CRA Clarifies Reporting for Employment Settlements
Recent developments have emerged regarding the impact of Bill C-47 amendments on employment dispute settlement agreements and their tax implications.
Last year, the federal government broadened the scope of reportable transactions under mandatory disclosure rules, sparking considerable concern among employment lawyers about how these changes might affect settlement agreements involving general damages and the associated reporting requirements to the Canada Revenue Agency (CRA).
This article provides an update on these concerns in light of the federal government's recent clarifications.
Background on Bill C-47
Enacted in June 2023, Bill C-47 saw the federal government introduce amendments to the Income Tax Act, with the intention of addressing situations of tax avoidance. The new legislation expanded the scope of reportable transactions subject to mandatory disclosure rules, raising questions as to whether employment dispute settlement agreements involving general damages could now be considered "avoidance transactions" under the updated definition, and thus reportable.
Under Bill C-47, an "avoidance transaction" is defined as a transaction where one of the main purposes is to obtain a tax benefit. The 3 key features in determining whether a transaction meets the new definition of an avoidance transaction are:
Contingency fees
Confidential protection
Contractual protection
Under these new amendments, any transaction meeting the updated definition of an avoidance transaction must be reported and filed with the CRA. Failure to report incurs substantial penalties: $500.00 per week for each failure, up to the greater of $25,000.00 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 $100,000.00 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.
Impact on Employment Settlements
Employment disputes often involve two types of damages: (1) income loss compensation (e.g., wrongful dismissal damages), which is taxable as employment income; and (2) compensation for expenses and non-monetary loss (e.g., general damages for discrimination), which is generally not taxable. It is common for employees to claim both types in a termination dispute, settling different claims upon reaching an agreement.
Employers have typically included tax indemnity clauses in these agreements to safeguard against potential disputes with the CRA regarding the characterization of payments as general damages rather than taxable income. Such indemnity clauses state that if the CRA disputes the characterization of general damages, and seeks to reclassify the payment as taxable income, the employee will be responsible for compensating the employer for the resulting tax liability.
The expanded mandatory disclosure requirements under Bill C-47 raised concerns that such otherwise standard arrangements and tax indemnity clauses might now trigger reporting obligations. Non-compliance with reporting requirements can result in substantial penalties—$500.00 per week for each failure, up to the greater of $25,000.00 or 25% of the tax benefit, and for corporations with assets exceeding $50 million, penalties of $2,000.00 per week, up to the greater of $100,000.00 or 25% of the tax benefit.
Clarifications
On November 2, 2023, the CRA initially clarified that tax indemnities in employment and severance agreements do not typically trigger reporting obligations, provided that the transactions occur in a normal commercial or investment context and parties deal at arm's length.
Further clarification on August 15, 2024, has offered more definitive guidance. The CRA has confirmed that the "contractual protection" feature does not apply in standard commercial or investment contexts, such as typical employment and severance agreements. Specifically:
Tax indemnities in employment and severance agreements are not considered "contractual protection" under the new definition of an avoidance transaction.
The typical indemnity clause, which protects the employer, does not grant a tax benefit to the employer, thereby not triggering reporting obligations.
Similarly, the indemnity clause does not provide protection to the employee in terms of tax treatment but requires the employee to compensate the employer if the CRA disputes the tax characterization.
Ongoing Considerations
While these clarifications should alleviate most concerns, it is important to note that the CRA's position could still evolve. The remaining point of concern is whether exceptionally high general damages might still prompt the CRA to view the settlement as a tax avoidance transaction and impose penalties.
Overall, the federal government's clarification aligns with pre-Bill C-47 practices, where the risk of CRA challenges to the characterization of general damages was mitigated by the inclusion of tax indemnity clauses. Employers can thus continue to use these clauses with a reduced risk of reporting obligations, provided they adhere to standard practices and avoid excessively high general damages that could raise red flags.
For employment lawyers and employers, staying informed about these developments and ensuring compliance with the latest guidelines is crucial to managing tax risks effectively in settlement agreements.