by Michael V. Coyle, JD*
Both employers and employees often have questions for me about income taxes when there is a lump sum payment made to employee for ‘pay in lieu of notice’ and about when legal fees can be deducted from their taxable income.
This article briefly covers the general situations and rules. For more complete, accurate and up to date information please consult the relevant current tax circulars and CRA bulletins or consult a tax professional.
Pay in lieu of notice of termination
An employer may voluntarily decide to pay an employee an amount of money as ‘pay in lieu of notice of termination’ to avoid a dispute. Or the employee may advance a claim for pay in lieu of notice on grounds of wrongful dismissal and the parties might agree to settle out of court for a certain amount of money. Or a Court might award pay in lieu of notices as ‘damages’ in a wrongful dismissal lawsuit.
In any of these cases the lump sum amounts paid to the employee are considered to be taxable employment income. In all of these cases the employer must withhold and remit to CRA a minimum percentage based on the amount to be paid. Currently, those percentages (outside of Quebec) are: 10% up to and including $5,000, 20% up to and including $15,000 and 30% on amounts over $15,000.
The employee may ask the employer to deduct and remit additional tax. If requested, the employer can do so.
The employer is also required to deduct and remit CPP contributions and EI premiums.
However, if the employee elects to treat the lump sum (or part of it) as what is known as a “retirement allowance” (their choice), that money can be deposited directly by the employer into the employee’s designated RRSP, without the withholding tax.
Reasonable legal fees paid by an employee to collect or establish the right to collect amounts that must be reported as employment income (i.e. pay in lieu of notice) are tax deductible. To claim that deduction the employee files a Form T777 (Statement of Employment Expenses) with their tax return.
Legal fees paid by employers for advice and representation on terminations are, of course, deductible as business expenses.
Generally speaking, amounts paid as “general damages”, whether through a settlement or by Court Order, are not taxable because they are not “income”.
General damages (as opposed to pay in lieu of notice) are typically paid to compensate for “pain and suffering”, including “hurt feelings” or “humiliation”. General damages are also awarded, for example, in defamation cases, human rights cases and in cases where there has been tortious interference with contract. These kinds of claims might be advanced at the same time as a wrongful dismissal claim.
If claims for which general damages are awarded are settled at the same time as a wrongful dismissal claim it is important that the settlement documents specify what amounts are for pay in lieu of notice (taxable) and which amounts are paid as “general damages” (not taxable). This should not be an issue if the payment is Court-awarded because the Court will invariably specify which amounts are awarded under each heading. It is sometimes overlooked in settlements, however, because as parties move closer to settlement they tend to speak in all-inclusive dollar amounts, despite sometimes very different views on how those sums are calculated for settlement purposes.
Legal fees paid by the employee to collect or establish the right to collect general damages are not tax deductible but legal fees paid by an employer to defend against such claims are business expenses.
*Michael Coyle is an experienced employment-labour relations lawyer and a neutral mediator and arbitrator based in Kentville, Nova Scotia. Information provided in this article is meant for general interest only and is not a substitute for legal, accounting or tax advice about your own situation. For advice on your own situation consult a qualified professional. For more information and tips on employment and labour law issues, visit Michael’s website at www.michaelcoyle.ca
©Michael V. Coyle, 2013