Published: January 16, 2024
Introduction: The Surrogatum Principle
The Canada Revenue Agency (“CRA”) has long adhered to the Surrogatum principle, which applies the same tax treatment of settlement payments and damages awarded at trial by a judge. This principle, established and developed by a series of Canadian tax cases, governs the tax treatment of these payments, irrespective of findings of liability or wrongdoing by the payor.
The Surrogatum principle, for Canadian tax purposes, considers any payment to take on the attributes of what the payments are meant to replace. In other words, the tax treatment of a settlement payment depends on the tax treatment of the item for which the payment is intended to substitute. For example, if a settlement was reached for a breach of contract which resulted in a business loss, then the settlement amount replaces the business loss and is taxable as business income for the payee. Another common example happens in employment-related issues. If an individual receives severance settlement from his or her employer as a result of the individual being discriminated against, the nature of the settlement resembles punitive damages. As a result, the severance settlement will typically not be taxable. In contrast, if the individual receives the severance settlement for back pay or for general notice periods, the settlement is likely taxable as employment income.
One of the first Canadian cases to consider the nature of damages for tax purposes is Parsons-Steiner Ltd. v Minister of National Revenue, 1962 CTC 231. The Court, after examining the lump-sum payment received by the taxpayer upon the cancellation of a sales agency contract, held that the damages related to the loss of the taxpayer’s interest in the goodwill and business should be viewed as “a capital asset of an enduring nature.” The lump-sum payment is found to be taxable business income.
In 65302 British Columbia Ltd. v The Queen,  2 CTC 304, the Supreme Court of Canada held that 1) the Canadian income tax system does not distinguish between levies/taxes and fines/penalties; and 2) the deductibility of a fine/penalty depends on how it was incurred, which also applies to the deductibility of damages. Later, the Supreme Court of Canada in Tsiaprailis v Canada, 2005 SCC 8, confirmed that the Surrogatum principle applied to employment income related cases where a taxpayer received a lump sum payment from her employer’s insurer as a settlement after the insurer terminated her long-term disability benefits. The Supreme Court of Canada found that since the payment was to replace monies payable on a periodic basis pursuant to a disability insurance plan, the payment was taxable under s. 6(1)(f) of the Income Tax Act.
Employment-related Monetary Awards and Settlements
In Saunders v The Queen, 2020 TCC 14, the Tax Court of Canada held that monetary award resulted from a successful grievance to the Public Service Labour Relations and Employment board should be taxed as employment income, since the compensation award “replaced the remuneration the appellants would have received had they been offered and in turn accepted overtime work.” This ruling reflects the Surrogatum principle in determining the tax treatment of an employment-related monetary awards and settlements. If the award or settlement is to compensate the person for work performed, unpaid overtime, or other employment compensation to which he or she would otherwise be entitled in the course of employment, then the amount received is likely taxable as employment income. Otherwise, if the payment is to compensate the person for harassment, defamation, discrimination, or similar issues that could result in punitive damages, then the amount is not taxable.
For more information on how severance pay and settlement may be taxed differently based on its structure, you can read our article here: “How Severance Pay Is Taxed In Canada: Guidance From A Canadian Tax Lawyer.”
New Mandatory Disclosure Rules
Effective June 22, 2023, Bill C-47 introduced updated disclosure rules impacting taxpayers. The legislation mandates the disclosure of reportable transactions, extending the reassessment period and introducing new penalties for non-compliance. In addition, Bill C-47 extended the normal reassessment period in non-compliance situations with new penalties. The CRA can assess or reassess a Form RC312 at any time for up to 4 years after the taxpayer files it. The new mandatory disclosure rules require a taxpayer to disclose a reportable transaction if he or she gets or expects to get a tax benefit, enters into the reportable transaction for the tax benefits of another person, is a promoter or an advisor entitled to a fee for the transaction, or does not deal at arm’s length with the promotor or advisor entitled to receive a fee for the transaction.
A reportable transaction is defined as an avoidance transaction in subsection 237.3(1) of the Income Tax Act, which is a transaction “if it may reasonably be considered that one of the main purposes of the transaction, or of a series of transactions of which the transaction is a part, is to obtain a tax benefit.” Tax benefits refer to a reduction, avoidance or deferral of tax or other amount payable under the Income Tax Act, an increase in a refund of tax or other amount under the Income Tax Act, or a reduction, increase, or preservation of an amount for tax purposes that could happen at a subsequent time. A reportable transaction has one of the three hallmarks: a contingent fee arrangement, confidential protection, or contractual protection.
How Do The New Rules Affect Tax Treatment Of The Severance Settlement?
It can be confusing for taxpayers to understand how the new reporting rules affect tax treatment of a severance settlement and their tax reporting obligations. The impact of the new rules arises from the confidential nature of a settlement agreement. Typically, to resolve a dispute with a former or current employee, an employer offers monetary awards in exchange for a waiver of liability, cessation of future legal actions, and confidentiality of the settlement agreement. As a result, a settlement agreement easily meets one of the three hallmarks, namely, confidential protection.
Individual taxpayers involved in employment-related disputes may suddenly find themselves in need of tax-law related advice, facing the additional obligation to report the settlement arrangement. Even if the taxpayer has retained an employer lawyer, the employment lawyer may or may not be aware of the tax reporting obligations or the tax treatment of different settlement structures. The employer will also have to report the settlement arrangements to the CRA, making it more challenging for them to agree to a settlement structure seemingly benefiting the individual employees, out of fear of getting audited and questioned by the CRA.
In addition to the reporting obligations, if the CRA decides to audit the settlement arrangements and finds them not bona fide, there may be taxes payable on the received payments. When entering into a settlement agreement, an employer commonly asks to be indemnified by the employees for tax-related issues. If such indemnity clauses are included in the settlement agreement, the taxes payable then become the responsibility of the individual employees. In that case, the received lump-sum payments may increase the individual employee’s income significantly and result in considerable tax liabilities.
Pro Tips – Engage a Canadian Tax Lawyer Before Finalizing a Settlement
Employment-related settlements often involve a great deal of flexibility when it comes to the structure of the settlement. The flexibility is largely beneficial for the individual taxpayers receiving the monetary awards but has minimal impact on the employers responsible for such payments. Consequently, the new mandatory reporting rule serves as a potential deterrence to the employers to consider settlement agreements that benefit recipients for tax purposes. Moreover, once a settlement is concluded, changing the tax treatment of received payments becomes a nearly impossible task without revising the settlement agreement.
It is therefore necessary and advantageous for taxpayers to engage with an experienced Canadian tax lawyer before finalizing a settlement with their employers. Our expert Canadian tax lawyers can provide legal advice on the tax treatment of employment-related settlements. We can also assist you with filing the RC312, ensuring that you fulfil your reporting obligations as a Canadian taxpayer.
What Is the RC312 Form?
A taxpayer needs to file an RC312 Reportable Transaction and Notifiable Transaction Information Return (the “RC312 Form”) if he or she is required to disclose reportable and notifiable transactions under sections 237.3 and 237.4 of the Income Tax Act. In the employment-related context, when an individual enters into a settlement agreement with a current or former employer, the individual and the employer will likely be required to report the settlement arrangement due to the common confidential protection clauses included in such an agreement.
What Happens If I Fail to File the RC312 Form?
The RC312 Form is due on or before the taxpayer’s income tax filing deadline for that tax year. Failure to file the RC312 Form or failure to file the RC312 Form by the required filing deadline can result in penalties up to $500 per week for Canadian taxpayers. For corporations with assets of $50 million or more, the maximum penalties increase to $2,000 per week.
This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."