General Principle – Income Must Come From a Source
The general principle under the Income Tax Act (the "Tax Act") is that for an amount to be considered income, it must belong to a source in section 3. These sources are: office, employment, business, and property. Amounts that are received that cannot be characterized under any of these sources may not be taxable. For example, windfalls from gambling or a damage award received for personal injury have been found not to be taxable income.
When someone is wrongfully terminated from their employment, he or she may be entitled to payment for an order from a Court, tribunal or through a settlement. These amounts may not fit squarely in the definition of the sources of income. A question that arises is whether an award received for compensating wrongful dismissal is taxable income.
Are Damages for Wrongful Dismissal Fully Included in Income?
Subparagraph 56(1)(a)(ii) of the Tax Act provides for the taxation of wrongful dismissal types of payments. In general, section 56 provides for the addition of amounts in a taxpayer's income that would not otherwise be captured by the sources in section 3. Specifically, subparagraph 56(1)(a)(ii) will operate to include a retiring allowance as income, other than an amount received out of or under an employee benefit plan, a retirement compensation arrangement or a salary deferral arrangement.
A "retiring allowance" is defined as an amount received in respect of a loss of an office or employment, whether or not received as, on account of, or in lieu of payment of, damages or pursuant to an order or judgment of a competent tribunal. To clarify, the amount paid to the taxpayer does not need to be paid as a result of an order or judgment from a tribunal. This means a settlement or even an amount ordered by a court to be paid to the taxpayer will qualify the payment as a retiring allowance. Thus, damages for wrongful dismissal are fully included in a taxpayer's income.
Employer's Obligations – Withholding Requirements
Paragraph 153(1)(c) of the Tax Act obligates every person who is a payer of a retiring allowance to withhold and remit the tax payable on the amount. In other words, an employer who pays an amount related to the loss of employment of an employee to an employee is required by this provision to withhold the tax and remit that amount to the government. This places the exact same obligation on the employer as if the employer were paying that employee's salary or wages.
If the ex-employee is a non-resident, then a different rule applies. Paragraph 212(1)(j.1) of the Tax Act requires the former employer to withhold 25% of the amount paid as a retiring allowance. There is a subsequent requirement for the former employer to remit the amount withheld.
Case Example: Schwartz v Canada – What Happens When You Are Terminated Before You Even Begin?
In the Supreme Court of Canada case of Schwartz v Canada, [1996] 1 SCR 254, the taxpayer accepted a position at a company and was later told, prior to commencing his employment, that he was no longer needed. A lump sum was offered and accepted as a settlement. CRA contended that that amount should be included in the taxpayer's income under subparagraph 56(1)(a)(ii) as a retiring allowance.
There were two issues in this case:
- Whether the settlement that the taxpayer received should be, in part, taxed under section 3 of the Tax Act, and
- Whether the settlement that was received was a retiring allowance.
On the first issue, the Supreme Court of Canada concluded that there was no evidence establishing what portion of the total amount was apportioned to losses or salary and mental anguish. Had there been clear documentary evidence showing that the sums were allocated to specific types of damages, then parts of the settlement could have been taxable income.
However, since there was no clear indication as to which amount was allocated to specific heads of damages, the Supreme Court of Canada found that the settlement could not be taxed, in whole or in part, under section 3.
On the second issue, the SCC held that the settlement was not a retiring allowance. Specifically, the definition of "employment" was considered. Under the Tax Act, employment refers to circumstances where one is in the service of another.
The taxpayer could not have been "in the service" of his prospective employer because he had not started his service at all. Therefore, the amount received could not have been in respect of loss of employment because the employment never began. Therefore, the settlement received by the taxpayer was not captured under sections 3 and 56(1)(a)(ii). Hence, it was not taxable income.
TAX PRO TIP – Understanding How Your Income is Treated under the Income Tax Act
Schwartz illustrates two things. The first is that not all settlements or awards of damages for wrongful dismissal will be treated as non-taxable income. Thus, when making, or accepting, a settlement offer, it is important to speak to an expert Canadian tax lawyer to ensure that the allocation of amounts to specific heads of damages be made clear and in particular that the maximum amounts be allocated to non-taxable heads of damage.
Second, for a payment to be considered a retiring allowance under the Tax Act, the employment must have started. However, not all cases are clear and will require careful examination of facts and evidence to determine whether the payments should be reported as income. Engage with an expert Canadian tax lawyer to discuss how your settlement or award of damages is treated under the Tax Act.
FAQs
What are the other sources of income under section 3?
The other sources of income that form your taxable income are from office, property, business and capital gains. Income from office generally includes amounts such as remuneration received as a judge or member of the Senate. Income from business is money received from carrying on a business, and can include income from an adventure in the nature of trade, such as trading in cryptocurrency.
Income from property includes amounts received as rents, royalties, dividends and interest. Capital gains form part of your income under section 3 and arise when there is a disposition of capital property, including cryptocurrency, that has accrued gains.
What happens if I received amounts from another country as a settlement?
Canada taxes income on a worldwide basis. If you are a Canadian resident, then you must report income from all sources in all countries. You may receive a foreign tax credit for taxes already paid abroad, or a tax treaty may decrease your tax liability in Canada, but the requirement to report all income still stands.