Written by Erin Kuzz (Sherrard Kuzz) and Jennifer Mathers McHenry
A recent article by a high-profile Toronto employment lawyer has caused quite a stir in the legal community, suggesting that a common practice among members of the employment bar is ‘a dirty little secret’ that is ‘pretty close to tax fraud.’ That’s simply not the case.
As a result of recent changes to Canada Revenue Agency requirements, in certain circumstances the settlement of employment claims may now need to be proactively reported to CRA. However, this doesn’t fundamentally change the principles guiding lawyers in advising their clients in the context of settling employment-related claims.
Civil claims in court, human rights applications and grievances pursuant to collective agreements sometimes contain claims of discrimination or harassment in relation to the employer’s treatment of the employee, often in the context of the termination of employment. For instance, these can include claims an employer’s decision to terminate was related to the employee having taken sick leave or having advised they are expecting a child. Such claims can also include an allegation the employer breached its obligation to provide a safe workplace, or engaged in some other conduct that entitles the employee to damages. It is also possible for an employee to accuse an employer of bad behaviour not falling within the bounds of applicable human rights legislation, but which could give rise to punitive damages if substantiated and determined to be especially egregious or high-handed.
If these allegations are litigated and a court, a human rights adjudicator, or a labour arbitrator finds the employer has breached certain legal obligations, ‘general damages’ will be awarded. Both damages relating to human rights breaches and punitive damages fall into this category. These types of damages are not treated as wages and taxes are not deducted.
When the parties to litigation (or potential litigation) are considering settlement, one of the things they consider, of course, is their potential liability if they are not successful in their position. This includes considering the risk general damages could be awarded against them.
There is no magic, and certainly nothing nefarious, in any of this; it has, for a long time, been permissible to pay a portion of any settlement as ‘general damages’ in such situations because there is a relationship between the claim and the types of damages an adjudicator may, in fact, award. However, the amount of the settlement characterized as general damages must be reasonable, proportionate to the claim, and can’t be inflated simply to avoid the payment of income tax.
Settlements in these circumstances have been, appropriately and lawfully, used for many years as a way to bring closure to disputes and avoid costly litigation.
A party that structures a settlement in such a way that the amount paid as general damages is excessive in the circumstances (that is not proportionate to what an adjudicator may potentially award in the circumstances) is, and was always, at risk CRA might take issue with the settlement and order the remittance of additional taxes (and any other remedy available to CRA). Employment lawyers providing good advice have always advised against an unsupported allocation of payments as general damages.
Nothing here has changed.
While I’m not a tax lawyer and don’t purport to provide tax advice, there have been ongoing discussions among many members of the employment law and tax law communities, and it appears the only thing that has recently changed is the CRA’s rules about when certain types of agreements must be proactively reported to CRA (a “reportable transaction”).
If the amount of a settlement paid as general damages is greater than what CRA ultimately considers reasonable and the settlement includes an indemnity provision (i.e.,a provision that specifies that if the employer is required to remit additional taxes to the CRA on the employee’s behalf, it is entitled to seek repayment from the employee) then the new rules create some risk that the combination of those two things could lead the CRA to consider the settlement a reportable transaction.
It doesn’t mean every settlement with amounts paid as general damages, with or without an indemnity provision, must be reported to CRA and it certainly doesn’t mean that when parties to employment litigation enter into settlements which include payment of general damages they are ‘pretty close to committing tax fraud.’
The new CRA rules are far from clear. Indeed, on their face they suggest that the lawyers involved in advising clients in relation to reportable transactions have their own obligation to report to CRA (which, of course, engages issues of solicitor client privilege). It’s possible an injunction recently granted to the Federation of Law Societies of Canada (temporarily suspending the requirement that a lawyer notify CRA of a ‘reportable transaction’ entered into by their client) may prompt CRA to provide more clarity.
In the meantime, as legal professionals it is our responsibility to conduct ourselves in a manner that encourages the public trust and confidence in our profession. This objective is not served when a lawyer makes disparaging and sensational statements, rather than providing thoughtful, accurate information.