Taxes change how much money ends up in our pockets and this truism also applies to wrongful dismissal awards. The way settlement money is lawfully characterized can have a big impact on how much goes to taxes and how much an individual gets to keep. In this post we will summarize the basic tax treatment of certain types of awards an individual might receive in a wrongful dismissal action.
We are lawyers, not financial advisors, so we provide this summary for what we hope is useful information, and encourage readers to seek advice from a financial professional when looking to determine the tax treatment of their severance package.
Notice damages are considered employment income and are thus taxed like a regular pay cheque. Deductions are taken for income tax, CPP and IE. This is generally the least tax favourable way to characterize damages but allocating some money to notice damages is generally unavoidable. For example, amounts paid that are the minimum notice under the Ontario Employment Standards Act must typically be subject to regular income tax.
Employees may be able to transfer a payment from their former employer directly into their RRSP. In this instance the amount will be subject to a tax deferral, as RRSP money is taxed when it is withdrawn from the RRSP, presumably in the distant future when you are no longer earning an annual income.
If an employee does not have sufficient room in an RRSP, or needs the money right away, they may be able to characterize an amount as a retiring allowance. A retiring allowance will be subject to a tax withholding rate of 10%, 20% or 30%, depending on the amount.
When the individual files their taxes they will have to pay normal income tax on the amount of the retiring allowance. The preferred tax treatment is therefore temporary.
According to Revenue Canada, a retiring allowance is an amount intended to compensate an employee for their long service or the loss of their employment. A retiring allowance is distinct from notice damages, which are employment income. However, the Ontario Employment Standards Act category of “severance pay” (as opposed to ESA “termination pay”) can usually be characterized as a retiring allowance.
General damages are non-taxable. To characterize an amount as general damages, there must be an element of the damages suffered by the individual that is separate from the damages suffered as a result of the loss of their employment. General damages are intended to compensate for personal injury, such as pain and suffering, mental distress or human rights violations.
In considering what portion of a total award can be characterized as general damages consideration should be given to what a reasonable amount of notice would be, as well as what a reasonable general damages award would be, in light of the case law.
Wrongful dismissal claims often include an amount for legal fees. Legal fees are usually tax-deductible for the employee. As long as the fees were incurred in order “to collect or establish a right to a retiring allowance or pension benefits” (Income Tax Act section 60(0.I)).
Amounts paid to an employee for the purposes of re-employment counselling are not considered a taxable benefits and are therefore not taxable.
Considering how money paid at the end of the employment relationship can be characterized is a worthwhile exercise for employers and employees. In addition to legal advice, we strongly recommend that employees always consult with their financial advisors when sorting through the details of their severance package.
At SpringLaw we regularly review and negotiate termination packages for employers and departing executives. Contact us for advice about your specific situation.