Since the enactment of Bill C-47 by the federal government to broaden the scope of reportable transactions under the mandatory disclosure rules, concerns have arisen among employment lawyers regarding the reporting of settlement agreements involving general damages to the Canada Revenue Agency (“CRA”). Lawyers must now strategize to prevent unnecessary reporting and mitigate associated risks for their clients. This legal update underscores the importance for employers to engage experienced counsel, as they may confront a more formidable adversary—the CRA—when navigating employment disputes incorrectly.

Bill C-47 is intended to deal with situations of tax avoidance. Typically, in a lawsuit arising from the employer’s termination of an employee, the latter may claim two types of damages with different tax implications. One type compensates for the loss of employment income (e.g., wrongful dismissal damages), taxable as employment income. The other compensates for expenses and non-monetary loss (e.g., general damages for discrimination), which is not taxable. It is common for employees to claim both types in a termination dispute, settling different claims upon reaching an agreement.

To protect against the CRA possibly disagreeing with the characterization as general damages, employers’ counsel often advises including a tax indemnity clause in settlement agreements.  If the CRA disagrees with the characterization of the payment as general damages and believes that the payment should be treated as income, the employee will compensate the employer for the resulting tax liability. However, the expansion of reportable transactions may require reporting this otherwise standard arrangement and tax indemnity clause under specific circumstances.

Failure to report incurs substantial penalties: $500 per week for each failure, up to the greater of $25,000 and 25% of the tax benefit. For corporations with assets exceeding $50 million, the penalty is $2,000 per week, up to the greater of $100,000 and 25% of the tax benefit. This has raised concerns among employment lawyers about the need to clarify if all similar transactions must be reported.

On November 2, 2023, the CRA clarified that “tax indemnities in employment agreements and severance agreements” do not trigger reporting obligations if they occur “in a normal commercial or investment context, where parties deal at arm’s length and act prudently, knowledgeably, and willingly.” However, this clarification does not alter the underlying issue: if general damages are unreasonably high, the CRA may still view it as tax avoidance and impose penalties. Additionally, considering this is still an early stage of implementing new reporting obligations, the CRA’s policies are subject to change.

This legal development underscores the importance of sound legal judgment in employment dispute settlements. A standard tax indemnity clause in a settlement template may prove inadequate. Employers need counsel to navigate settlement agreements cost-effectively while guarding against excessive general damages to prevent substantial tax liabilities. This concept may appear counter-intuitive to many employers who may assume they have unrestricted freedom to agree on any amount of general damages to resolve private disputes with their employees. This is not always the case. They should seek their counsel’s advice to determine the reasonableness of the settlement and ensure it can withstand the scrutiny of the CRA.

 

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