• Tony Wong

What’s the Tax Treatment of Severance Pay Settlement or Damages in a Dismissal Case?

Updated: Oct 21

Have you ever wondered what the Tax Treatment of your Severance Pay you received in a settlement or in Court? Continue reading to find out.

Topics Will be Covered in This Post:

  1. How are Severance Pay Taxed?

  2. Employment Income

  3. Retiring Allowances

  4. Non-Taxable Receipts

  5. Determining the Characterization of a Dual Purposes Termination Payment

  6. Transferring Some or All of a Retiring Allowance Directly into an RRSP or RPP

  7. Legal Fees Paid to Obtain a Retiring Allowance or Employment Income

  8. Tax Treatment of Legal expenses in related to Salary and Wages

  9. Tax Treatment of Legal expenses in related to Retiring Allowance

  10. How to Determine What’s The Proper Tax Treatment of Legal Expenses?

  11. Case Analysis: Bonsma v. The Queen, 2010 TCC 342

  12. Conclusion

1. How Are Severance Pay Taxed?

1. How Are Severance Pay Taxed?

First of all, to avoid confusion severance pay in our everyday usage means any and all money we received as a result of a loss of employment. According to the government of Canada, severance pay is defined as "money your employer pays you when you lose your job through no fault of your own." But for income tax purposes, severance pay means something very different. Please read on to find out.

Three types of termination payouts that an employee can receives are:

1. Employment income

2. Retiring Allowance

3. Non-taxable deductible

With respect to income earned by an employee, s. 5(1) of the Income Tax Act (ITA) includes in a taxpayer’s income, income from office or employment which includes salary, wages and other remuneration and s. 6(1)(a) includes in a taxpayer’s income, benefits from employment (such amounts together referred to as “employment income”).

With respect to employee severance pay, s. 56(1)(a)(ii) of ITA identifies a retiring allowance (also referred to as a severance pay) as an income source to be included in calculating taxable income. Accordingly, any amount received by an employee that is either employment income (including employment benefits) or a retiring allowance will be subject to tax.

What is important to note is that where an employee receives an amount for reasons not connected to employment, and therefore, the amount is neither employment income nor a retiring allowance, the amount may not be subject to tax.

With respect to a payment made by an employer to a terminated employee, such an amount will be deductible as a business expense as long as it is made for the purpose of gaining or producing income from the business pursuant to s. 18(1)(a) of the ITA, and the amount of the payment is reasonable within the meaning of s. 67 of the ITA.

2. Employment Income

2. Employment Income

In order for an amount to be employment income, generally it must meet two criteria: 1) the employee must have obtained the benefit in the context of a work relationship and 2) the employee must have personally received the benefit (cannot be a corporation).

Employment income are tax deductible to employer if two criteria are met:

  1. It’s a benefit conferred to employee (must be a person and not a corporation)

  2. It’s a reasonable amount

S. 6(3)(b) of the ITA considers certain amounts received by a taxpayer before, during, or after employment to be remuneration for services rendered unless it can be established otherwise. This section includes amounts received in anticipation of entering into an employment relationship (e.g., a signing bonus) and amounts received on or after the termination of employment.

Pre-judgment interest on awards relating to employment or the loss of employment is taxable as employment income pursuant to s. 12(1)(c) of the ITA.

tax withholding

Employment income is taxable in the year of receipt and is subject to normal source deduction withholdings, including income tax, Canada Pension Plan contributions and employment insurance premiums.

3. Retiring Allowances

3. Retiring Allowances

A retiring allowance is defined in s. 248(1) of the Income Tax Act (ITA). For an amount to be a retiring allowance it must have been received by the employee either:

(a) on or after retirement of the individual from an office or employment in recognition of the individual’s long service, OR

(b) in respect of a loss of an office or employment of the individual, whether or not received as, on account or in lieu of payment of, damages or pursuant to an order or judgment of a competent tribunal.

An important distinction between the first and second alternative requirements for an amount to be considered a retiring allowance is that under the first requirement described in (a) above, the amount must be paid “on or after a retirement” whereas under the second requirement described in (b) above, the amounts may be paid at any time.

Accordingly, a retiring allowance can be paid to an employee prior to the termination of employment and still be considered retirement allowance as long as the terms of the second requirement described in (b) above are met.

As you can see retiring allowance, also referred to as severance pay for income tax purpose, is VERY different than our everyday usage of the term severance pay.

Pursuant to Income Tax Folio S2-F1-C2, Retiring Allowances, published by the government of Canada, at para. 2.23, a payment in lieu of severance resulting from the elimination of the future accrual of severance benefits is employment income if the payment is received while employed. If the payment is received after retirement, however, it will be a retiring allowance.

Overin v. The Queen

In Overin v. The Queen, 1997 CanLII 159 (TCC), the Tax Court of Canada formulated a two-step test to confirm whether the connection between a payment and the loss of employment is sufficient to meet the requirement that an amount be “in respect of” a loss of office or employment:

(a) Bur for the loss of employment, would the employee have received the payment?

(b) Was the goal of the payment to compensate the individual for the loss of employment?

If the answer to the first question is no and the answer to the second question is yes, then the amount will be considered to be a retiring allowance.

Retiring allowance are tax deductible to employer if three criteria are met:

  1. The employee is no longer under employ, and is no longer receiving vacation pay, sick leave or medical benefits;

  2. The employee would not have received the retiring allowance but for the termination; AND

  3. It’s a reasonable amount.

In determining reasonableness for a retiring allowance, consideration will be given to the length of service involved, its relationship to the remuneration received by the employee and the value of any pension or other benefits the employee receives.

CRA published a very detailed ultimate guide on taxation of retiring allowance, and what kind of termination payouts, also called “receipts” by CRA, are regarded as employment income or retiring allowance:

Income Tax Folio S2-F1-C2, Retiring Allowances

tax withholding

Retiring allowances are subject to income tax withholdings, but are not subject to Canada Pension Plan contributions or employment insurance premiums.

Combined federal and provincial withholdings apply at flat rates for retiring allowances, which in most cases, would be less than the tax rate the employee would ordinarily pay on employment income.

For Ontario employers, these rates are currently: 10% on amounts up to and including $5,000; 20% on amounts from $5,000 up to and including $15,000; and 30% on amounts over $15,000.

Click here to learn more about withholding rates for lump-sum payments.

4. Non-Taxable Receipts

4. Non-Taxable Receipts

Non-Taxable Receipts (i.e. not tax deductible) are a result of damages unrelated to loss of employment. Personal injuries damages in related to harassment and emotional distress and damages in related to human rights violations are deemed to be non-taxable.

It has been held that damages or settlements in lieu of expenses sufficiently connected to the loss of an employment or office, including relocation expenses, counselling and job search expenses, are part of a retiring allowance. However, when expenses are unconnected to the loss of employment, but related to discrimination or harassment, the expenses will be tax exempt.

The leading case is Schwartz v. Canada, [1996] 1 SCR 254, wherein the Supreme Court of Canada held that damages received for termination of an employment contract before the individual commenced employment were not taxable. In this case, the court found that the damages were not a retiring allowance because they did not relate to employment of the individual, they related to future employment. The amount couldn’t be an employment income as well, as it’s not a payment for service rendered. For these reasons, the damages were not taxable under the general provisions of s. 3 of ITA as they did not fall into one of the five enumerated sources (office, employment, business, property and capital gain).

As set out above in Schwartz v. Canada, certain damages awards could be considered non-taxable where they represent payments for events or actions separate from the loss of employment. Where it can be clearly demonstrated that an amount was unrelated to the loss of employment, such as certain types of moral damages, the amount would likely be considered damages for personal injury and not taxable.

Although the test as outlined by the Supreme Court of Canada in Schwartz is very straightforward, it is not simple to apply and is dependent on the facts in each situation. The following are examples of situations where the courts have found payments to employees are not taxable receipts:

- damages for a tort action for the wrong done to a taxpayer in stripping the taxpayer of his ability to work as a nuclear researcher; (see e.g. Ahmad v. The Queen, 2002 CanLII 1127 (TCC))

- damages for human rights violations; (see e.g. Fournier v. The Queen, 1999 CanLII 260 (TCC); Mendes-Roux v. The Queen, 1997 CanLII 134 (TCC))

- damages related to potential future employment; (see e.g. Schwartz v. Canada, [1996] 1 SCR 254)

- Moral damages such as aggravating damages and punitive damages are non-taxable receipts. (see e.g. Abenaim v. The Queen, 2017 TCC 223)

Abenaim v. The Queen

In Abenaim v. The Queen, 2017 TCC 223, at para. 101, the Tax Court of Canada, citing to Overin v. The Queen and Schwartz v. Canada, stated that "damages received that can be linked to a contract of employment are … taxable as a retiring allowance. However, an amount received by a taxpayer as moral damages is not taxable since there is no link to a loss of employment. As a result, those damages are not taxable as a retiring allowance”.

For example, the Canada Revenue Agency (CRA) has said that general damages obtained in connection with personal injuries suffered before or after the taxpayer's loss of work may be deemed unconnected to the taxpayer's loss of employment and therefore non-taxable.

However, the CRA may consider payments received from an employer for damages paid outside of an employment contract but in respect of a loss of employment to be taxable retirement allowances.

To effectively assert that damages were obtained for personal injuries unrelated to job loss, taxpayers must show unequivocally that the damages were incurred for events or acts unrelated to job loss.

tax withholding

There is no income tax withholding required for a non-taxable payment to an individual.

5. Determining the Characterization of a Dual Purposes Termination Payment

5. Determining the Characterization of a Dual Purposes Termination Payment

Determining the appropriate characterization of a payment can be difficult in circumstances where the payment may be made for more than one purpose.

If dual purposes of a payment exists, the most appropriate characterization for which the payment is made must be identified to determine the applicable tax treatment for the entire amount.

In other cases, the payment may be made to address two distinct complaints. In such a case, it is the appropriate amounts attributable to each purpose that must be determined to confirm the applicable tax treatment which may be different for the two distinct amounts.

The Canada Revenue Agency (CRA) takes the view that payments in lieu of notice of termination by virtue of the employment terms are considered to be income from employment. However, where a damages payment arising from the loss of employment includes an amount in respect of reasonable notice, this will be considered to be a retiring allowance.

Forest v. Canada

The Supreme Court of Canada laid out the general principle to be followed in Tsiaprailis v. Canada, 2005 SCC 8, in which the Court held that the determination is to be made based on “what the payment was intended to replace”. This is known as the “surrogatum principle”, by which the tax treatment of a payment of damages or a settlement payment is considered to be the same as the tax treatment of whatever the payment is intended to replace.

The determination of what the payment is intended to replace is dependent on the facts and in particular on the documents in any given case. Accordingly, it will be important that all settlement agreements, statements of claim or other complaints or correspondence between the parties and with advisors be consistent with, and as supportive as possible of, the position being taken by the parties on the character of the payment.