As an employer, it is sometimes difficult to determine which
awarded damages are taxable after an employee is terminated. In
general, damages awarded are taxable as income from such employment
or as a "retiring allowance." Certain damages discussed
below, however, are non-taxable.
"Retiring allowance" is broadly defined in the
Income Tax Act ("ITA") to include all amounts
received in respect of a loss of an office or employment, whether
or not received as damages or pursuant to an order or judgment of a
competent tribunal. This definition is much broader than payments
received as a result of retirement. Retiring allowances are
specifically excluded from the definition of "salary or
wages" in the ITA but they still are taxable income to the
employee (i.e. they have to be reported by the employee in the year
they are received and are subject to deductions at source as
The courts have set out a two-part test to determine whether
there is a connection between the loss of employment and the
receipt of the amount. Such a connection would mean the amount is a
retiring allowance and is therefore taxable income to the employee,
The two questions that should be asked are:
1. Would the amount have been received if there was no loss of
2. Was the purpose of the payment to compensate a loss of
If the answer to the first question is negative and the answer
to the second question is positive, the amount received will be
considered a retiring allowance and thus taxable.
Special as well as general damages related to one's
termination of employment and received for mental anguish, hurt
feelings, etc. (types of damages generally awarded in employment
termination cases) will be taxed as a retiring allowance and tax
should be withheld at source.
However, where damages are received on account of personal
injuries including harassment or defamation, such damages may be
considered as being unrelated to the loss of employment and
therefore non-taxable. This is also the case for damages relating
to a violation of human rights. A reasonable allocation will have
to be made if such damages are awarded as part of a settlement and
not directly by a human rights tribunal.
In order for the retiring allowance paid by the employer to be a
deductible expense for the employer, it must be reasonable
considering the length of service and remuneration received during
Tax has to be withheld on a retiring allowance, but the employer
may not be required to deduct tax at source on the portion of
retiring allowance transferred directly to the employee's RPP
or RRSP, if certain conditions are met.
Particular attention should be paid to the wording of settlement
agreements concluded upon termination of employment and a clear
allocation of the amounts agreed on should be made. If this is not
done, the tax authorities or the courts may be called upon to
determine the intention of the parties.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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