2014-0565251E5 Taxation of an arbitration award

Principal Issues: Whether damages awarded through arbitration are taxable?

Position: Question of fact, but damages received as compensation for a loss of employment are included in income under 56(1)(a)(ii).

Reasons: See response.

Author: Baltkois, Thomas
Section: 5(1); 6(1)(a); 56(1)(a)

XXXXXXXXXX
                                                     2014-056525
                                                      T. Baltkois

May 29, 2015

Dear XXXXXXXXXX:

Re: Taxation of an arbitration award

We are writing in response to your correspondence of December 10, 2014, concerning whether damages awarded to you through arbitration would be taxable. In the situation described, you were awarded damages from your former employer following the loss of employment, and have indicated that the amount received relates to the loss of rights under a collective agreement rather than the replacement of salary.

Our Comments

This technical interpretation provides general comments about the provisions of the Income Tax Act (Act) and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R6, Advance Income Tax Rulings and Technical Interpretations.

The tax treatment of an amount received as an arbitration award is dependent on the facts in each particular case. Generally, compensation received by an employee from the employee’s employer or former employer on account of damages may be a retiring allowance, employment income, non-taxable damages, or a combination thereof.

Retiring allowance

Subparagraph 56(1)(a)(ii) of the Act requires a taxpayer to include in computing income for a taxation year, the amount of a retiring allowance received by the taxpayer in the year. The definition of “retiring allowance” in subsection 248(1) of the Act includes an amount received “in respect of a loss of an office or employment of a taxpayer, whether or not received as, on account or in lieu of payment of, damages or pursuant to an order or judgment of a competent tribunal.” In this context, the words “in respect of” have been held by the Courts to imply a connection between the loss of employment and the subsequent receipt, where the primary purpose of the receipt was compensation for the loss of employment.

The Courts have generally taken the view that a retiring allowance can include any compensation on account of damages for a loss of employment, including special damages, and general damages received for loss of self-respect, humiliation, mental anguish, etc. Damages received in connection with a loss of employment clearly fall within the definition of a retiring allowance and consequently are taxable by virtue of subparagraph 56(1)(a)(ii) of the Act. Only where an award of damages can be traced to events or actions unrelated to or separate from the loss of employment, will damages not be considered a retiring allowance.

Thus, where it is established that a connection exists between the loss of employment and the payment of compensation, such compensation (including payments received for special and general damages), will generally be taxed as a retiring allowance. The Courts have set out two questions to determine whether a connection exists for purposes of a retiring allowance:

(1)   But for the loss of employment would the amount have been received? and,
(2)   Was the purpose of the payment to compensate a loss of employment?

Only if the answer to the first question is no and the answer to the second question is yes, will the amount received be considered a retiring allowance.

Income from an office or employment

If an amount is not a retiring allowance but is received “in respect of, in the course of, or by virtue of an office or employment”, it may be taxable as employment income under paragraph 6(1)(a) of the Act. It is well established that there need only be a small connection between a benefit and the employment, in order to trigger the operation of paragraph 6(1)(a) of the Act.

Paragraph 10 of Interpretation Bulletin IT-337R4 (Consolidated), Retiring Allowances, provides that “special damages, such as those received for lost (unearned) wages or employee benefits, are taxable as employment income if the employee retains his or her employment or is reinstated.” The Courts have consistently viewed damages received as the result of grievances filed by virtue of a contract of employment (e.g., grievance for violation of a collective agreement) to be taxable as employment income.

Non-taxable damages

As noted in paragraph 12 of IT-337R4, where general damages are received in respect of personal injuries sustained before or after the loss of employment (for example, in situations of harassment during employment or defamation after dismissal), or where a loss of employment involves a human rights violation and is settled out of court, such damages will be viewed as unrelated to the loss of employment and therefore non-taxable. In order to claim that damages received upon loss of employment are for personal injuries unrelated to the loss of employment, it must be clearly demonstrated that the damages received relate to events or actions separate from the loss of employment.

Summary

The taxation of damage awards for income tax purposes is generally based on the nature and purpose of the payment, which is a question of fact. In the case of arbitration, the reasons or rationale provided in the arbitration decision generally provide the best indication as to why damages were awarded.

According to the arbitration decision (XXXXXXXXXX) and the supplementary award (XXXXXXXXXX), the reason for awarding damages was to compensate you for your termination (i.e., loss of employment). In our view, the arbitrator’s labelling of the damages, XXXXXXXXXX, as a non-taxable capital payment for loss of rights (as opposed to salary replacement) does not change the reason why the damages were awarded.

Thus, unless it can be clearly demonstrated that some of the damages were unrelated to or separate from your loss of employment, the entire amount of the damages should be included in your income as a retiring allowance under subparagraph 56(1)(a)(ii) of the Act.

We trust these comments will be of assistance to you.

Yours truly,

Nerill Thomas-Wilkinson, CPA, CA
Manager
for Director
Business and Employment Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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