On June 22, 2023, changes to the reportable transaction regime of the Income Tax Act came into force. Since that time, there has been ongoing debate about how these rules might apply to employment settlement agreements.
On November 2, 2023, the Canada Revenue Agency ("CRA") revised its guidance to clarify the reporting rules generally and provide some reassurance that normal employment severance agreements probably do not fall within these rules. While the legislative changes may not have been enacted with the intention of capturing settlement agreements in the labour and employment context, it is still important to be aware of the reporting rules as there still may be unintended reporting requirements that warrant a closer look at future settlement agreements.
What are Reportable Transactions?
Transactions will be "reportable transactions" if they meet the following criteria:
- Criteria 1: One or more of the following hallmarks apply: contingent fee arrangements, confidential protection, or contractual protection; and
- Criteria 2: If one of the main (though not necessary the only) purposes of the transaction was to obtain a tax benefit.
To be clear, just because a transaction is reportable does not mean that the transaction is unacceptable or that the anticipated tax treatment is not correct. There is no prohibition against entering into or structuring transactions to obtain a tax benefit. It is merely that such transactions now have an additional reporting requirement.
That being said, reported transactions could conceivably have a higher risk of being subject to an audit.
When Could a Settlement Agreement be Considered a Reportable Transaction?
With respect to Criteria 1, if a settlement agreement contains a tax-related indemnity provision, this will fall under the "contractual protection" hallmark.
Indemnity provisions are standard in employment settlement agreements and are often used to protect employers in the event a CRA audit were to determine additional taxes should have been withheld. An indemnity provision requires an employee to reimburse an employer for any unexpected tax payments with respect to the settlement payment.
A settlement agreement containing a tax indemnity provision will not alone trigger the reporting requirements. Criteria 2 must also be present: one of the purposes of the agreement was to obtain a tax benefit.
When some or all of the settlement funds in an agreement are allocated to non-taxable damages such as general damages, there is a risk that the CRA could consider this a tax benefit being provided to an employee, satisfying Criteria 2 of the reporting requirement.
While the new reporting requirements are still too new for the Tax Court to have considered yet, and the CRA has only provided limited commentary itself, we can identify some higher and lower risk scenarios.
In its most recent guidance, the CRA stated: "The contractual protection hallmark will not apply in a normal commercial or investment context in which parties deal with each other at arm's length and act prudently, knowledgeably and willingly, and does not extend contractual protection for a tax treatment in respect of an avoidance transaction. Without providing an exhaustive list of examples, these can include... tax indemnities in employment agreements and severance agreements."
This would appear to suggest that standard tax indemnities provided by employees in severance agreements are not caught, and on the basis that the settlement of a wrongful dismissal is a "severance agreement," this would appear to suggest those indemnities do not fall under the contractual protection hallmark.
That being said, this CRA guidance is not a guarantee that no employment settlements are reportable. First, not all employment settlements are "severance agreements." Some arise without termination of employment. Second, CRA policy is not law and is subject to change at any time. Third, their comments may apply differently to different circumstances. The CRA is more likely to claim more aggressive tax positions are not the "normal" or "standard" situations the CRA says are acceptable.
Application to Different Tax Treatment
Even if the reportable transaction rules apply, some provisions will have little risk because they are not in the nature of tax avoidance.
For instance, reimbursement of legal fees and allocation of settlement funds to a Registered Retirement Savings Plan ("RRSP") without tax deductions are very unlikely to be considered a tax benefit or tax avoidance. This is because, from a tax perspective, these allocations do not actually change the tax characterization. Instead, they just take advantage of tax deferral mechanisms in the Income Tax Act. Specifically, an employee may deduct from taxable employment income amounts paid into an RRSP or for legal fees paid to obtain the employment income. When an employer knows an amount will be used for these purposes, the employer is not required to withhold taxes in anticipation of the deductions. Such an allocation in a settlement agreement does not make these funds not taxable, it just recognizes any tax will be offset with an associated deduction. Accordingly, settlement agreements with funds only allocated to deductible legal fees and/or an RRSP are unlikely to meet the criteria of a reportable transaction [Note: legal fees paid to obtain payment for non-taxable damages are not deductible].
Settlements where the allocation is clearly reasonable are also less likely to satisfy Criteria 2 on the basis that the employee is not receiving a tax benefit, if that was the likely tax treatment in any event. For example, case law supports awarding non-taxable general damages for a successful human rights complaint, though the amount of such damages varies. In Alberta, human rights general damages have been awarded up to $50,000, though in most cases, the current high-water mark is thought to be around $30,000 (several decisions have awarded this amount). Therefore, allocating $30,000 or less as non-taxable general damages for a human rights complaint is unlikely to satisfy Criteria 2 because the parties did not do anything to make it non-taxable. The general damages settlement amount might safely be higher in other jurisdictions where higher general damages awards are more common.
However, when settling a termination claim and treating a large or possibly disproportionate part of the settlement as non-taxable general damages, there is a greater possibility the allocation of the settlement may be viewed as being for the purpose of creating a tax benefit under Criteria 2.
If a settlement agreement meets the criteria of a reportable transaction, the transaction must be reported to the CRA within 90 days by taxpayers and their advisors.
A significant unknown will be how this exclusion will impact lawyers' reporting requirements, given that lawyers may have their own reporting requirements as "Advisors." Are lawyers excluded from any reporting requirement based on solicitor-client privilege? Will they still have to report in some cases? And if so, when? And how does this interact with lawyers' other obligations, such as the duty of confidentiality and avoiding conflicts of interest with their clients? In response to these uncertainties, the Federation of Law Societies of Canada has filed a petition in the BC Supreme Court seeking a declaration that the reporting requirements of "Advisors" do not apply to lawyers. We are awaiting the results of that petition.
If a reportable transaction is not reported within this quick turnaround, there may be severe penalties for failing to report. For corporations with greater than $50 million of assets, $2,000 per week for each failure, up to the greater of $100,000 or 25% of the tax benefit. In all other cases, $500 per week for each failure to report, up to the greater of $25,000 or 25% of the tax benefit. Given the CRA is unlikely to complete an audit and assess such penalties for a couple of years, the maximum penalty could easily apply.
Settlement agreements that have no tax avoidance purposes or indemnity provisions are not affected by the new legislation. However, where an agreement contemplates a tax avoidance mechanism and contains an indemnity provision, reporting may be required.
In some settlement agreements, the monetary value a tax indemnity provision provides to an employer can be relatively minor. In such cases, removing the indemnity provision altogether may provide relief from the new reporting requirements without significantly altering the risks of the parties of entering into the agreement. Employers are not responsible for any income tax not deducted. That is the employee's responsibility. However, in the worst case, employers could be liable for a penalty based on 10% or 20% of the tax that should have been deducted. In most cases, this amount will not be significant.
Where it is determined that the reporting requirements are triggered, the safest approach is to properly report the transaction to the CRA within 90 days of the agreement being effective.
The newness and uncertainty around the applicability of the CRA reporting requirements to settlement agreements warrant a thoughtful approach to future settlement agreements. While much uncertainty remains, we hope clarity will be added through future CRA publications or court decisions.
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.