Tax Implications in Employment Law Settlements

As with most areas of law, the vast majority of disputes between employers and employees are often resolved through negotiated settlements, whether via direct negotiations or mediation, without the need for a trial. Unlike settlements with respect to other areas of law, such as personal injury claims, or denied life insurance claims, when an employment law claim is settled there are tax implications that need to be considered by all parties involved.

Tax Treatment of Settlement Payments

When an employee receives a payment as a result of the settlement of an employment law dispute, the tax implications can vary depending on the nature of the settlement. The general rule of thumb is that if a payment is intended to replace income, or if it is contemplated in the employment agreement, then it is likely taxable. The Canada Revenue Agency (CRA) usually treats settlement payments as follows:

  • Termination and Severance Pay: Payments made for termination or severance are usually considered as monies in lieu of employment income and are subject to income tax in the same way as employment income would.
  • Punitive or Aggravated Damages: Punitive or Aggravated damage awards are awards that are made with the intent to punish the employer for malicious misconduct, and are generally not taxable as they are not related to compensation for loss of income.
  • Human Rights Damages: Damages for violations of human rights damages through the British Columbia Human Rights Tribunal, for discriminatory conduct of an employer based on protected ground (i.e.: race, age, gender, disability, etc.). These damages are not taxable as they are not related to compensation for loss of income.

Depending on the specific circumstances the foregoing payments can be subject to certain tax exemptions and deductions.

It is important for both employers and employees to carefully consider the tax implications of each component of a settlement to ensure compliance with tax laws and to accurately report the payments to the CRA.

Tax Considerations for Employers

Employers involved in employment law settlements must deal with the tax implications of any payments made to former or current employees. This includes withholding and remitting applicable income taxes, Canada Pension Plan (CPP) contributions, and Employment Insurance (EI) premiums from any taxable settlement payments made to employees.

Employers must also issue a T4 slip to the employee for any taxable amounts paid, including salary, bonuses, vacation pay, and any other employment income that forms a part of any settlement.

Tax Considerations for Employees

Employees who receive settlement payments should also be aware of their obligation to accurately report all taxable settlement amounts received on their personal income tax returns. If they fail to do so, this could result in penalties and interest payments from the CRA.

If you have questions about employment law settlements and associated tax implications contact the lawyers at Taylor & Blair LLP today.