In June 2023, the federal government passed new legislation expanding the mandatory disclosure rules under the Income Tax Act, which may affect general damages and severance settlements. In particular, the new rules may require parties to report severance settlements in general, and specifically general damages within settlement agreement, to the Canada Revenue Agency (CRA).

New Rules

The revised section 237.3 of the Income Tax Act broadens the definition of reportable “avoidance transactions” (as outlined below).

  1. An avoidance transaction is no longer defined by having a ‘primary purpose’ of tax avoidance. Instead, an avoidance transaction includes a transaction if it may reasonably be conceived that one of the main purposes of the transaction, or of a series of transactions of which the transaction is part, is to obtain a tax benefit.
  2. A reportable transaction now includes an avoidance transaction which has one of three hallmarks:
    • a. Contingency fees to a promoter or advisor;
    • b. Confidential protection; or
    • c. Contractual protection.

Where a transaction falls within the new rules, every person who expects a tax benefit based on the tax treatment of the transaction, every person who has entered into the transaction, and any advisor/promoter of the transaction (with exceptions for solicitor-client privilege) must file an information return (Form RC312, Reportable Transaction and Notifiable Transaction Information Return).

How Does This Affect Severance Agreements?

Employment lawyers are divided with respect to the impact of the new legislation on severance agreements and/or general damages. In some situations, employers may allocate a portion of a settlement to general (i.e., non-taxable) damages. General damages provide the employee with a significant tax advantage in exchange for an indemnity for the employer. Indemnities typically ask the employee to indemnify the employer against any legal issues between the parties, including tax issues. The new legislation does not specifically target severance agreements but may affect indemnities associated with severance agreements.

Some employment lawyers have argued that an indemnity may constitute a “contractual protection” such that the settlement transaction would become a reportable transaction. Therefore, each party must file an information return to the CRA. If this were to be the case, the CRA would be in a position to know the details of every settlement, including if general damages were paid, which would increase the chances of being audited and could ultimately have the effect of discouraging settlements.

Other lawyers have argued that an indemnity does not turn the settlement into a reportable transaction. To be considered a contractual protection, the indemnity must protect the person indemnified, the employer from the failure of the transaction to achieve a tax benefit. However, the indemnity does not result in a tax benefit to the employer, rather, the employee. Therefore, there is no indemnity aimed at the tax benefit and the parties do not need to file an information return.

Key Take-Aways

Given considerable literature that the recent changes to the Income Tax Act do not apply to severance agreements, it is unclear whether parties will be required to report severance settlements and/or general damages within settlement agreements to the CRA. As a result, most parties will likely not report severance settlements to the CRA until the federal government directly addresses this issue and explicitly makes it a requirement.

The Law Society of Ontario continues to discuss the impact of the changes to the Income Tax Act with the federal government. The lawyers at Heeney Vokey are actively monitoring the situation and will keep you updated in the event of changes.