Halloween frights came early this year for employment lawyers and their clients when a nationally syndicated lawyer claimed new tax rules required them to disclose the contents of settlement agreements. This spurred two (2) months of frenzied debate in the employment law world, and caused confusion and difficulties in negotiating labour and employment settlements. Fortunately, new guidance from the CRA released just yesterday has clarified that those fears are likely unfounded.
In this blog post, we explain what type of settlement agreements these tax rules could have impacted, how we got into two months of uncertainty, and what the new guidance says.
Tax Free Damages, Indemnified – The Agreements Impacted By These Rules
Our firm routinely assists employers in negotiating employment settlements. These settlements frequently involve an agreement to pay an employee some amount of money in exchange for dropping a legal claim (almost always without admission of liability). This makes sense given the high costs of litigation.
Most commonly, money paid out under these agreements is in response to a claim of lost employment income (like wages). That income is typically going to be subject to reporting to the CRA and taxation (and maybe also CPP and EI deductions).
However, the employee may agree to pay out damages for reasons other than claimed loss of employment income. This can happen when an employee claims they’ve suffered a violation of their human rights or a personal injury. These sums (generally referred to as “general damages”) are typically not required to be reported and not subject to taxation (at source or otherwise).
Employers are often willing to agree to pay these sums so long as the amounts agreed on are reasonably justifiable. However, employers almost always insist on the inclusion of an indemnity clause in the settlement when these types of damages are agreed on. Those clauses say that if the CRA decided that the general damages allocation was inappropriate, the employee would cover related costs to the Employer. This is generally accepted by employee and employer lawyers as a fair bargain, particularly as the amounts are routinely justifiable, and the CRA is unlikely to ever even learn of them.
Overall, these types of damages help the parties reach agreements to settle litigation and avoid needless costs of going to court or a hearing.
The New Rules Cause a Fright
The rules required reporting by a client and their lawyer when they made a transaction (or a legal agreement) whose main purpose was to obtain a tax benefit, and one of three other hallmarks was there of an avoidance transaction. The most important of these hallmarks for our purposes was where a taxpayer (or someone who is not at arm’s length with them) protects themselves in the agreement with an indemnity clause. Failure to report could be accompanied by fines and penalties for both the contracting party and their lawyer.
In response, legal opinions in the media and court challenges to the reporting rules sparked great debate in the employment law bar as to the impact of these rules on general damages settlements. Hesitancy in negotiating settlements involving general damages ensued.
The New CRA Rules Return Us to Calm
Fortunately, the CRA has finally stepped in and clarified that, in their view, the rules likely do not apply in the case of tax indemnities in employment severance agreements (e.g. settlements) where the parties act at arm’s length and act prudently, knowledgeably, and willingly in coming to the agreement. That, more or less, removes the concern that these reporting requirements apply to the types of employment settlements we’ve talked about above.
Ultimately, the actual interpretation of these rules may be further elaborated on by the courts, but this should put many employers and their lawyers at ease, and lead to a return of normal settlement negotiations. The full guidance document is linked here:
PooranLaw will continue to monitor developments related to employment tax law that are relevant to the developmental services sector. In the meantime, if you require legal assistance in determining how these rules may impact your organization, we encourage you to reach out to your regular PooranLaw lawyer, or any member of our team.
Note: This article provides general information only and does not constitute, and should not be relied upon as, legal advice or opinion. PooranLaw Professional Corporation holds the copyright to this article and its contents may not be copied or reproduced in any form, in whole or in part, without the express permission of PooranLaw Professional Corporation.