Janna Krieger, Toronto, and Jennifer Smith, Ottawa
The Canada Revenue Agency (CRA) was recently asked whether a payment for general damages on termination of employment is subject to income tax and withholding.
Based on the situation presented, the CRA confirmed that such a payment is, in fact, taxable and subject to withholding — unless it is clearly shown to be unrelated to the loss of employment.
This response is consistent with the CRA’s established position on the taxation of settlement payments, and serves as a reminder of the employer’s requirement to withhold. It also reminds us that the CRA will consider the true nature of a payment in determining its tax treatment, regardless of how that payment is labelled by the parties involved.
In its brief summary of the relevant facts, the CRA noted the following:
- An individual was terminated by his employer.
- The original settlement awarded the individual a termination payment consisting of “in lieu of notice,” severance and vacation pay. The tax treatment of this payment was not in question.
- The individual had several grievances outstanding with the employer at the time of termination.
- The individual subsequently filed an additional grievance for termination without just cause.
- At arbitration, the termination settlement was revised to include an additional amount for general damages and the withdrawal of the individual’s existing grievances.
- The arbitration agreement stated that the payment for general damages was to be paid to the individual without income tax withholdings.
The CRA was asked for clarification as to whether the general damages payment is subject to withholdings.
An amount an employee receives on or after termination of employment may be treated as employment income, a retiring allowance, non-taxable damages or a combination thereof, depending on the purpose of the payment and the specific fact scenario.
The term “retiring allowance” is defined for income tax purposes to include an amount received “in respect of a loss of an office or employment of a taxpayer, whether or not received as, on account or in lieu of payment of, damages....”
If an amount falls within this definition, it must be included in income and is subject to withholding of tax at source.
The Canadian courts have applied a broad scope in determining whether an amount is received “in respect of” a loss of employment, looking only for a connection between the loss of employment and the amount received. The courts have summarized this as the “but for” test, which has been incorporated into the CRA’s policy: if the amount would not have been received “but for the loss of employment,” the connection is established and the amount will be considered a retiring allowance.
The CRA’s policy has generally followed the courts, and is documented in Interpretation Bulletin IT-337R4, Retiring Allowances.
The CRA’s response
Based on the information in the example, the CRA expressed the view that the general damages payment was a retiring allowance because it related to the individual’s loss of employment. As a result, it should be included in income and subject to withholding.
The CRA further stated that even if an amount is not connected to the loss of employment but rather a pre-existing grievance, if there is any connection between the payment and the employment, that amount may be taxable and subject to withholding as employment income.
In fact, based on the CRA’s policy and case law, general damages would only be considered non-taxable if they are clearly proven to be for personal injuries unrelated to the loss of employment. Examples of cases where the courts have held such payments to be non-taxable include the following:
- Damages for human rights violations (Dunphy v The Queen, 2009 TCC 619)
- Damages related to potential future employment (Schwartz v The Queen, 96 D.T.C. 6103)
- Damages for a tort action resulting from the wrongful stripping of an employee’s responsibilities (Ahmad v The Queen, 2002 DTC 2065 (TCC))
- Damages related to a former employer’s negligent misrepresentation (Rae v The Queen, 2010 TCC 130
The CRA also made a point of noting that in determining the tax treatment of a particular amount, it would consider the character of and reason for the payment, and not just the words used in a settlement agreement to label that payment.
The treatment of general damages as a retiring allowance in this case is a straightforward application of the law and CRA policy. This interpretation specifically highlights the withholding requirement in the context of settlement payments and serves as a reminder to employers to consider their requirement to withhold on payments that are considered to be retiring allowances.
If you’re negotiating settlement agreements, consult your EY advisor. Remember that the words used to describe the tax treatment of a payment will not determine the treatment unless they reflect the actual nature of the payment.
<< Previous | Next >>