Have you ever wondered what the Tax Treatment of your Severance Pay you received in a settlement or in Court? Continue reading to find out.
Topics Will be Covered in This Post:
1. How Are Severance Pay Taxed?
First of all, to avoid confusion severance pay in our everyday usage means any and all money we received as a result of a loss of employment. According to the government of Canada, severance pay is defined as "money your employer pays you when you lose your job through no fault of your own." But for income tax purposes, severance pay means something very different. Please read on to find out.
Three types of termination payouts that an employee can receives are:
3. Non-taxable deductible
With respect to income earned by an employee, s. 5(1) of the Income Tax Act (ITA) includes in a taxpayer’s income, income from office or employment which includes salary, wages and other remuneration and s. 6(1)(a) includes in a taxpayer’s income, benefits from employment (such amounts together referred to as “employment income”).
With respect to employee severance pay, s. 56(1)(a)(ii) of ITA identifies a retiring allowance (also referred to as a severance pay) as an income source to be included in calculating taxable income. Accordingly, any amount received by an employee that is either employment income (including employment benefits) or a retiring allowance will be subject to tax.
What is important to note is that where an employee receives an amount for reasons not connected to employment, and therefore, the amount is neither employment income nor a retiring allowance, the amount may not be subject to tax.
With respect to a payment made by an employer to a terminated employee, such an amount will be deductible as a business expense as long as it is made for the purpose of gaining or producing income from the business pursuant to s. 18(1)(a) of the ITA, and the amount of the payment is reasonable within the meaning of s. 67 of the ITA.
2. Employment Income
In order for an amount to be employment income, generally it must meet two criteria: 1) the employee must have obtained the benefit in the context of a work relationship and 2) the employee must have personally received the benefit (cannot be a corporation).
Employment income are tax deductible to employer if two criteria are met:
It’s a benefit conferred to employee (must be a person and not a corporation)
It’s a reasonable amount
S. 6(3)(b) of the ITA considers certain amounts received by a taxpayer before, during, or after employment to be remuneration for services rendered unless it can be established otherwise. This section includes amounts received in anticipation of entering into an employment relationship (e.g., a signing bonus) and amounts received on or after the termination of employment.
Pre-judgment interest on awards relating to employment or the loss of employment is taxable as employment income pursuant to s. 12(1)(c) of the ITA.
Employment income is taxable in the year of receipt and is subject to normal source deduction withholdings, including income tax, Canada Pension Plan contributions and employment insurance premiums.
3. Retiring Allowances
A retiring allowance is defined in s. 248(1) of the Income Tax Act (ITA). For an amount to be a retiring allowance it must have been received by the employee either:
(a) on or after retirement of the individual from an office or employment in recognition of the individual’s long service, OR
(b) in respect of a loss of an office or employment of the individual, whether or not received as, on account or in lieu of payment of, damages or pursuant to an order or judgment of a competent tribunal.
An important distinction between the first and second alternative requirements for an amount to be considered a retiring allowance is that under the first requirement described in (a) above, the amount must be paid “on or after a retirement” whereas under the second requirement described in (b) above, the amounts may be paid at any time.
Accordingly, a retiring allowance can be paid to an employee prior to the termination of employment and still be considered retirement allowance as long as the terms of the second requirement described in (b) above are met.
As you can see retiring allowance, also referred to as severance pay for income tax purpose, is VERY different than our everyday usage of the term severance pay.
Pursuant to Income Tax Folio S2-F1-C2, Retiring Allowances, published by the government of Canada, at para. 2.23, a payment in lieu of severance resulting from the elimination of the future accrual of severance benefits is employment income if the payment is received while employed. If the payment is received after retirement, however, it will be a retiring allowance.
In Overin v. The Queen, 1997 CanLII 159 (TCC), the Tax Court of Canada formulated a two-step test to confirm whether the connection between a payment and the loss of employment is sufficient to meet the requirement that an amount be “in respect of” a loss of office or employment:
(a) Bur for the loss of employment, would the employee have received the payment?
(b) Was the goal of the payment to compensate the individual for the loss of employment?
If the answer to the first question is no and the answer to the second question is yes, then the amount will be considered to be a retiring allowance.
Retiring allowance are tax deductible to employer if three criteria are met:
The employee is no longer under employ, and is no longer receiving vacation pay, sick leave or medical benefits;
The employee would not have received the retiring allowance but for the termination; AND
It’s a reasonable amount.
In determining reasonableness for a retiring allowance, consideration will be given to the length of service involved, its relationship to the remuneration received by the employee and the value of any pension or other benefits the employee receives.
CRA published a very detailed ultimate guide on taxation of retiring allowance, and what kind of termination payouts, also called “receipts” by CRA, are regarded as employment income or retiring allowance:
Retiring allowances are subject to income tax withholdings, but are not subject to Canada Pension Plan contributions or employment insurance premiums.
Combined federal and provincial withholdings apply at flat rates for retiring allowances, which in most cases, would be less than the tax rate the employee would ordinarily pay on employment income.
For Ontario employers, these rates are currently: 10% on amounts up to and including $5,000; 20% on amounts from $5,000 up to and including $15,000; and 30% on amounts over $15,000.
Click here to learn more about withholding rates for lump-sum payments.
4. Non-Taxable Receipts
Non-Taxable Receipts (i.e. not tax deductible) are a result of damages unrelated to loss of employment. Personal injuries damages in related to harassment and emotional distress and damages in related to human rights violations are deemed to be non-taxable.
It has been held that damages or settlements in lieu of expenses sufficiently connected to the loss of an employment or office, including relocation expenses, counselling and job search expenses, are part of a retiring allowance. However, when expenses are unconnected to the loss of employment, but related to discrimination or harassment, the expenses will be tax exempt.
The leading case is Schwartz v. Canada, [1996] 1 SCR 254, wherein the Supreme Court of Canada held that damages received for termination of an employment contract before the individual commenced employment were not taxable. In this case, the court found that the damages were not a retiring allowance because they did not relate to employment of the individual, they related to future employment. The amount couldn’t be an employment income as well, as it’s not a payment for service rendered. For these reasons, the damages were not taxable under the general provisions of s. 3 of ITA as they did not fall into one of the five enumerated sources (office, employment, business, property and capital gain).
As set out above in Schwartz v. Canada, certain damages awards could be considered non-taxable where they represent payments for events or actions separate from the loss of employment. Where it can be clearly demonstrated that an amount was unrelated to the loss of employment, such as certain types of moral damages, the amount would likely be considered damages for personal injury and not taxable.
Although the test as outlined by the Supreme Court of Canada in Schwartz is very straightforward, it is not simple to apply and is dependent on the facts in each situation. The following are examples of situations where the courts have found payments to employees are not taxable receipts:
- damages for a tort action for the wrong done to a taxpayer in stripping the taxpayer of his ability to work as a nuclear researcher; (see e.g. Ahmad v. The Queen, 2002 CanLII 1127 (TCC))
- damages for human rights violations; (see e.g. Fournier v. The Queen, 1999 CanLII 260 (TCC); Mendes-Roux v. The Queen, 1997 CanLII 134 (TCC))
- damages related to potential future employment; (see e.g. Schwartz v. Canada, [1996] 1 SCR 254)
- Moral damages such as aggravating damages and punitive damages are non-taxable receipts. (see e.g. Abenaim v. The Queen, 2017 TCC 223)
In Abenaim v. The Queen, 2017 TCC 223, at para. 101, the Tax Court of Canada, citing to Overin v. The Queen and Schwartz v. Canada, stated that "damages received that can be linked to a contract of employment are … taxable as a retiring allowance. However, an amount received by a taxpayer as moral damages is not taxable since there is no link to a loss of employment. As a result, those damages are not taxable as a retiring allowance”.
For example, the Canada Revenue Agency (CRA) has said that general damages obtained in connection with personal injuries suffered before or after the taxpayer's loss of work may be deemed unconnected to the taxpayer's loss of employment and therefore non-taxable.
However, the CRA may consider payments received from an employer for damages paid outside of an employment contract but in respect of a loss of employment to be taxable retirement allowances.
To effectively assert that damages were obtained for personal injuries unrelated to job loss, taxpayers must show unequivocally that the damages were incurred for events or acts unrelated to job loss.
There is no income tax withholding required for a non-taxable payment to an individual.
5. Determining the Characterization of a Dual Purposes Termination Payment
Determining the appropriate characterization of a payment can be difficult in circumstances where the payment may be made for more than one purpose.
If dual purposes of a payment exists, the most appropriate characterization for which the payment is made must be identified to determine the applicable tax treatment for the entire amount.
In other cases, the payment may be made to address two distinct complaints. In such a case, it is the appropriate amounts attributable to each purpose that must be determined to confirm the applicable tax treatment which may be different for the two distinct amounts.
The Canada Revenue Agency (CRA) takes the view that payments in lieu of notice of termination by virtue of the employment terms are considered to be income from employment. However, where a damages payment arising from the loss of employment includes an amount in respect of reasonable notice, this will be considered to be a retiring allowance.
The Supreme Court of Canada laid out the general principle to be followed in Tsiaprailis v. Canada, 2005 SCC 8, in which the Court held that the determination is to be made based on “what the payment was intended to replace”. This is known as the “surrogatum principle”, by which the tax treatment of a payment of damages or a settlement payment is considered to be the same as the tax treatment of whatever the payment is intended to replace.
The determination of what the payment is intended to replace is dependent on the facts and in particular on the documents in any given case. Accordingly, it will be important that all settlement agreements, statements of claim or other complaints or correspondence between the parties and with advisors be consistent with, and as supportive as possible of, the position being taken by the parties on the character of the payment.
In Forest v. Canada, 2007 FCA 362, the Federal Court of Appeal, relying on the Supreme Court of Canada’s decision in Schwartz v. Canada, ruled that once it has been established that a settlement amount has dual purpose, the bar on establishing an apportionment should not be set so high. As long as there is some evidence from which a judge can reasonably identify the individual components of a settlement amount, that evidence should be accepted. Reliance must be placed on any relevant documents which can support a reasonable allocation between the two purposes.
The CRA acknowledged that it is the parties to the agreement who are best able to make the determination of the tax treatment based on the nature and purpose of the amount.
Generally, in a legal dispute that is ultimately settled, it is the statement of claim that would be looked at first. In cases where the statement of claim does not clearly determine the nature of the payment, the courts have turned to the correspondence or agreements between the parties. For example, if some or all of an amount is received in settlement of human rights dispute, the settlement agreement or letter should clearly state this and also identify the portion of the amount being paid for that.
Consideration should be given to prior decisions of courts and tribunals that are most similar to the facts involved with the taxpayer’s case. In addition, any evidence of a policy or legislative basis for awards to individuals in similar circumstances may be helpful.
For example, the CRA considers payments in lieu of notice of termination pursuant to the employment contractual terms or the part of a settlement agreement designated as compensation for lost income to constitute income from employment. However, where a damages payment arising from the loss of employment includes an amount in respect of reasonable notice, this will be considered to be a retiring allowance.
6. Transferring Some or All of a Retiring Allowance Directly into an RRSP or RPP
For CRA purposes, a retiring allowance may include an eligible portion and a non-eligible portion.
Income Tax Act (ITA), s. 60(j.1) allows a long term employee to defer some or all of the income tax on a retiring allowance by transferring the eligible portion of the retiring allowance to a registered pension plan (RSP) or registered retirement savings plan (RRSP).
Click here to learn more about eligible transfer of retiring allowance to RRSP or RPP from the government of Canada website.
The benefit of eligible transfer is that the amount transferred will not count towards the taxpayer’s RRSP deduction limit (also referred to as “RRSP room”).
The non-eligible part can be contributed to your RRSP or to a spousal or common-law partner RRSP, up to the amount of your available RRSP deduction limit, pursuant to s. 146(5) of the ITA.
Click here to learn more about non-eligible transfer of retiring allowance to RRSP.
7. Legal Fees Paid to Obtain a Retiring Allowance or Employment Income
Payment paid directly to service providers are also tax deductible for employer. For example, if employer sent the settlement funds to the employee’s RRSP account directly, or paid legal fees directly, then those are tax deductible.
Employers may deduct legal expenses as a "business expense" to the extent that the employer pays or reimburses the employee for legal expenses and that the amount paid does not exceed a reasonable amount.
Employers may deduct legal expenses as a "business expense" if they pay or reimburse employees for legal expenses that are reasonable in the circumstances.
Legal expenses for the purposes of s. 8(1)(b) and s. 60(o.1) of the ITA are narrowly defined to only include legal type services and expenses. Expenses for auxiliary services such as the use of accountants or labour relations consultant in a legal action can also be deducted (see e.g. Medynski v. The Queen, 2009 TCC 216, at para. 7, 20-21).
Click here to learn more about what qualifies as legal and account fee and expenses.
A. Tax Treatment of Legal expenses in related to Salary and Wages
Pursuant to s. 8(1)(b) of the Income Tax Act (ITA), legal expenses paid to collect or establish a right to salary or wages can be deducted from a taxpayer’s income for tax purposes. This deduction is limited to amounts “owed” by an employer, or former employer. Therefore, legal expenses paid for an unsuccessful claim against an employer or former employer are not deductible. However, if the taxpayer establishes the amount is owed, but is unsuccessful in collecting such amount, the related legal fees are still deductible.
Click here to learn more about tax treatment of legal and account fee paid to collect or establish a right to salary or wages.
B. Tax Treatment of Legal expenses in related to Retiring Allowance
Section 56(1)(l.1) of the ITA provides that the amount of an award or reimbursement in respect of legal expenses paid to collect or establish a right to a retiring allowance is included as income for tax purposes in the year it is received. Therefore, legal cost awards for expenses paid by the employee to establish a right to a "retiring allowance" are not considered part of a "retiring allowance".
However, employees are entitled to relief under s. 60(o.1) of the ITA which provides a deduction for legal expenses. Under s. 60(o.1) of the ITA, an employee who obtains legal representation or must go to court to collect or establish a right to a retiring allowance may deduct legal expenses paid to collect or establish that right.
Legal fees can only be deducted if the employee can show that 1) the retiring allowance has been received by the employee; and 2) the legal fees were actually incurred. (see e.g. Bonsma v. The Queen, 2010 TCC 342, at para. 21)
The deduction for legal fees paid to collect or ensure a right to collect a retiring allowance is limited to:
(a) the amount of any retiring allowance or pension benefit related to those legal fees which is received and included in the taxpayer's income for the year or a previous year,
plus
(b) any reimbursement of legal expenses included in the taxpayer's income under s. 56(1)(l.1) for the year or a preceding year,
minus
(c) transfers to a RPP or RRSP pursuant to Sections 60(j), (j.01), (j.1) or (j.2); this reduction is only required to be made to the extent that the amounts so transferred are amounts for which legal expenses eligible for deduction under s. 60(0.1) were incurred.
Any legal expenses which exceed what can be deducted in a year may be carried forward and deducted in the same way for up to7 years to the extent that the employee continues to receive a retiring allowance that was not previously deductible.
According to Filion v. Canada, 2017 FCA 67, at para. 12, the seven year carry forward is strictly enforced even if there was a good reason for delay in resolving the dispute.
C. How to Determine What’s The Proper Tax Treatment of Legal Expenses?
Pursuant to Income Tax Folio S2-F1-C2, Retiring Allowances, at para. 2.14-2.18:
Retiring allowance includes any compensation on account of damages for loss of employment. This applies to special damages (also referred to as peculiar damage) as well as general damages (also referred to as non peculiar damage) received for loss of self-respect, humiliation, mental anguish, hurt feelings, etc. Only where an award of damages can be traced to events unrelated to or separate from the loss of employment will the amount not be considered a retiring allowance.
Special damages, such as those received for lost (unearned) earnings, on the other hand, are considered to be employment income if the individual retains employment or is awarded an reinstatement, regardless of whether the employee actually return to work.
D. Case Analysis: Bonsma v. The Queen, 2010 TCC 342
Bonsma v. The Queen, 2010 TCC 342 is directly on point and demonstrates how to establish the appropriate tax treatment of legal costs.
In this case, the Appellant was an employee of Tesco Corporation, and sued for wrongful dismissal in 2005. In the statement of claim, the Appellant sought, among other things, damages for loss of employment income prior and after the termination as a result of the alleged wrongful dismissal and bad faith treatment he received while under employed.
The Appellant did not receive from Tesco, as a result of his legal action against that company, a retiring allowance, including any damages or settlement for wrongful dismissal, in the 2005, 2006 or 2007 taxation years. Neither did he include in his income for the 2005, 2006 and 2007 taxation years any amount from Tesco in respect of a retiring allowance, including any damages or settlement for wrongful dismissal.
But the Appellant claimed deduction for legal fees in 2005, 2006 and 2007. The Appellant got reassessed in 2009, and all the deduction for legal fees were disallowed. The Appellant appealed to the Tax Court of Canada.
The Respondent, the Minister of National Revenue, submits at para. 15 that:
The legal fees paid by the Appellant in the 2005, 2006 and 2007 taxation years were incurred for the purpose of establishing a right to damages from Tesco for the loss of employment and not for the purpose of collecting or establishing a right to salary or wages owed to the Appellant by Tesco.
The legal fees were incurred for the purpose of establishing a right to a retiring allowance within the meaning of s. 248(1) of the Income Tax Act (the “Act”).
The deduction of legal fees paid to collect or to establish a right to a retiring allowance is limited to the amount of the retiring allowance received and included in income in the year.
The Appellant did not receive and include in income any amount on account of a retiring allowance from Tesco in the 2005, 2006 and 2007 taxation years, and thus the deductions of his legal fees under s. 60(o.1) was properly disallowed.
The Tax Court of Canada agreed with Respondent and dismissed the appeal. In reaching its decision, the Court reasoned that:
For the purpose of s. 8(1)(b) of the ITA, salary and wages include amounts owing to a person for services already rendered in circumstances where the employer has failed to pay such salary and wages. The Court found that the evidence in this case clearly revealed that none of the amounts claimed in the Statement of Claim were related to services already rendered by the Appellant to Tesco, and as such the Appellant couldn’t deduct the legal expenses that he paid in the years at issue. (at para. 18)
For the purpose of s. 248(1) of the ITA, to qualify as a retirement allowance, two criteria have to be met:
1) But for the loss of employment would the amount have been received?
2) Was the purpose of the payment to compensate a loss of employment?
(at para. 19)
The Court found that the evidence in this case revealed that:
i. The Appellant lost his employment;
ii. But for the loss of his employment, the amount of damages claimed in his Statement of Claim would never be received; and
iii. The purpose of any amount that he received would clearly be to compensate him for his loss of employment and not to pay salary or wages owed him by Tesco,
and as such the Appellant’s legal fees were incurred to establish a right to a retiring allowance. (at para. 20)
For the purpose of s. 60(o.1) and s. 248(1) of the ITA, any legal fees deductions are limited to the amount of the retiring allowance received and included in income in a taxation year. The Court found that the evidence revealed that the Appellant did not receive and include in income any amount on account of a retiring allowance paid by Tesco in the 2005, 2006 and 2007 taxation years, and as such it was proper to disallow the deductions of legal fees in questions. (at para. 21)
Please bear in mind though, for example, if an employee is a federal regulated employee and claims for unjust dismissal under s. 240 of the Canada Labour Code after a termination, and asks for a reinstatement, and gets it, all the special damages, such as those received for loss (unearned) wages or employee benefits WILL be deemed as employment income, pursuant to Income Tax Folio S2-F1-C2, Retiring Allowances, at para. 2.15.
8. Conclusion
In a legal dispute that is ultimately settled, it is the statement of claim that would be looked at first, then the correspondence or agreements between the parties if needed.
Certain termination payments are taxed as employment income, while others are taxed as retiring allowances, and yet others are tax exempted if they fall into neither category.
To maximize the amount deductible by the employer as business expenses and to limit the income tax the employee must pay after the employment law issue is settled, it is essential that the settlement agreement clearly defines the nature and purpose of each payment, as well as the percentage of the sum allocated to that payment header. You need an employment lawyer who is familiar with the tax treatment of severance pay and other termination payments.
When you have been terminated wrongfully or you have been constructively dismissed, you should consults with an employment lawyer or you risk waiving your legal rights under Common law or your rights in suing for wrongful dismissal, constructive dismissal or workplace discrimination.
Call us now at 647-849-6582 or Contact Us Now if you have any questions or concerns in related to employment contract or severance package or you want to book an appointment for a legal consultation.