CRA Tax Interpretation Provides Helpful Commentary on Structuring Employment Settlements

In 2023, Field Law reported on how certain amendments to the Income Tax Act regarding reportable transactions had the potential to impact how employers should approach settling employment disputes for tax purposes.

Under the amendments, any transaction meeting the legislated definition of a “reportable transaction” must be reported and filed with the Canada Revenue Agency (CRA). This raises the question of whether employment settlements that include tax indemnity clauses and the payment of non-taxable general damages must be disclosed to the CRA as reportable transactions.

The recent CRA Tax Interpretation, 2024-1006831E5 – Employment settlements and reporting requirements provides much-needed clarity on this issue for employers.

A Refresher on the Reportable Transaction Amendments

Under the June 2023 amendments to the Income Tax Act, the mandatory disclosure rules for reportable transactions apply when two legislated criteria are met:

1. A transaction or series of transactions has at least one of the three generic hallmarks: contingent fee arrangements, confidential protection or contractual protection, and
2. It can reasonably be concluded that one of the main (though not necessarily the only) purposes of entering into the transaction or series is to obtain a tax benefit.

A taxpayer who enters into a reportable transaction (or another person who enters into the reportable transaction for the benefit of the taxpayer) must report the transaction to the CRA within 90 days. These amendments raised concerns for employers regarding reportability due to two common characteristics present in employment settlements: tax indemnity clauses and the payment of non-taxable general damages.

Regarding the first criteria, the question arises whether a tax-related contractual protection, such as a tax indemnity clause in an employment settlement, falls under the “contractual protection” hallmark. Such clauses are standard in employment settlements to protect employers in the event of a CRA audit relating to the settlement payment. Regarding the second criteria, when some or all the funds paid in a settlement are structured as non-taxable general damages, the question arises whether the CRA could conclude that one of the main purposes for entering into the transaction is to provide a tax benefit to the employee. If the answer to both questions is ‘yes’, the settlement payment would be considered a “reportable transaction” under the amendments.

Although reportable transactions are not prohibited, they must be disclosed to the CRA, which may increase the risk of being subject to an audit. Accordingly, the 2023 Income Tax Act amendments created uncertainty and concern among employers regarding how employment dispute settlements should be structured for tax purposes.

The CRA Tax Interpretation

In Tax Interpretation 2024-1006831E5 – Employment settlements and reporting requirements, the CRA was asked to consider whether a settlement agreement signed in the context of an employment termination is a “reportable transaction” due to the indemnity clause. The CRA’s stated position in response was “Generally, no”. In reaching this conclusion, the CRA considered the applicability of the two legislated criteria required for a reportable transaction.

Regarding the first criteria, the CRA commented that where an employment dispute settlement includes a tax indemnity that benefits the employer, that protection is unlikely to engage the “contractual protection” hallmark required for a reportable transaction:

Generally, the person having contractual protection is the person that would be entitled to compensation in the event of a failure of the transaction to achieve a tax benefit. In an employment context, where the employer is protected by an indemnity clause like that in the Settlement, we are of the view that the contractual protection hallmark is unlikely to be triggered in most instances.

Regarding the second criteria, the CRA commented that including non-taxable general damages as part of a settlement does not alone confirm that the main purpose of the transaction is to avoid taxes. Where such a settlement is justified and negotiated in good faith, it is unlikely to qualify as an “avoidance transaction”:

While the existence of a tax benefit is a fact driven determination, to qualify as an “avoidance transaction” it is still required that obtaining such tax benefit be reasonably considered as one of the main purposes of the settlement. Presumably, the main purpose of an employment settlement is to resolve a dispute between an employer and employee. In our view, the fact that damages are paid as a result of a settlement should not systematically lead to the conclusion that “one of the main purposes” of the settlement is to obtain a tax benefit. In situations where the parties negotiated in good faith and reached a principled settlement that provides for a proper characterization of the damages, it is unlikely that such settlement would qualify as an “avoidance transaction”.

However, the CRA cautioned that there still may be some instances where an employment settlement may be reportable. For example, where there is no legal or factual basis to the payment of non-taxable general damages.

Takeaway for Employers

The CRA’s comments should provide comfort to employers that bona fide negotiated employment settlements are unlikely to meet the definition of a “reportable transaction” triggering mandatory disclosure.

Firstly, to be a reportable transaction, the transaction must satisfy both legislated criteria required by the Income tax Act. The conclusion by the CRA that employer tax indemnity clauses are unlikely to trigger the contractual protection hallmark means that standard employment settlements incorporating such an indemnity clause are unlikely to satisfy the first criteria. Accordingly, absent the inclusion of any additional unconventional contractual clauses triggering any of the generic hallmarks, standard employment settlements are unlikely to be considered reportable transactions under the Income Tax Act.

Regarding the second criteria, the CRA’s comments suggest that where there is a legal justification for structuring some or all of a settlement payment as non-taxable general damages, this will not be considered an avoidance transaction. For example, if an employee files or threatens to file a wrongful dismissal lawsuit or human rights complaint that includes a supportable claim for general damages, a negotiated settlement that includes an apportionment for tax-free general damages is likely to be considered reasonable and justified such that it does not constitute an avoidance transaction. In contrast, if an employer pays out the entirety of a severance payment as non-taxable general damages for the sole purpose of encouraging settlement, this is much more likely to be considered an avoidance transaction and attract the attention of the CRA in the event of an audit.

Although this decision adds clarity to what constitutes a “reportable transaction” in the context of employment settlements, employers should still seek legal advice regarding what contractual protections to include in settlement agreements and avoid structuring settlement payments in a manner that is not legally justified. Seeking proactive advice will help mitigate the risk of mandatory reporting and potential liability in the event of a CRA audit. Please contact Austin Ward in Canmore, David Di Gianvittorio in Calgary, Joël Michaud in Edmonton, or any member of Field Law’s Labour + Employment group for advice and support.