10 April 2003 External T.I. 2002-0179835 - WRONGFUL DISMISSAL SETTLEMENT

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: Tax treatment of settlement received in lawsuit against former employer

Position: Question of fact. The representative contends the settlement to be made up of amounts for balance owing under employment contract, compensation for lost opportunity to earn rental income from principal residence, and pre-settlement interest.

Reasons: General comments given. We would need to review final settlement agreement, employment contract, and other relevant documents in order to provide definitive comments.

XXXXXXXXXX 2002-017983
Wayne Antle, CGA
April 10, 2003

Dear XXXXXXXXXX:

Re: Tax Treatment of Wrongful Dismissal Settlement

This is further to your letter of December 12, 2002, concerning the taxation of an amount received by your client in settlement of a lawsuit filed against her former employer. You have summarized the facts as follows.

In XXXXXXXXXX (the "employees") entered into an employment contract with the XXXXXXXXXX (the "Board") to XXXXXXXXXX. The contract was for the period from XXXXXXXXXX to XXXXXXXXXX, and paid a combined salary of $XXXXXXXXXX plus room and board. After a series of events, the employees were effectively terminated on or about XXXXXXXXXX. Up to this point they had received $XXXXXXXXXX under the contract, which left a balance of $XXXXXXXXXX unpaid. The employees filed a lawsuit against the board alleging, among other things, wrongful dismissal. In XXXXXXXXXX, the employees reached a settlement agreement with the Board, which resulted in a payment of $XXXXXXXXXX (the "settlement amount") to XXXXXXXXXX (the "employee"). This payment was intended to cover the balance owing under the employment contract, reimbursement for lost rental income that could have been earned from rental of their home while they resided at the boarding house, and pre-judgment or pre-settlement interest (hereinafter referred to as pre-judgment interest).

As we were not provided with the final settlement agreement, we cannot comment on your proposed allocation of the lump sum settlement among the components outlined above. Nevertheless, as per our telephone conversation (Antle/XXXXXXXXXX) on March 31, 2003, you have asked for our general comments on the taxation of such amounts.

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an Advance Income Tax Ruling request. Where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office. However, we are prepared to provide the following comments.

Generally, compensation received by an individual from the individual's former employer on account of damages related to a loss of employment is either employment income or a retiring allowance. Whether an amount received by an employee, upon or after termination of employment, is income from employment, and therefore included in income pursuant to subsection 5(1) of the Income Tax Act (the "Act"), or a retiring allowance that is included in income pursuant to subparagraph 56(1)(a)(ii) of the Act, is a question of fact that can only be determined after a review of the employment contract, other agreements and all of the other circumstances relevant to a particular situation.

Retiring Allowance

The term "retiring allowance" is defined in subsection 248(1) of the Act, in part, as "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". The Supreme Court of Canada found in Savage (83 DTC 5409) and Nowegijick (83 DTC 5041) that the words "in respect of" are

"... of the widest possible scope. They import such meanings as 'in relation to', 'with reference to' or 'in connection with'. The phrase 'in respect of' is probably the widest of any expression intended to convey some connection between two related subject matters."

Accordingly, it is our view that the portion of the settlement amount related to the lost rental income would fall within the definition of "retiring allowance" as being in respect of the loss of employment.

Employment Income

A payment received on or after retirement or loss of employment by reason of a contractual arrangement with a former employer is generally viewed as remuneration from the former office or employment, either in the normal sense, or by virtue of the extended meaning given under subsection 6(3) of the Act. Subsection 6(3) essentially provides that an amount received pursuant to an agreement made immediately before, during or immediately after a period of employment is considered to be remuneration for services rendered during the period of employment unless it can be established that it is not reasonable to consider the payment as being received under the employment contract, for entering the contract of employment, or for a covenant with respect to what the payee is or is not to do before or after his employment terminates. As noted in paragraph 4(c) of Interpretation Bulletin IT-196R2 Payments by Employer to Employee, subsection 6(3) would apply to "a payment received on the termination of employment, where the contract of employment either expressly or implicitly provides that the payee is entitled to receive such payment on account of, in lieu of payment of, or in satisfaction of the employer's obligation to pay his salary, wages, commissions, etc., remaining under the contract of employment or for a period coincident with a reasonable period of notice of the termination of his employment".

The Canada Customs and Revenue Agency ("CCRA") has developed a position related to the payment of an amount where there is some doubt with respect to its nature and has expressed this position in Interpretation Bulletin IT-337R3 Retiring Allowances. The bulletin indicates that a payment made upon or after a termination of employment or in respect of a loss of employment will generally be treated as income from employment if it was paid pursuant to the terms of an employment contract. However, where it is also reasonable to regard the amount as the payment of an amount in respect of the loss of employment, it will be considered a retiring allowance.

Whether the portion of the settlement amount related to the balance owing under the employment contract would be considered a retiring allowance or employment income is a question of fact that can only be conclusively determined after reviewing the employment contract, terms of the settlement agreement, and any other relevant documentation. If the settlement agreement calls for the fulfilment of the term of the employment contract, then the amount so paid would generally be considered employment income. On the other hand, if the settlement agreement directs that a payment is to be made with reference to the unfulfilled terms of the employment contract, then the payment will likely be considered a retiring allowance. As noted above, in cases of doubt where the payment can be considered to be made under the terms of the employment contract, and also reasonably considered to be in respect of the loss of an office or employment, then the CCRA will accept that the payment may be treated as a retiring allowance.

Pre-judgment Interest

Finally, you have indicated that the lump-sum payment includes an amount for pre-judgment interest. Pre-judgment interest refers to an amount, classified as interest by the courts or under the terms of the settlement agreement, that is interest payable for the time between the emergence of the cause of action and the receipt of the damages. In general terms, interest means compensation, computed by reference to time, for the use or retention by one person, of a sum of money owed or belonging to another person for the period during which the person who is owed the money did not have it in their hands to invest or use as desired.

Pre-judgment interest is generally required to be included in income pursuant to paragraph 12(1)(c) of the Act. However, there is an administrative exception for pre-judgment interest related to an award for personal injury or death, wrongful dismissal, or retroactive worker's compensation payments wherein such interest is not subject to tax.

Whether the settlement amount includes an amount for pre-judgment interest can only be determined after reviewing all of the facts and documentation including the final settlement agreement. Where it is determined that a portion of the settlement payment is, in fact, pre-judgment interest, it is our view that this interest should be included in the employee's income pursuant to paragraph 12(1)(c) of the Act, unless it can be established that it relates to the portion of the settlement amount that was paid for wrongful dismissal.

We trust that our comments will be of assistance.

Yours truly

John Oulton, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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