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Tax Gross-up Methodology and Fairness

In cases of catastrophic injuries and significant future care settlements/awards – how does the court ensure that the future care fund is not diminished by taxes on investment income?

In the recent decision of Pestano v. Wong (2017 BCSC 1666) from Mr. Justice Branch of the British Columbia Supreme Court, the major issues were post-settlement items of management fees and tax gross-ups. The facts are sad: the plaintiff suffered a brain injury when he was three days old, secondary to a severe hypoglycemic episode.  As a result of his injuries, he would never be competitively employable, need lifelong care, and be unable to manage his estate or manage the investment of his settlement fund. The claim was for medical malpractice, and the matter settled. The decision relates to post-settlement issues of investment management fees, and tax gross-up.

Mr. Justice Branch concluded that neither the plaintiff or his parents were capable of managing the investment of his settlement (which was in excess of $5 million). He concluded, that in order to achieve the 2% discount rate (a discount rate applied to future losses – to recognize the assumed investment earnings generated, countered by inflation), the plaintiff would continue to incur fees for an investment group to manage his settlement fund. After much review, he accepted the fee proposal presented by the plaintiff.

He then turned to the methodology to “gross-up” the cost of future care funds to provide funds that will be able to meet the projected expenses throughout the plaintiff’s lifetime (rather than ending prematurely). Gross-up is necessary because amounts for future care are paid as a lump sum fund, reduced on the assumption that the ongoing unused portion will be invested and earn income. However, because investment income is taxed, the lump sum will be insufficient to provide the care intended – and a complicated “tax gross-up” is necessary to ensure the fund is sufficient. The major issue in this case was how to assess the future uncertainties about the plaintiff’s life expectancy – i.e. how long the future care expenses would be needed depending on hypothetical contingencies.

The plaintiff’s experts’ analysis ran 97 scenarios covering the potential range of life expectancies, and applied the cost of future care to the same. The defence experts started with life expectancy, and applied mortality tables to reduce the life expectancy further.  The defence analysis was criticized because it yielded outcomes that led to the fund expiring even before the average life expectancy without contingencies. To put it simply, the defence approach double counted the likelihood of death.  In preferring the plaintiff’s “Probability of Death method” set out by economist Rob Carson, Mr. Justice Branch provided the following reasons:

[76]         Having reviewed the authorities, I derive the following general principles:

1.       the gross-up methodology should, to the extent possible, provide funds at a level that will be able to meet the projected expenses throughout the plaintiff’s lifetime, and not end prematurely; and

2.       the methodology should, to the extent possible, be consistent with the methodology used for the underlying awards upon which the gross-up is based.

[77]         I find that these principles favour Mr. Carson’s Probability of Death method, in that this method is more closely aligned to the probabilistic approach used to derive the cost of care and future income lost. By way of contrast, Mr. Hildebrand admits that his approach “decouples” the gross-up calculations from the underlying calculations. Furthermore, the Probability of Death method is more likely to yield a stream that matches the plaintiff’s average expected life expectancy. Finally, Mr. Hildebrand accepted that the Burnell paper, from which the Probability of Death method was derived, is a recommended resource for actuaries. This was affirmed by Mr. Banville. Mr. Cheng agreed that there was very little else out there other than Mr. Burnell’s paper. Conversely, there was no evidence of any actuary approving of Mr. Hildebrand’s approach.

[78]         In terms of the defendant’s critiques of the Probability of Death method, the concern about certain illustrated scenarios being unrealistic is overstated, since they were simply a step along the road of a longer mathematical calculation that eventually adjusts in such a way that the final expected outcome matches the award. Furthermore, this complaint overlooks that the interim scenarios in the early years vastly underutilize the agreed amount. This only highlights the need to assess the approach in its totality, not on the basis of what is illustrated half-way through the order of mathematical operations. It is somewhat akin to critiquing a student for showing that (2X2)-1=4 part way through a student’s calculations, without turning over the page to see that the student subsequently subtracted 1 to reach 3.

[79]         I conclude that the calculations guiding the court’s assessment in this case should be performed using Mr. Carson’s Probability of Death method.