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Tax Implications of Employment Settlements

September 27, 2022

woman reviewing taxes

Author: Kate Perala

Settlement of an employment dispute can result in benefits to both an employee and employer. 

In general, a wrongful dismissal settlement will consist partly or entirely of Employment Income; meaning the structure of the settlement can have major tax implications. When considering how to maximize a settlement for an employee and minimize the cost to the employer, there are two main considerations: What is the payment for? And when should it be paid? 

This blog post will examine how the Canada Revenue Agency (CRA) has interpreted settlement payments through their issuance of Interpretation Bulletins and Income Tax Folios.

Employer Obligations upon Termination of Employee 

When terminating an employee, employers are obligated to provide at least the minimum notice under the Alberta Employment Standards Code. Whether or not an employee is entitled to any additional payment-in-lieu of notice, is a question that can be assessed by an employment lawyer.  In most cases, an employment settlement will include both a minimum payment owing under the Code, and an additional contractual amount. 

Pay-in-lieu of notice is taxable income. When providing a terminated employee with pay-in-lieu of notice, the employer is required to withhold taxes on the payment made to the employee. 

Taxable vs Non-taxable Settlement Payments 

According to Income Tax Folio S2-F3-C1, and Income Tax Interpretation Bulletin IT-365R2, the CRA treats settlement payments which are intended to replace an individual’s earnings as taxable income. Any severance which is contemplated in the employment contract is taxable income. However, not all payments made to employees upon their termination are (a) intended to replace income or (b) contemplated by the employment agreement. Payments outside of these categories may not be taxable. When first claiming a wrongful dismissal, it is important to note all the different types of damages which are being sought so that some of the non-taxable categories can be included in a settlement. 

Wrongful Dismissal Claims

There are four categories of damages which can be claimed in a wrongful dismissal:

  1. Damages for pay-in-lieu of notice: also referred to as termination pay, includes salary, wages, accrued vacation, bonuses (usually) and the value of any benefits which would have been paid by the employer during the notice period. Termination pay is intended to replace the earnings of a terminated employee while they seek alternative work. The length of the notice period reflects how long it reasonably should take for an individual in the circumstances of the terminated employee to find work. This is taxable income.
  2. General Damages: General damages may include aggravated and punitive damages which are based on some kind of “bad faith” conduct of the employer, or mistreatment of the employee. Aggravated and punitive damages can compensate for mental distress, harassment, bullying, withholding final paycheques until the terminated employee signs a release, failure to investigate the employee’s complaints, failure to provide a safe workplace and many others. This is not taxable income. 
  3. Human Rights Damages: If an employee has been terminated, or treated unfairly on the basis of a protected ground (race, religion, gender, etc.) under the Alberta Human Rights Act, they may be entitled to additional “human rights damages.” This is not taxable income.
  4. Special Damages: special damages arise out of additional costs that an employee incurred as a result of the termination. It includes costs associated with mitigating the loss of employment. For example; counselling, job retraining, etc. This is not taxable income. 

Legal fees may also be included in a settlement agreement from which additional taxes would not be withheld by the employer.

Wrongful dismissal claims tend to focus on the length of the notice period as the central issue with all the other types of damages as “side issues” but these other types of damages can be advantageous to both employer and employee in a settlement negotiation. Framing a settlement under the heading of “general damages” can in some circumstances close the gap in a negotiation entirely. 

For example: A settlement agreement for $100,000 with the entirety structured as pay-in-lieu of notice would have $30,000 withheld and remitted as tax under the Retiring Allowance rules discussed below. However, a settlement agreement for $100,000 with $75,000 attributed to pay-in-lieu of notice and $25,000 to non-taxable categories would have $22,500 withheld and remitted as tax.  

Non-taxable categories of damages are only available in situations where an employee has reasonable grounds to pursue such a claim.  If an employee has a reasonable claim for aggravated damages, or human rights damages, and an employer is willing to agree to a settlement including such an attribution, then the total amount paid could potentially be reduced with the employee achieving a total post-tax amount received increased.  This can be a factor in helping two parties achieve a settlement. 

Retiring Allowances 

Sometimes there is no reasonable way to ground a claim in any type of damages aside from notice itself, or an employer will not admit any underlying facts that could be construed as misconduct. In those situations there are still options to lessen the burden of taxes.

One way to offer tax advantageous settlements to terminated employees is through a “retiring allowance”. In Income Tax Folio S2-F1-C2, the CRA defines a retiring allowance as “an amount received on or after the retirement of an employee in recognition of long service or in respect of a loss of employment.” A retiring allowance can not include salary, wages, accrued vacation, overtime, or bonuses. Nor can it include anything that would fall under human rights damages or special damages. A retiring allowance is a payment made beyond the minimum pay in lieu according to employment standards. 

Retirement allowances are taxable, but they can help reduce the amount withheld by the employer in respect to taxes. Retirement allowances include an option to allow an employee to receive payments or partial payments directly into their RRSP and have no withholdings from those amounts. 

Depending on an employee’s earning status in each calendar year, the employee may want to defer all or a portion of a settlement payment thus allowing a deferral and potential reduction of tax owing. Any payment is taxable in the year it is received regardless of the time that it is intended to compensate for. This can make a big difference, particularly where an employee is dismissed at the end of the year and then has a longer period of unemployment in the following year.  Employees should consider speaking to a financial advisor in deciding how and when to receive settlement amounts, particularly when considering retiring allowance or payment deferrals.

Alberta Employment Lawyers 

If you have questions about any employment law matters including settlement structures, please contact any of Carbert Waite’s Employment Lawyers.

For further information concerning termination of employment, please visit our practice area page here.

Carbert Waite LLP