Allocation of settlement funds in wrongful dismissal – between taxable and tax exempt

October 23, 2012 Earl Altman Employment/Labour Standards, Human Resources, Payroll, Pensions and Benefits, Source Deductions and Reporting, Wages and Compensation

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Damages for wrongful dismissal are intended primarily to compensate the dismissed employee for income lost due to the dismissal. As such, the amount of such compensation, whether as a result of a settlement or a judgment by the court is, prima facie, taxable.

When wrongful dismissal claims are settled, the question arises as to how the plaintiff (person who filed the claim) would like the settlement funds allocated. Most plaintiffs are puzzled by this question as they naturally assumed they would simply receive a cheque for the amount agreed upon and that would be the end of the claim. However, there are a number of deductions which must be taken off the amount payable. If the settlement is paid in full to the plaintiff, the plaintiff will end up paying tax at his/her marginal rate on the full amount of the settlement. This amount will be deducted by the employer and remitted to Canada Revenue Agency.

In addition, if the plaintiff has been off work for more than a month or so, he/she will have presumably filed a claim for Employment Insurance benefits. The provisions of the Employment Insurance Act require an employee who has collected EI benefits for a period for which he/she is then compensated by his/her employer, to repay those benefits to the Crown. Service Canada will provide, on request, an exact figure of the amount to be repaid. This amount is generally repaid out of the proceeds received from the employer.

As a result of these repayment obligations, plaintiffs and their lawyers will seek to have the former employer allocate the settlement proceeds in a way that will reduce the employee’s obligation to pay. Employees’ counsel will often seek to have the amounts classified as “general damages”, repayment of expenses, or legal fees. However, as is to be expected the Canada Revenue Agency (CRA) will have something to say about such allocation. CRA has the power to review the allocation agreed upon by the parties and reject it. They will often review the pleadings and assess whether or not an allocation to general or punitive damages is reasonable based on the allegations in the Statement of Claim. Similarly, CRA can seek proof that the amount paid for legal fees was, in fact, paid. It will normally require copies of legal accounts with proof of payment. If CRA concludes that the amount paid for legal fees is unreasonable given the amount of the settlement, that amount can be rejected and included in taxable income.

Where the plaintiff employee has unused RRSP contribution room, an amount up to the maximum of such contribution room can be paid directly to the plaintiff’s RRSP tax free. Of course, if the plaintiff requires some or all of that money to either pay his/her living expenses, or repay debt accumulated during the period of unemployment, any amounts withdrawn from the plan will be included in income for the year of the withdrawal. Employer’s counsel will usually require proof of such contribution room, normally by way of a copy of the plaintiff’s most recent Notice of Assessment from the CRA.

For those amounts that cannot be sheltered in one of the ways described herein, the Income Tax Act does provide for a reduced taxation for retirement allowances. Normally, such allowances will be taxed at the rate of 25 percent.

Finally, where the plaintiff was employed by the defendant for a period prior to 1996, he/she is entitled to contribute an additional $2,000 per year to his/her RRSP regardless of contribution room. He/she can similarly contribute up to $1,500 a year for years worked between 1989 and 1996.

As mentioned, CRA is entitled to challenge the reasonableness of any such allocations. If the allocation is rejected, it may result in added tax liability to the employee. This, in turn, could expose the employer to liability for failing to remit should the employee fail to pay his/her tax liability. An employer’s counsel will therefore usually insist on an indemnity from the plaintiff for any amount assessed on that basis. From the employee’s perspective, this indemnity should be as limited as possible, and should not include penalties assessed for insufficient remitting for amounts not related to the allocation of the settlement funds.

Co-operation among the parties in the allocation of settlement funds can often bridge the gap in order to reach a settlement of the wrongful dismissal claim, as it can increase the amount received by the plaintiff without additional cost to the defendant. The individual plaintiff’s tax position, and the potential for reducing taxation of any settlement, will normally be something discussed by plaintiff’s counsel with their client at the outset of the file, and as matters progress.

Earl Altman
Garfinkle, Biderman LLP

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Earl Altman

Legal consultant at EA Consulting

Earl Altman was a partner at Garfinkle, Biderman and now heads his own consulting firm. Earl has practiced commercial and employment litigation. Earl’s practice focuses on employment disputes, including acting for employees and employers in wrongful dismissal claims, and in breach of contract and breach of fiduciary duty claims. Read more