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“Can we allocate a portion of the settlement to general damages to reduce the tax hit?”
That is a question that you, as HR professionals, may be asked in the course of settlement discussions, or mediation, of a wrongful dismissal claim. So, what should you do?
I will begin with a caveat: I am not a tax lawyer, nor do I play one on TV. However, I have negotiated the resolution of countless wrongful dismissal claims, both as counsel and as a mediator.
Some companies and some defence counsel simply refuse to discuss allocation to non-taxable damages without any consideration or thought; that is short-sighted. Where there is a legitimate basis to do so, you should not be scared to allocate a reasonable portion of the settlement funds to a non-taxable head of damages.
Have CRA reporting obligations changed?
In early September, a member of the Employment Law Bar published a column in which he suggested that our Bar routinely settles wrongful dismissal cases with an allocation to general damages and that this is “pretty close to a tax fraud, albeit practiced with abandon in the employment bar”.
The column went on to state that CRA has gotten wise to this “dirty little secret” and that as of June 2023, the reporting obligations had changed and that companies will have to report many of these settlements.
After this article was published, many of us who do not have tax expertise were uncertain of how to advise our clients, and this led many lawyers who would previously have recommended reasonable allocations were justified to refuse to consider them. All of a sudden, cases became harder to settle, as the article predicted.
Many of us consulted with our friends in the Tax Law Bar in order to understand the implications of the changes to the Income Tax Act, and we have learned that they have little, if any, impact on the settlement of wrongful dismissal claims.
Implications of CRA changes
In order to help our Bar understand the true implications of the changes, I worked with the Ontario Bar Association’s Labour and Employment Section to plan an urgent program, which I moderated last week. However, before that session even took place, a post co-authored by two members of our Bar appeared on LinkedIn. The post, endorsed by dozens more, refuted the assertions in the original article.
Among other key points, the post confirms that:
- the only thing that has recently changed is the CRA’s rules about when certain types of agreements must be proactively reported to CRA (a “reportable transaction”)
- [the change] doesn’t mean every settlement with amounts paid as general damages, with or without an indemnity provision, must be reported to CRA
- it certainly doesn’t mean, as the columnist suggests, that when parties to employment litigation enter into settlements which include payment of general damages, they are ‘pretty close to committing tax fraud’
Subsequently, at the session I moderated, Bhuvana Rai of Mors & Tribute and Sean Bawden of Kelly Santini offered their comments on the issue. Bhuvana, who has extensive expertise in Tax Law, was blunt in stating that the changes to the Income Tax Act was not motivated by employment law considerations, and that a straightforward settlement of a wrongful dismissal action with appropriate and justifiable allocations to damages/taxable income would be unlikely to create a reporting obligation even where there is an allocation to general damages and an indemnity.
Bhuvana also posted her comments on LinkedIn in a very helpful article titled “Tax Reporting Requirements for Employment Lawyers”. As she writes:
“To be a reportable transaction, one of the main purposes of the transaction must be to obtain a tax benefit. Provided that the amounts are correctly characterized, there should be no issue with reportable transaction legislation in any event - well before the examination of indemnities.
Does an indemnity mean you have to report? No
Some were of the view that the inclusion of an indemnity in settlement documents can turn a non-reportable transaction into a reportable one. That caused many lawyers to reverse the position they had taken for years: that if there was an allocation, the recipient employee would have to indemnify the payor employer.
However, Bhuvana wrote that:
“It seems unlikely that the indemnity would turn the settlement into a reportable transaction, because the person indemnified is not obtaining any purported tax benefit, let alone the one at the heart of the transaction.”
The bottom line: Don’t let fear prevent a reasonable resolution
For years, I have encouraged clients, counsel, and parties to mediation not to reject the idea of allocating damages out of hand. Of course, non-taxable amounts should not be included or inflated simply to avoid tax obligations; that is where the risk of liability arises.
Any amount characterized as general damages in the context of the settlement of a wrongful dismissal claim must be reasonable and commensurate to the claim. If that is true, there should not be any concern about CRA involvement.
And as the recent changes to the Income Tax Act have been explained, nothing has changed and there is no “new reporting requirement”. So I will continue to encourage a reasonable approach to settlement which includes a justifiable allocation of damages, as appropriate.
Stuart Rudner is managing partner at Rudner Law in Toronto. He can be reached at (416) 864-8500 or [email protected].