On wrongful termination of employment, employees are often in a position to receive payments from their employers. How these amounts are to be taxed is, however, not always clear.
Subparagraph 56(1)(a)(ii) of the Income Tax Act (the “Act”) requires that employees include retiring allowances (other than amounts received under an employee benefit plan, retirement compensation arrangement or salary deferral arrangement) in their incomes. A “retiring allowance”, in the context of a wrongful dismissal, is defined as an amount in respect of the employment loss, whether or not received as, on account or in lieu of payment of, damages or pursuant to an order or judgement of a competent tribunal.
The definition of “retiring allowance” is quite broad. However, it is of note that, even where an amount does not constitute a “retiring allowance”, it still may be taxed under other provisions of the Act, including subsection 5(1) (which relates to salary, wages and other remuneration received by a taxpayer) and subsection 6(3) (which relates to amounts received in respect of agreements made by the employer with the employee during or immediately after the employee’s employment.)
What is to be made of settlements that relate to human rights violations? The courts have held that general damages relating to human rights violations are considered to be unrelated to the loss of employment, even where the employee’s employment is lost as a result of the making of the human rights complaint. That said, where it is clear that but for the loss of employment, the amount would not have been received, the amount may be taxable as a retiring allowance. For example, where a taxpayer uses the threat of a human rights claim to exact a higher severance package from the employer, the entire amount may constitute a retiring allowance. (See Fawkes and Dunphy).
Awards made by a human rights tribunal are generally not required to be included in income. (See Dunphy). Similarly, settlement amounts that relate to human rights violations may not be taxable. Matters are, however, often complicated by the fact that payments may be made as a lump sum consisting of both a “retiring allowance” (made on account of the loss of employment) and an award made in respect of a human rights violation.
How is a lump-sum of this nature to be apportioned for tax purposes? The Federal Court of Appeal noted in Forest that, once it has been determined that a settlement amount has a dual purpose (that is, once it has been determined that the settlement amount comprises an amount relating to the loss of employment as well as an amount relating to a human rights complaint), it is not necessary for the party that has the burden of proof (which, in many cases, will be the employee) to present specific evidence of what portion of the payment was made in respect of the human rights complaint. Some evidence is, however, necessary so that the trial judge may determine the intended allocation. (See Schwartz). It is of note that the courts have held that the portion to be allocated to the human rights complaint is not what the employee might have been awarded if the claim had been prosecuted and not settled; rather, the question is what value the employer placed on having the human rights complaint withdrawn. (See Dunphy).
In recently released CRA Document 2011-0421931E5, Taxability of Settlement Amount, the CRA indicated that, “in order to properly determine the portion of the settlement payment that might reasonably be considered as a damage award for human rights violations, Human Rights Tribunal decisions would need to be reviewed to find the most comparable situations to the Taxpayer’s situation.” This is not consistent with Dunphy where, as noted above, the Court took the position that the “the question is not what the Appellant might ultimately have been awarded had he prosecuted his claim but rather, what value the [employer] put on laying it to rest.” This is an interesting disparity and should be noted by those dealing with disputes relating to the allocation of a settlement amount.