Tax Issues in Employment CasesWritten on behalf of Peter McSherry
The issue of how damages for wrongful dismissal or constructive dismissal are treated for the purposes of taxes can be complicated and important.
The Default Setting
Generally speaking, a claim for lost income for the “notice period” and also payment of the minimum statutory sums will not only be taxable, but also will require the employer to withhold tax at source on such payments. The employee will not be required to pay tax on any legal costs paid by the employer. As this sum is usually not payment of the entire legal bill of the employee, he or she will be able to deduct the residual sum as an expense against the taxable severance.
Oddly enough, should the employee’s claim fail, the costs paid by the employee, whether to his or her own legal counsel or that of the company, will not be deductible against other income.
Should an otherwise taxable severance payment be agreed to be paid, the employee may direct that this sum be paid to his or her RRSP account to the extent that there is unused room in this account. In that event, there is no tax withheld upon the payment to the RRSP.
There are claims which, when made in good faith, may result in payments which are non-taxable.
Unfair Employer Conduct
When a case has been made out for “aggravated damages” due to unfair conduct of the company, this sum will likely not be taxed nor subject to tax at source. The same result will apply to punitive damages, an exceptional award designed to punish the wrongdoer for malicious conduct.
Human Rights Violations
Human rights cases, which may be included as a component of a civil action or by a human rights complaint, may also give rise to a non-taxable payment. Human rights claims are complicated with respect this issue. Generally such a case can lead to three forms of compensation. These may include (1) damages for personal suffering and humiliation, (2) a claim for lost income from the date of termination forward to the date of settlement or hearing, and (3) a claim for a future income loss where reinstatement is not ordered.
The damage award or settlement for damages for personal suffering and a future income loss are both likely non-taxable but the claim for lost income is taxable.
Where the employer has provided disability insurance as an employment term and a successful claim has been made against the employer or the disability insurer for lost disability, this situation again raises tax issues.
A claim for past disability sums due will be taxable, whereas a claim for a future loss of disability sums will be non-taxable.
Employment Termination Prior to Start Date
In the rare situation where employment has been offered and accepted, yet this agreement has been terminated before the actual commencement date, the resulting payment for the lost employment opportunity will be non-taxable income.
Underlying Good Faith
All of the above non-taxable situations require an underpinning of good faith. Claims cannot be invented strictly to improve upon tax consequences.
Setting Out the Deal
Typically, legal counsel will set out the terms of settlement by an agreement which designates the total sum to be paid and further allocate this amount to various headings, as may be appropriate. This agreement will likely define that no tax will be withheld on any sums to be paid as non-taxable and further may state that no T-4 or T-4A will be issued with respect to this particular damage amounts.
Even if all of the above has been completed meticulously, there is no impediment to Revenue Canada reviewing the transaction to confirm that the non-taxable sums have been bargained in good faith and not based on inventive tax planning. Revenue Canada may not only re-assess the claims but also impose penalties where it believes that the claims are fictitious. In such an event, the responsibility for the tax payable is that of the employee.
To complete this review, the employee is required to repay any sums of employment insurance which he or she may have received, which is reflective of the severance period. For example, if 6 months taxable severance is received, the employee must pay not only tax, but also repay EI received allocable to this time period.
Presume this sum is $50,000 gross dollars. If the payment made was $50,000 as non-taxable human rights damages as opposed to severance, not only is there no tax, the EI repayment issue is also not required.
The distinction is vivid. It may prompt the employee to exaggerate the non-taxable components for these reasons, but this temptation must be restrained by a good faith obligation.
Tax Can be Taxing
Tax issues are important for obvious reasons. When acting honestly, you may be able to reduce your tax burden and even the EI repayment sum. This may dramatically improve the result of your case.
If you are an employee seeking legal advice in this situation, contact the offices of Guelph employment lawyer Peter McSherry. We can guide you through the issues and help you maximize any financial benefits in your situation. Contact us online or by phone at 519-821-5465 to schedule a consultation today.