Recent B.C. case highlights issues around taxation of severance
Exclusive to Canadian HR Reporter from Rudner Law.
Employment lawyers like to joke that we chose employment law because we don’t want to do math… otherwise we would have been tax lawyers! However, there are times when tax, employment law, and math collide.
One of these times is when a claim for severance settles. Usually, severance pay is taxable income and the employer paying it must make the applicable deductions and remittances.
Only when there are grounds for general damages can some (or all) of the severance payment be non-taxable.
While the taxation of severance is often an afterthought, its tax treatment is a fundamental term of any settlement agreement. This was the issue in Brink v Xos Services (Canada), Inc.
In Brink, the parties agreed on the number (US$441,667) for the severance payment, but not on its tax treatment. The plaintiff brought a motion for summary judgment to attempt to enforce the settlement and seeking the full sum without deductions, while the employer offered the sum less applicable deductions. The motion failed because the court found that there was no “meeting of the minds,” since the parties did not agree on tax treatment, and therefore no agreement to be enforced.
Devil in the details
The court analyzed the settlement discussions to determine whether there was an agreement. There was no dispute that the employer’s offer was as follows: “$441,667.00 USD less applicable deductions”; other terms included an additional sum in lieu of benefit continuation and the requirement for the plaintiff to execute a release in favour of the employer containing confidentiality and non-disparagement provisions.
The plaintiff responded prior to the expiry of the employer’s offer, stating that she accepted the offer on the condition that the form of the release is acceptable, and that the payments be made as a “1099” (a US tax form), or without source withholdings, similar to general damages under Canadian law. The employer’s counsel responded that it would provide a draft release and seek instructions regarding the payment’s tax treatment.
The employer declined to provide the payment as a 1099, citing risks of penalties for missclassifying the nature of the severance payment and failing to make the required source deductions.
Case law and binding settlements
The plaintiff then brought the motion to enforce the agreement, arguing that all essential terms of the settlement were agreed upon. She relied on case law which stated that parties can enter into binding settlements even where the form of the release is not concluded. According to the plaintiff, there was a binding settlement and the form of the release, as well as the issue of deductions, were matters of performance rather than essential terms. Therefore, there was a binding agreement that could be enforced.
The employer argued that the issue of deductions was an essential term and that a conditional acceptance is a counter offer, so there was no binding settlement. The court agreed, finding that the tax treatment of the payment was a term of fundamental importance to both parties and that the plaintiff’s proposed tax treatment marked a significant departure from the employer’s offer.
The court concluded that this substantial gap - the difference between paying no tax and paying 32% of the severance funds in tax - was not an issue of contractual performance, and it could not be bridged by resorting to common sense or practice. It dismissed the motion.
Pith and substance
Brink reminds us of the importance of the tax treatment in employment settlements, as well as the need for clear agreement on all key points of a settlement. The reality is that, when there is a basis for general damages that has been alleged, the ability to make some or all of a payment tax free can help employers bridge gaps in negotiations.
There is no reason to shy away from offering general damages when it is defensible.
As Brink shows, the real issue is ensuring that the parties are on the same page with respect to the tax treatment of the settlement payments. When negotiating a settlement, working with HR counsel ensures that employers get strategic advice as to the right offer to make, its tax treatment, and the way to document it properly.
David Gelles is an associate lawyer at Rudner Law in Toronto. He can be reached at (416) 864-8500 or [email protected].
