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Tax and employment insurance issues when settling dismissal claims

Employment lawyers are generally quite adept at negotiating and resolving disputes arising out of the termination of an individual’s employment. We have all seen the statistics that only a miniscule number of dismissals result in a full trial and we know that in almost every case, it is better for the parties to reach a resolution than to proceed with litigation. That said, many traps exist in the settlement of a wrongful dismissal claim.

The parties can negotiate a settlement that is based upon some form of salary and benefit continuance or a lump sum payment. In the event of salary continuance, tax withholdings will apply as they would in the normal course when the individual was actively working. However, if a settlement is paid as a lump sum (and this can be divided into several payments), then it can be treated as a retiring allowance under the Income Tax Act, which provides for different tax treatment. Despite the name, a retiring allowance does not only arise in relation to an individual’s retirement; rather, it relates to an amount received by a taxpayer:

(a)  On or after retirement from an office or employment in recognition of long service; or

(b)  In respect of a loss of office or employment (including damages).

The Canada Revenue Agency has clarified that, “where a payment of damages arising from loss of employment includes an amount in respect of the period of reasonable notice, this amount will be considered a retiring allowance.” The withholdings to be applied are as follows:

  • For amounts up to $5,000: 10 percent
  • For amounts between $5,000 and $15,000: 20 percent
  • For amounts over $15,000: 30 percent

(The amounts are different in Quebec.)

It is also important to note that retiring allowances are not subject to withholdings for CPP or EI.

Dismissed employees can avoid tax withholdings altogether if they have retiring allowance amounts paid directly into an RRSP or RPP. For pre-1996 employment, there is an automatic eligibility of $2,000 per year. For pre-1989 employment, there is a further $1,500 per year. In addition, if individuals have room currently available in their RRSPs, they can contribute up to that amount. Employers that are asked to transfer amounts into an individual’s RRSP are required to make reasonable inquiries to confirm that there is sufficient room available.

While it is possible to pay a retiring allowance in several instalments, it is important to distinguish such payments from regular salary continuance. The payments should not be made on the usual payroll schedule, or in similar amounts. Finally, a recent change in procedure provides that retiring allowances are to be reported on T4 slips, rather than T4A slips.

It is often possible to make some payments more tax-effective in other ways. First, any money that is paid to reimburse the dismissed employee for legal fees incurred is not counted as income. It is advisable for an employer’s counsel to receive written confirmation that any amounts allocated to this heading do not exceed the actual amount of legal costs incurred by the individual.

Furthermore, where there is a legitimate basis, a portion of the settlement can be allocated toward payment of general damages, which are also not treated as income. Such damages can be based upon, for example, allegations of breaches of the applicable human rights legislation. There must be a legitimate basis for such a claim, and the amounts allocated must be reasonable. It is always open to the CRA to investigate such payments and make its own determination regarding the appropriateness of the allocation.

The other issue that often arises in the settlement of a wrongful dismissal claim is the repayment of employment insurance payment benefits. Section 45 of the Employment Insurance Act requires that a claimant repay employment insurance benefits received when a former employer pays a judgment or settlement in respect of the subject employment. Moreover, section 46 of the Act provides that it is the obligation of the employer to withhold an amount equal to the employment insurance benefits received by the claimant from any judgment toward settlement. Therefore, the employer or payor will have an obligation to make appropriate inquiries in order to determine whether any employment insurance benefits were received, and if so, the amount to be held back for repayment. This often surprises counsel that do not practice regularly in the area of employment law. As a matter of practice, counsel should be clear during the negotiations that any payments discussed will be subject to withholding for repayment of EI benefits.

As we know, the vast majority of disputes arising out of dismissals are resolved. It is important for counsel to understand some of the legal issues that can arise, and ensure that they do not expose their clients to any unnecessary liability.

Stuart Rudner
Miller Thomson LLP

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Rudner Law, Employment / HR Law & Mediation

Employment Lawyers and Mediators at Rudner Law
Rudner Law is a firm specializing in Canadian Employment Law. They provide clients with strategic advice regarding all aspects of the employment relationship, negotiate and advocate on their behalf and represent them before courts, mediators and tribunals. Blog posts are written by Stuart Rudner, the principal and founder of Rudner Law, Brittany Taylor, a Senior Associate at Rudner Law, Nadia Zaman, an Associate at Rudner Law and Anique Dublin, a Law Clerk at Rudner Law. Read more
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