2017-0685961E5 Taxation of Settlement Amounts

Principal Issues: The tax treatment of a lump-sum amount paid pursuant to a settlement agreement.

Position: Question of fact.

Reasons: Generally, the tax treatment of a settlement amount should be the same as the amount it is intended to replace.

Author: Baltkois, Thomas
Section: 5(1); 6(1)(a); 6(3); 56(1)(a)(ii); 248(1) “retiring allowance”

XXXXXXXXXX                                                                                                      2017-068596
                                                                                                                              T. Baltkois
July 28, 2017

Dear XXXXXXXXXX:

Re: Taxation of settlement payments

We are writing in response to your correspondence of February 1, 2017, concerning the income tax treatment and withholding requirements of a lump-sum amount (Settlement Amount) paid by the XXXXXXXXXX (Employer) pursuant to a settlement agreement (Agreement). You have also asked whether the reasoning in Tsiaprailis v. The Queen, 2005 SCC 8 (Tsiaprailis) could be applied to determine the tax treatment of the Settlement Amount.

In the situation described, a Settlement Amount was provided to each current XXXXXXXXXX employee of the Employer, and to each former XXXXXXXXXX employee of the Employer who retired effective on or after XXXXXXXXXX, to settle a grievance and other litigation regarding the cancellation of certain post-retirement benefits (PRBs). According to the Agreement, the Employer agreed to pay a Settlement Amount to the employees “in consideration of the loss of entitlement to PRBs, the alleged violation of their Charter rights and discontinuing litigation … as general damages for future loss of PRBs...” The Settlement Amount was calculated with reference to an employee’s pensionable years of service, up to a maximum of XXXXXXXXXX years. Where an employee did not have pensionable service, or had less than one year of pensionable service, the employee was entitled to receive a flat amount.

Based on the information provided, it is our understanding that PRBs were comprised of medical and dental coverage provided through a self-insured private health services plan (PHSP), and life insurance benefits provided through a group term life insurance policy (GTLIP).

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 70-6R7, Advance Income Tax Rulings and Technical Interpretations.

In determining the tax consequences of a settlement payment, the essential question is to ascertain what the settlement payment was intended to replace. In this regard, the Canadian courts rely on the common law concept referred to as the “surrogatum principle” (which was discussed and applied by the SCC in Tsiaprailis). Therefore, depending on the particular facts and circumstances, a settlement payment may be a retiring allowance, employment income, non-taxable damages, or some combination thereof.

Retiring allowance

If a settlement payment is a retiring allowance, the amount is included in income under subparagraph 56(1)(a)(ii) of the Act. As discussed in ¶2.3 of Income Tax Folio S2-F1-C2, Retiring Allowances:

 “ A retiring allowance is defined in subsection 248(1) of the Act as an amount received by an individual:

* on or after retirement of the individual from employment in recognition of the individual’s long service; or
* in respect of loss of employment of the individual, whether or not received as, on account of or in lieu of payment of, damages or pursuant to an order or judgement of a competent tribunal. ”

Since the Settlement Amount is being paid to both current (including employees with less than one year of pensionable service) and former employees, it is unlikely that the Settlement Amount would be a retiring allowance. That is, the amount likely is not paid in recognition of the employees’ long service or in respect of loss of employment.

Income from an office or employment

If a settlement payment 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.

A settlement payment may also be deemed by subsection 6(3) of the Act to be employment income for purposes of section 5 of the Act where the payment is provided to an employee (or former employee) to satisfy an obligation outlined in a written or oral agreement made with his or her employer (or former employer), either immediately before, during, or immediately after employment.

For example, when an employer and employee enter into an employment contract that provides for the payment of certain benefits to employees (or former employees), the employer establishes an obligation at that time to provide such benefits. If the employer subsequently provides employees (or former employees) with a lump-sum payment to modify or cancel these benefit entitlements, the employer’s payment would likely be made to satisfy the obligation that was created in the employment contract. See paragraphs 1.4 to 1.6 of Income Tax Folio S2-F3-C1, Payments from Employer to Employee, for more information.

Based on the terms of the Agreement, it appears that part or all of the Settlement Amount was for the loss of future PRBs. Accordingly, to the extent that the Settlement Amount was intended to replace the loss of post-retirement PHSP or GTLIP benefits under the collective agreement, subsection 6(3) of the Act will deem the payment to be employment income in the year it is received. This position is consistent with the current position adopted by the Canada Revenue Agency concerning the tax treatment of lump-sum payments provided to employees in lieu of continuing PHSP benefits (http://www.cra-arc.gc.ca/gncy/bdgt/2011/qa07-eng.html).

It also appears that part of the Settlement Amount may have been provided to settle a grievance. The Canadian courts have consistently viewed amounts 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. Therefore, to the extent that the Settlement Amount was provided for this purpose, that portion of the amount would be included in employment income under subsection 5(1) or paragraph 6(1)(a) of the Act.

A settlement payment that is required to be included in employment income under subsection 5(1) or paragraph 6(1)(a) of the Act is subject to withholdings in accordance with subsection 153(1) of the Act. Please refer to Guide T4001, Employers’ Guide - Payroll Deductions and Remittances, for more information.

In your submission, you asked whether the reasoning applied in Tsiaprailis would apply to determine the tax treatment of the Settlement Amount. In our view, while the surrogatum principle applied in Tsiaprailis is generally relevant in determining the tax treatment of the Settlement Amount, the specific finding of fact regarding the tax treatment of future benefits would not apply. More specifically, Tsiaprailis concerned the tax treatment of a lump-sum payment provided in respect of a group disability insurance plan contemplated by paragraph 6(1)(f) of the Act. In the situation you describe, the PRBs (e.g., PHSP and GTLIP benefits) are not benefits contemplated by paragraph 6(1)(f) of the Act.

Non-taxable damages

As noted in ¶2 of Interpretation Bulletin IT-365R2, Damages, settlements and similar receipts, a settlement payment, or a portion thereof, may represent damages in respect of personal injury (including general damages for pain and suffering). Damages of this nature are excluded from income, even if the amount of damages are determined with reference to the loss of earnings.

Therefore, to the extent that part of the Settlement Amount was provided as a remedy for the violation of the employees’ rights under the Canadian Charter of Rights and Freedoms, that portion will be considered non-taxable damages and excluded from income. There are no reporting or withholding requirements for non-taxable damages.

Summary

The income tax treatment of a settlement payment is generally based on the nature and purpose of the payment, which is a question of fact. In most cases, the parties to the settlement agreement are in the best position to make this determination. After reviewing the limited information provided, it appears likely that the Settlement Amount would constitute a combination of employment income and possibly some non-taxable damages.

We trust these comments will be of assistance to you.

Yours truly,

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

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