In order for an amount to be taxable, a clear and applicable provision in the Income Tax Act (the Act) must be identified. Section 3 of the Act sets out inclusions in a taxpayer’s income for a taxation year. In particular, included in income is the aggregate of any income earned by the taxpayer from each office, employment, business, property and capital gains. In addition to these five enumerated sources of income, the Act includes in income other sources as identified in subdivision (d) of Division B of Part I.

With respect to income earned by an employee, subsection 5(1) of the Act includes in a taxpayer’s income, income from office or employment which includes salary, wages and other remuneration and paragraph 6(1)(a) includes in a taxpayer’s income, benefits from employment (such amounts together referred to as “employment income”). In addition, subparagraph 56(1)(a)(ii) includes in other sources of income found in subdivision d of the Act, a retiring allowance. Accordingly, any amount received by an employee that is either employment income or a retiring allowance will be subject to tax.

However, 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. A non-taxable termination payment is advantageous to an employer and an employee provided the related payment is deductible.


The courts have had the opportunity to consider the taxation of amounts related to employee termination that are neither employment income nor a retiring allowance. The leading case is Schwartz v R.,1 wherein the Supreme Court of Canada held that damages received for termination of an employment contract before the individual commenced employment were not taxable. This conclusion was based on the findings of the court that the damages were not taxable under the general provisions of section 3 as they did not fall into one of the five enumerated sources and they could therefore only be taxable if they qualified as a retiring allowance. 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 position taken by the Canada Revenue Agency towards such payments is consistent with the courts. In Interpretation Bulletin IT-365R2, dated May 8, 1987, and entitled “Damages, Settlements, and Similar Receipts”, the CRA states at paragraph 2:

“All amounts received by a taxpayer or the taxpayer’s dependant, as the case may be, that qualify as special or general damages for personal injury or death will be excluded from income regardless of the fact that the amount of such damages may have been determined with reference to the loss of earnings of the taxpayer in respect of whom the damages were awarded. However, an amount which can reasonably be considered to be income from employment rather than an award of damages will not be excluded from income.”

Similarly, the CRA stated in Interpretation – internal 2006- 0204971I7 – Retiring allowance versus non-taxable damages, dated November 2, 2006:

“only where general damages are received in respect of personal injuries sustained before or after the loss of employment (for example, in situations of harassment during employment or defamation after dismissal), or where a loss of employment involves a human rights violation and is settled out of court, will general damages be viewed as unrelated to the loss of employment and therefore non-taxable….”


  • Personal injury damages must “relate to events or actions separate from the loss of employment”; and 
  • Human rights damages must be a reasonable amount up to the maximum amount awarded under any human rights legislation.  

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 of each situation. The following are examples of cases where the courts have found payments to employees are not taxable:  

  • 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;2  
  • compensation to retirees for cancellation of private health coverage;3  
  • damages for not renewing a fixed term contract;4  
  • damages for human rights violations;5 and  
  • damages related to potential future employment.6  

There will be no withholding required for a non-taxable payment to an individual. However, care must be taken to avoid characterizing a payment as non-taxable, when the facts surrounding the termination of employment do not support such a payment.