Tax Considerations in Wrongful Dismissal Settlements

April 3rd, 2013 by Meliha Waddell

When employment litigation resolves in a wrongful dismissal settlement, an important issue for the employer and the employee is the tax considerations and how the settlement funds will be allocated. Employees should ensure that the settlement funds are allocated in order to minimize their tax liability. Employers may also be able to settle cases for less if they cooperate with employees in the allocation of the settlement funds.

There are many different ways in which the payments can be allocated, such as wages, retiring allowance, general damages and legal fees.

Any money allocated as wages will be subject to withholdings. The employer is required to withhold Canada Pension Plan (CPP) and Employment Insurance (EI) contributions, as well as income tax from settlement funds allocated as wages.

The Canada Revenue Agency (CRA) defines “retiring allowance” as “an amount paid to officers or employees when or after they retire from an office or employment in recognition of long service or for the loss of office or employment.” Significantly, the employee does not have to be retiring in the colloquial sense in order to be entitled to a retirement allowance. In other words, an employee who is terminated from one job and starts a new one shortly thereafter could still be entitled to a retiring allowance.

The employer is required to withhold money on retiring allowance payments at the following lump sum rates:

  • 10% for amounts up to and including $5,000.00;
  • 20% for amounts between $5,000.00 and $15,000.00; and
  • 30% for amounts of $15,000.00 and over.

No withholdings are required for CPP, EI and income on retiring allowance payments.

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General damages are monies awarded to a litigant as compensation for pain and suffering for bullying/harassment, breaches of human rights legislation and other torts. If settlement funds are allocated as general damages, and the payment relates to the loss of employment, it would be subject to withholdings at the lump sum rates. In other words, if the employee would not have been entitled to the payment but for the loss of employment, the money is subject to withholdings.

On the other hand, if a payment of general damages is made as compensation for events that are unrelated to the loss of employment, the money would be non-taxable.

Settlement funds allocated as legal fees are non-taxable. No withholdings are required and the employee will not pay tax on these amounts. This is dealt with in the Income Tax Act by way of an income inclusion and an offsetting deduction.

Please talk to one of our employment lawyers to review your tax considerations and legal options before accepting a wrongful dismissal settlement.


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