Tax Relief? What Employers Should Know About New Disclosure Rules

There has been significant debate about what recent changes to Canada’s tax legislation mean for employers and their settlement agreements. Initially, employers and their advisors feared that new mandatory disclosure rules, introduced in the summer, would broaden the scope of when employment settlements were reportable to the CRA.

Recent CRA guidance provides some clarity—and reassurance—that the changes are not as impactful on employers as some thought. However, employers should still understand the scope of the changes and when a settlement agreement might be a reportable transaction.

Noteworthy Changes for Employers

In June 2023, the federal government amended the Income Tax Act (the “Act”) through Bill C-47. The Bill amended existing mandatory disclosure rules and added new ones. Today, any transaction that meets the updated definition of a “reportable transaction” must be reported to the CRA.

There are two elements for a “reportable transaction”: (1) there must be an “avoidance transaction”, and (2) the transaction must include one of the following: (a) contingent fees, (b) confidential protection, or (c) contractual protection.

Employment settlements often include a form of “contractual protection” through an indemnity clause. An indemnity clause can obligate the employee to indemnify the employer for certain tax liabilities as a result of the settlement.

A transaction is an “avoidance transaction” if, reasonably, one of the main purposes of the transaction is to obtain a tax benefit. The meaning of “tax benefit” is quite broad and includes any reduction, avoidance, or deferral of tax, an increase in a tax refund and the preservation or creation of a tax account for use at a later time.

An employment settlement could be a reportable transaction. This will depend on how the settlement money in the agreement is characterized and paid out, and if the agreement features a form of contractual protection, as noted above.

Who Must Report?

The reporting obligations apply to all persons who receive or expect to receive a tax benefit from the transaction. The obligations also apply to persons who enter into a transaction to provide such a tax benefit to another person, and include advisors regarding the transaction. Both employers and employees might, therefore, have reporting obligations.

For now, legal advisors are exempt from the disclosure requirements. On November 24, 2023, the Supreme Court of British Columbia, in the case of Federation of Law Societies of Canada v. Canada (Attorney General), granted a temporary injunction prohibiting the application of certain amendments to the Act requiring legal professionals to report confidential, and potentially privileged, client information to the CRA.

Recent CRA Guidance

On November 2, 2023, the CRA provided new guidance regarding the mandatory disclosure obligations with respect to employment settlements. On its website, the CRA set out that:

“The contractual protection hallmark will not apply in a normal commercial or investment context in which parties deal with each other at arm’s length and act prudently, knowledgeably and willingly, and does not extend contractual protection for a tax treatment in respect of an avoidance transaction. Without providing an exhaustive list of examples, these can include: […] Tax indemnities in employment agreements and severance agreements”.

It now seems that the CRA, generally, will not consider a standard tax indemnity in most employment and severance agreements as “contractual protection” so long as the employer and employee act conscientiously and deal at arm’s length in coming to agreement. Those agreements would, therefore, not be reportable transactions.

However, the CRA’s guidance does not guarantee that employment settlements are not reportable. CRA policy is not law, and the courts have yet to comment on the new legislation. The policy could also change at any time. Further, the circumstances behind a settlement and the particulars of said agreement may fall outside of the “normal” context. Not every settlement is a simple severance agreement.

Treatment of Payment Types in Settlements

Even if an indemnity clause in a settlement agreement does amount to “contractual protection”, most payment types will likely not be treated as tax avoidance.

Settlement money is not always payment for the employee’s lost wages. Settlement agreements might be structured to include amounts that are characterized as non-taxable general damages, as well as RRSP contributions and/or reimbursement of legal fees, which are also non-taxable.

RRSP contributions and reimbursement of legal fees are less likely to trigger a reporting obligation. These payments are unlikely to be considered a tax benefit or tax avoidance because these allocations do not actually change the tax characterization. However, there is still some risk given the broad definition of avoidance transactions.

The more significant risk with triggering the reporting mechanism comes with characterizing money in settlements as “general damages”. In Alberta, general damages may be awarded in cases involving discrimination. If an employer and employee reasonably believe a human rights tribunal could award general damages to the employee, they might agree to characterize part of the settlement money as general damages.

However, characterizing money as general damages when there is no reasonable basis to do so would likely be considered an avoidance transaction. Characterizing too much money as general damages when the case does not warrant such a total may also be an avoidance transaction. Ultimately, deliberately designating money as general damages will make it reportable if one of the main purposes is for the employee to obtain a tax benefit (assuming there is also contractual protection in the agreement).

Takeaways

When a tax indemnity clause is present, the allocation of money in settlement agreements should be reasonable. Settlement agreements that abuse allowable allocations, such as characterizing money as general damages where there is no reasonable basis for it or where the parties do not deal conscientiously and at arm’s length, may still be subject to the reportable transaction rules. However, the settlement agreement will not be reportable if it lacks one of the two elements described above.

Given the new guidance from the CRA regarding tax indemnities and the definition of avoidance transaction in the Act with respect to the different types of settlement payments, most employment settlements will likely not be caught by the new disclosure rules. However, if an employer is concerned that a draft settlement agreement contains an avoidance transaction and an indemnity clause amounting to contractual protection, it may choose to remove the indemnity altogether if the potential value is fairly minor.

This is an area we expect to see more developments over the coming year. Employers may wish to seek legal advice on whether their employment settlements will trigger a reporting obligation.

_{This post is meant to provide information only and is not intended to provide legal advice. Although every effort has been made to provide current and accurate information, changes to the law may cause the information in this post to be outdated.}