results of calculations in which withdrawals are expected values (Methods 2 and 3) and the results produced by calculations in which withdrawals are made with certainty (Method 1) increase. It follows that the older the plaintiff, and/or the greater the impairment to life expectancy, the greater will be the differences between the results of calculations made using methods in which withdrawals equal expected values (Methods 2 and 3) and calculations made with certain withdrawals (Method 1). 6.3 The B.C. Controversy There is a fourth method of calculation that has been tendered in evidence in court in British Columbia and has, on several occasions, been accepted as the basis for awards for tax gross-up and for fund management. There is no reference to this method in any of the published documents or texts listed in Section 3.1, and there is no reference to it in Mr. Burnell s paper. The method has had, like other methods, no consistent connection to a name. When the method was presented in court in Sammartino v. Hiebert, it was described as the life certain method. In Lines v. Gordon, it was the natural withdrawal method. In Whetung v. West Fraser Real Estate Holdings, it was the full specified withdrawal method, and recently its proponents have called it the probabilistic model.