Keep taxes in mind when structuring your wrongful dismissal claim

Employment/Labour /
Stuart Rudner
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By Tony Poland, LegalMatters Staff • Knowing how to structure a wrongful dismissal claim can help to reduce tax obligations and put more money in your pocket, says Toronto-area employment lawyer and mediator Stuart Rudner.

“Whether I am acting as counsel or mediator, much of the discussion when it comes to termination packages centres not so much on the amount of money to be paid but how it will be paid,” says Rudner, founder and principal at Rudner Law. “Taking the time to seek advice is essential from an employment lawyer is critical; there are ways that you can get more money through a settlement than if you just negotiate on your own, but you have to understand the nuances”

He tells LegalMattersCanada.ca that according to some lawyers who have been practicing since the 1980s, a tax loophole used to allow any settlement of a wrongful dismissal claim to be paid on a tax-free basis, but that loophole has long since been closed. 

Claims can be settled tax-effectively

However, there are ways to settle a wrongful dismissal claim more tax-effectively, Rudner says, 

If you take salary continuance, the money is treated as income and the Canada Revenue Agency (CRA) will expect its share, he says. However, if you take the settlement in a lump sum, there are several ways to minimize the tax hit, Rudner says.

“First, if a portion of the lump sum is for reimbursement of legal fees incurred for the purpose of pursuing your rights relating to a termination, that would not be taxable income,” he says.

For example, if you negotiated a settlement of $100,000 with the help of a lawyer and paid $10,000 in legal fees, you could “allocate” $10,000 to non-taxable reimbursement of legal fees,” Rudner explains

“Of course, there has to be documentation to show the fees were actually paid and you cannot claim more than you actually spent,” he says.

The second way to save tax is through RRSP contributions if you or your spouse have contribution room, Rudner says. If so, funds can be paid into your account without tax withholdings.

He says the third way to save on taxes is “often the most contentious.”

‘You end up with more because you are paying less tax’

“This involves payment of general damages,” Rudner explains. “Any pay in lieu of notice of dismissal is treated as taxable income, whether it is paid as salary continuance or lump sum. But if you are paid money for damages for a breach of human rights, or for bad faith in the course of dismissal, or as punitive damages, that would not be taxable. As a result, the same amount of money would be paid, but you would end up with more because you are paying less tax.

“It is really up to your lawyer to lay the groundwork here,” he adds. “But there is a bit of a caveat. I never encourage people to try to claim a tax-free payment when there is no legitimate basis for it. Allegations of bad faith or breaches of human rights cannot just come out of thin air.”

Rudner says it is important to ensure “there is a plausible basis” for making a claim for general damages, especially if the CRA decides to investigate the settlement. 

“We always have this discussion to ensure the risk of CRA questioning a settlement is minimal. The odds of the CRA looking at these things are minuscule,” he says. “I have been practising law for more than 23 years and I have seen CRA question only one settlement payment, and that was seven figures, a large enough number to draw attention.

Lawyers work to minimize risk to clients

“However, as lawyers, it is our job to minimize risk for our clients. It is up to counsel to ensure the allegations support the payment that we are contemplating,” Rudner adds. “If there is a basis for it, counsel should ensure that demand letters and pleadings include claims that would justify general damages.”

It is also important to note that unlike salary continuance, even a lump sum payment for pay in lieu of notice is treated differently, he says. 

“Consider a ‘Retiring Allowance.’ It is not subject to the usual deductions for Employment Insurance and CPP premiums, and the tax withholding is lower than on regular salary payments, Rudner says. “So even without allocating the funds to another head of damages, a lump sum is often better than salary continuance.”

There is also a benefit to allocating money as non-taxable income for those who collected Employment Insurance (EI) benefits, he notes.

“If the dismissed worker received those payments and later receives additional severance pursuant to a settlement, there may be an obligation to repay some of their EI benefits, which can really complicate the settlement,” Rudner explains. “But if they get money as general damages, that would not trigger a repayment obligation.”

At the end of the day, allocating a portion of a settlement to general damages can help bring about a resolution, he says.

‘Can mean the difference between settling and not settling a case’

“As a mediator, I can tell you it can mean the difference between settling and not settling a case, especially when you get down to the final strokes during prolonged negotiating and you are trying to reach an amount that both parties can live with,” Rudner says. “Often the only way to bridge that final gap is to allocate damages payments.”

He says it is not always an easy task to get an employer to consider paying general damages as part of a termination package.

“It can be a source of frustration,” Rudner says. “There are some employers who, as a matter of course, simply refuse to even consider paying general damages that are not taxable. 

“I fully understand if there is no plausible basis for it. But if there are legitimate allegations, there is no reason not to,” he adds. “That being said, I have noticed recently that companies seem to be more open to the concept where the underlying facts would support it.”

Rudner says it can be a matter of persuading the employer that they are not paying anything extra. When it hits the bottom line, it can be quite convincing, he says.

“Of course, I also make it clear to the employer that just because they paid money on a general-damages claim, it does not mean they are admitting liability,” he says. “Typically, they are agreeing to pay general damages for pragmatic purposes.

“Tax-effective payments are a key benefit of using mediation to settle these claims. You can negotiate these points and agree on a reasonable allocation,” he adds. “If you go to trial, a judge will simply impose their view of what is appropriate in terms of payments and it may not be the most tax-effective way to do it.” Most mediations I run include discussion of how to allocate the payments tax-effectively, and that can be a great tool.”