Sunday, 19 August 2012

Income Tax and Wrongful Dismissal


Are wrongful dismissal damages taxable? Like the answer to most legal questions, the answer is it depends. Not all wrongful dismissal damages are taxable; those that are taxable do not always have to be. In this post I will be going over some of the basics of the income tax implications of starting a wrongful dismissal case.


Not all Wrongful Dismissal Damages are Taxable


As my tax professor in law school taught me, to understand tax law one has to understand what the law is trying to do. Policy considers run deep in tax law, and typically all one has to remember when it comes to tax law is that at some point in time the government of the day thought that the prevailing idea was a good one. Because governments change, sometimes policies and laws do not align; it’s a reality with which we are forced to live in a democratic nation.

So, returning to the point, not all damages that a plaintiff can be awarded in a wrongful dismissal lawsuit are taxable. For example, damages to compensate for:

  •       violations of the Ontario Human Rights Code;
  •       intentional infliction of mental suffering; or
  •       the egregious manner of the employee’s dismissal

are not generally taxable.

At the same time, subject to the comments below, damages to compensate for lost income are taxable. (For a discussion of how to calculate reasonable notice and severance packages, see my post about What is Wrongful Dismissal?

Not to over simplify things, but a reasonable rule of thumb to employ is that if the damages replace employment income, then they are generally taxable. If the damages are awarded to compensate for something else, then they likely are not taxable.

Damages that are Taxable can be Received Tax Free


Adding more confusion to the matter is the fact that pursuant to the provisions of the Income Tax Act, dismissed employees are entitled to deposit amounts received from a former employer arising out of or in consequence of the cessation of employment into their registered retirement savings plan (RRSP) without any taxes being applied to that amount.

For a complete explanation of this subject matter I would direct you to Canada Revenue Agency Interpretation Bulletin IT-337R4.

The Canada Revenue Agency provides the following summary of the issue:

A "retiring allowance" is an amount received on or after the retirement of an employee in recognition of long service or in respect of a loss of an office or employment. The amount, which may be paid by instalments, may be received by the former employee, or after his or her death, by a dependant or a relation or by the former employee's legal representative. The amount is included in income as it is received. Paragraph 60(j.1) [of the Income Tax Act] permits a taxpayer who has received a retiring allowance to defer payment of some or all of the income tax on the amount received by making a payment to a registered pension plan (RPP) or to a registered retirement savings plan (RRSP) under which the taxpayer is the annuitant. The amount that can be transferred is determined in part by reference to the number of years of employment before 1996 with the employer who made the payment or with a person related to the employer.

The critical words from the above summary are “retiring allowance.” Indeed this post is going to focus on "retiring allowances" and how employees who find themselves suddenly unemployed can use the “retiring allowance” provisions of the Income Tax Act to their advantage.

Tax Implications to Payer


Because the rest of this post will get a little technical and may be beyond what some wish to read, the critical tax away from this discussion is that:

If the retiring allowance or a part thereof is paid directly to an RRSP, there is no requirement for the payer to withhold income tax on the transferred amount if the payer has reasonable grounds to believe the transfer is within the deduction limits under paragraph 60(j.1) or can be deducted pursuant to subsections 146(5) or (5.1).

What is a Retiring Allowance?


The first question that must be answered is whether or not the money that a dismissed employee receives can properly be labelled a “retiring allowance.” (I am going to stop putting the quotation marks on “retiring allowance”, but note that when I use the term, I am using it as it is used in the Income Tax Act.)

The definition of retiring allowance is set out in section 248 of the Income Tax Act, is an amount received:

as a consequence of the death of an employee or a benefit described in subparagraph 6(1)(a)(iv)) received
(a) on or after retirement of a taxpayer from an office or employment in recognition of the taxpayer’s long service, or
(b) in respect of a loss of an office or employment of a taxpayer, 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,
by the taxpayer or, after the taxpayer’s death, by a dependant or a relation of the taxpayer or by the legal representative of the taxpayer;

Thus, in order to qualify as a retiring allowance the money must be received “in respect of a loss of an office or employment.” Generally, payments made to fired workers qualify under this definition. Therefore, items such as accrued vacation time, unpaid commissions, or travel expenses paid at the time of dismissal would not be payments made “in respect of a loss of an office or employment” as they are amounts that accrued during employment.

As IT-337R4 sets out, the two critical questions to be asked are:

1 – But for the loss of employment would the amount have been received? and,
2 – Was the purpose of the payment to compensate a loss of employment?

Only if the answer to the first question is “no” and the answer to the second question is “yes”, will the amount received be considered a retiring allowance.

As IT-337R4 makes clear:

Payments in lieu of earnings for a period of reasonable notice of termination by virtue of the terms of the taxpayer's employment (explicit or implied) are considered income from employment. However, where a payment of damages arising from the loss of office or employment includes an amount in respect of the period of reasonable notice, this amount will be considered a retiring allowance.

Transfers of Retiring Allowances into a RRSP


As noted at the start, the amount of the retiring allowance received by the dismissed employee is captured into the dismissed employee’s income as it is received. However, paragraph 60(j.1) of the Income Tax Act, provides for a deduction for all or part of a retiring allowance included in a taxpayer's income and transferred to an RPP or to an RRSP under which the taxpayer is the annuitant.

As it provided for in IT-337R4:

In general terms, the deduction under paragraph 60(j.1) is limited to the least of:
(a) the amount of retiring allowance included in income for the year;

(b) the eligible portion of the retiring allowance (see “Calculating the Eligible Portion of a Retiring Allowance, below), less all amounts deducted under paragraph 60(j.1) in respect of retiring allowances paid by the employer in a previous year or paid by a person related to the employer in the current or a previous year; and

(c) the total of all amounts paid by the taxpayer in the year or within 60 days after the end of the year,

(i) to an RPP (other than any portion thereof deductible either for current or past service contributions or as a transfer of superannuation benefits); or

(ii) to the taxpayer's own RRSP (other than any portion thereof that has been designated as a transfer of superannuation benefits or as a refund of premiums under an RRSP)
to the extent such amounts were not deducted in computing income for a preceding taxation year.

Calculating the Eligible Portion of a Retiring Allowance


In order to make such a contribution to one’s RRSP, one needs to know the amount that one can eligibility contribute.

IT-337R4 provides as follows:

The eligible portion of a retiring allowance, for the purpose of [paragraph (b) above], is computed as the sum of:
(a) $2,000 times the number of years before 1996 during which the former employee was employed by the employer or a person related to the employer; and
(b) $1,500 times the number of years that is equal to:
(i) the number of years before 1989 during which the former employee was employed by the employer or a person related to the employer
less
(ii) the equivalent number of years before 1989 in respect of which employer contributions to a pension plan or deferred profit sharing plan had vested in the retiree at the time the retiring allowance is paid.

Example


The following example is copied verbatim from IT-337R4:

Mr. A was employed from October 1985 to June 2000 when he retired. In recognition of his long service, Mr. A was entitled to a retiring allowance on his retirement of $30,000 which he chose, in advance, to receive in two annual instalments of $15,000 in each of 2000 and 2001.

His employer made RPP contributions on Mr. A's behalf starting in 1987. Mr. A's RPP contribution and deduction for 2000 was $3,000. In addition, he contributed $12,000 to his RRSP in 2000 and $15,000 in 2001.

The amount deductible by Mr. A under paragraph 60(j.1) in 2000 and 2001 is limited to the lesser of (a), (b) and (c) as follows:



2000
2001
(a) Retiring allowance included in income

$ 15 000
$ 15 000
(b) Eligible portion of retiring allowance



  
(i) $2,000 x 11 years (1985 to 1995 inclusive1)
$ 22,000



(ii) $1,500 x (4 years – 2 years)
$ 3,000
$25,000
$25,000

Less: 60(j.1) deduction in previous years

NIL
12,000


$25,000
$13,000
(c) Total of:



  
(i) RPP contributions

$ 3,000
NIL
  
Less: RPP deduction for current service

(3,000)



NIL

  
(ii) RRSP contributions

$12,000
$15,000


$12,000
$15,000

1 While there are 16 years between 1985 and 2000, it is the number of years before 1996 that are relevant in this calculation.

Accordingly, Mr. A's maximum designated amount under paragraph 60(j.1) is $12,000 for 2000 and $13,000 for 2001.

Commentary:


If you are still reading this post I congratulate you. Tax law is by far one of the driest and most complicated areas of law. It, however, happens to be an area that I personally enjoy.

What the above demonstrates is that by understanding how to use tax law to one’s advantage one can save a significant amount of money. Allocating amounts as “retiring allowances” and depositing them into RRSPs can have a significant tax savings, especially for those who find themselves recipients of large lump-sum severance packages.

Takeaways


If you have recently been dismissed, and have been offered a severance package it is always prudent to seek professional legal advice. First of all, as is contemplated in my post about wrongful dismissal, it is possible that you have been offered less than that to which you’re entitled. Second, by seeking legal and/or accounting advice you may be able to save a significant amount of money by reducing your income tax burdens.

Thus, if you are an employee who has been recently terminated and want advice about either the reasonableness of your offer, or advice on how to structure your offer so as to best address the income tax implications of it, I would also be happy to speak to you. To see a full range of employment law services that I provide to employees please click here.


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As always, everyone’s situation is different.  The above is not intended to be legal advice for any particular situation and it is always prudent to seek professional legal advice before taking any decisions on one’s own case.

Sean Bawden is an Ottawa, Ontario employment lawyer and wrongful dismissal lawyer. He tweets from @SeanBawden.


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