IT Bulletin

CRA has issued an interpretation bulletin in an attempt to define what payments related to employment issues may be taxable or non-taxable. The present bulletin became effective on November 8, 2016 and replaced Interpretation Bulletin IT-337R4 on the same subject. The Bulletin is, of course, not a statement of law, but rather only the views of CRA. It is important, nonetheless. Regrettably, the modern bulletin contains a fundamental misunderstanding of basic employment law concepts. For example, in S. 2.16 it states:

The courts have generally taken the view that a retiring allowance includes any compensation on account of damages for loss of employment. This applies to special damages, as well as general damages 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.

This is not an accurate summary of the law. It is accepted that the usual payment for loss of fair notice or the balance of an employment contract would fit within this definition, but incremental aggravated damages and/or punitive damages for unfair conduct at the time of termination would not.

All this being said, it is better to understand the views of CRA, even when clearly wrong.

The bulletin does continue to create a distinction between "personal injuries" sustained before or after the loss of employment, in S. 2.17. This section looks to a temporal distinction for such damages to have been incurred, either during or after employment has ceased. The door is slightly opened for such damages to have been suffered on termination, however, where such damages are unrelated to the loss of employment and "clearly demonstrated" that such a claim is distinct from the loss of employment. This misses the point that aggravated damages for unfair treatment must be sustained on termination of employment.

The precise wording of this section is as follows:

General damages relating to personal injuries sustained before or after a loss of employment, may be viewed as unrelated to the loss of employment and therefore are non-taxable. This would include, for example, damages for harassment during employment or damages for defamation after dismissal. In order to claim that damages received upon loss of employment are for personal injuries and unrelated to the loss of employment, it must be clearly demonstrated that the damages relate to events or actions separate from the loss of employment. In making such a determination, the amount of severance that the employee would reasonably be entitled to will be taken into consideration.

As noted above, the analysis made by CRA would then take into account the expected normal severance sum, seemingly intended to ensure that the allocation of the non-taxable sum is fair.

The bulletin continues to address the issue of human rights damages, specifically in S. 2.18. It excepts human rights claims from the general proviso above that the non-taxable claim should ideally be unrelated to the termination event.

It concedes that the award made a tribunal for "general damages" would not normally be considered taxable. One might expect that CRA would at least use the correct vocabulary as "general damages" is not a term of art in human rights law. This presumably is intended to refer to a sum awarded for emotional suffering, described in human rights awards as "injury to dignity and self-respect".

The same section then contemplates a situation in which the claim is settled without a hearing. It allows for a "reasonable amount" of such "general damages" to be excluded from taxable income. The assessment of reasonable, as the bulletin continues, will be determined by the maximum sum allowed under the relevant human rights statute and the evidence presented in the case.

This statement is again flawed as only three statutes impose a statutory ceiling and "evidence" is not presented typically at the stage of settlement. ¹

Lawyers negotiating a fair compromise in all jurisdictions will thus look to awards of damages awarded by the Human Rights Tribunal and by trial judges, for a fair background of reasonable expectation. Regard should also be made to the sums paid in comparable civil actions for aggravated and mental distress damages as a barometer of what may be considered a fair and reasonable allocation of the settlement sum to non-taxable consequences, particularly where the claim for past income sums would be taxable.

The Bulletin makes no reference to damages attributed to a future income loss which, as noted below, are non-taxable.

Counsel will be expected to set out clearly in settlement documentation the sum that has been attributed to non-taxable components and be prepared to rationalize the allocation, if called upon to do so. Regard should also be had to the accompanying review of the right of CRA to obtain access to settlement notes and discussions between counsel and/or the mediator. Regard may also be had to issues involving the repayment of E.I. benefits.

Case Law

The onus rests upon the taxpayer to show that the settlement of the non-taxable sum was a “claim as existing apart from the loss of employment” as was the issue in the referenced case. ²

In a further case, the minutes did not allocate a specific sum to the alleged human rights violation, but the Federal Court nonetheless accepted that a bona fide claim was asserted and made an apportionment on its own initiative, splitting the respective positions.³

In yet another case, the appellant taxpayer had failed in his request for all allocation of the settlement funds paid to him were attributable to a claim for harassment made against the employer. The settlement sum did not contain any allocation of the sum paid which was approximately $150,000. The Federal Court of Appeal concluded that the taxpayer had an obligation to produce “some evidence” to identify that the settlement did include non-taxable components. ⁴

On the facts in this case, the Court found such evidence in the form of the severance policy manual of the employer to determine the expected normal entitlement and concluded the balance was to be allocated to the non-taxable harassment damages.

In a similar fact situation, the taxpayer had received a payment of $160,000, again without a specific stated allocation. It was asserted that this payment had included a payment to his tort claim of negligent misrepresentation and other tort claims. The Federal Court examined the facts in detail and concluded, that notwithstanding the fact that there was no specific agreed allocation, the sum of $115,000 should be allocated to the tort claims and hence were non-taxable. ⁵

Not all claims recoverable under human rights legislation will be considered non-taxable. Lost income claims based on pay equity violations have been held to be taxable.⁶ Similarly, it would be expected that claims for lost income and not emotional distress in a human rights claim would be considered taxable. It is to be noted that the IT Bulletin above speaks of an award of “general damages”.

Care should be taken to distinguish a specific lost income award and other damage claims arising from a human rights claim.

Loss of Future Earnings

Awards made for the loss of future earnings are considered as non-taxable earnings. ⁷ This is particularly important where the employee is surrendering the claim for reinstatement and future earnings.

Claim for Lost Income

In human rights cases, where the clock for past income ticks until the date of settlement or hearing, the arrears in income will be taxable where the employee has been reinstated. Further, this context will not qualify for  a retirement allowance, as this requires a complete cessation of the employment relationship. The benefit of the sum being considered a retirement allowance only allows for the RRSP tax deferral. The Bulletin states as follows:

Damages where employment is retained or reinstated 2.15 Special damages, such as those received for lost (unearned) earnings, are considered to be employment income if the individual retains employment or is reinstated. This would be the case regardless of whether they actually return to work.

Legal Costs

Legal costs incurred are agreed by CRA to be eligible deductions from the taxable sum received. ⁸It could be argued that the fees should be prorated where there are several components to the award or settlement. For example, should 50% of the settlement sum be taxable, it could be submitted that the fees should be prorated on a similar basis. There is no caselaw to this effect. The sum to be deducted should be net costs paid, that is, the employer's contribution to legals should reduce the sum to be claimed as the offset. This is clarified in the same IT Bulletin:

An individual may deduct legal expenses paid to collect or establish a right to a retiring allowance, within the limits set out in paragraph 60(o.1). Any amount received by the individual as an award or reimbursement of legal expenses must be included in income under paragraph 56(1)(l.1). For more information see Interpretation Bulletin IT-99R5, Legal and Accounting Fees.

However, where costs are incurred in an unsuccessful claim, no deduction is allowed. ⁹ Legal fees incurred and paid in the year of receipt of a taxable claim will be deductible. ¹⁰

Anticipatory Termination

The IT Bulletin does not deal with this issue but the Supreme Court of Canada did in 2016, ¹¹ holding that a termination in advance of actually commencing the employment relationship will result in the compensation payment being non-taxable.