As an employer, it is sometimes difficult to determine which awarded damages are taxable after an employee is terminated. In general, damages awarded are taxable as income from such employment or as a “retiring allowance.” Certain damages discussed below, however, are non-taxable.
“Retiring allowance” is broadly defined in the Income Tax Act (“ITA”) to include all amounts received in respect of a loss of an office or employment, whether or not received as damages or pursuant to an order or judgment of a competent tribunal. This definition is much broader than payments received as a result of retirement. Retiring allowances are specifically excluded from the definition of “salary or wages” in the ITA but they still are taxable income to the employee (i.e. they have to be reported by the employee in the year they are received and are subject to deductions at source as discussed below).
The courts have set out a two-part test to determine whether there is a connection between the loss of employment and the receipt of the amount. Such a connection would mean the amount is a retiring allowance and is therefore taxable income to the employee, The two questions that should be asked are:
- Would the amount have been received if there was no loss of employment?
- Was the purpose of the payment to compensate a loss of employment?
If the answer to the first question is negative and the answer to the second question is positive, the amount received will be considered a retiring allowance and thus taxable.
Special as well as general damages related to one’s termination of employment and received for mental anguish, hurt feelings, etc. (types of damages generally awarded in employment termination cases) will be taxed as a retiring allowance and tax should be withheld at source.
However, where damages are received on account of personal injuries including harassment or defamation, such damages may be considered as being unrelated to the loss of employment and therefore non-taxable. This is also the case for damages relating to a violation of human rights. A reasonable allocation will have to be made if such damages are awarded as part of a settlement and not directly by a human rights tribunal.
In order for the retiring allowance paid by the employer to be a deductible expense for the employer, it must be reasonable considering the length of service and remuneration received during employment.
Tax has to be withheld on a retiring allowance, but the employer may not be required to deduct tax at source on the portion of retiring allowance transferred directly to the employee’s RPP or RRSP, if certain conditions are met.
Particular attention should be paid to the wording of settlement agreements concluded upon termination of employment and a clear allocation of the amounts agreed on should be made. If this is not done, the tax authorities or the courts may be called upon to determine the intention of the parties.