The issue of how damages due to termination of employment are treated for tax issues is somewhat complex and important to understand.
The Default Setting
Generally speaking, a claim for lost income for the “notice period” and also payment of the minimum statutory sums will lead to two conclusions. The first is that the payment will lead to taxable income to the employee. The second is that the employer must deduct tax at source upon this payment, generally in Ontario at 30%.
A sum paid by the company towards the employee’s costs will not be taxable, nor will tax be required to be withheld tax on this amount. As this sum is usually not payment of the entire legal bill of the employee, they will be able to deduct the residual sum as an expense against the taxable severance.
Curiously, should the employee’s case lose, the costs paid by the employee, whether to their own legal counsel or that of the company, will not be deductible against other income.
Should an otherwise taxable severance payment be agreed to be paid, the employee may direct that this sum be paid to their RRSP or TSA account to the extent that there is unused room. In that event, there is no tax withheld upon the payment to such account.
All this being said, there are nonetheless certain claims which, when made in good faith, may result in payments which are non-taxable.
Unfair Employer Conduct
When a case has been made out for “aggravated damages” due to unfair conduct of the company, this sum will likely not be taxed nor subject to tax at source. The same result will apply to punitive damages, an exceptional award designed to punish the wrongdoer for malicious conduct.
Human Rights Violations
Claims for violations of human rights which are employment related may also give rise to certain sums which are likely non-taxable. 
Human rights cases can lead to three forms of monetary payments. These may include (1) damages for personal suffering and humiliation, (2) a claim for lost income from the date of termination forward to the date of settlement or hearing, and (3) in certain cases, damages for a future income loss where reinstatement is not ordered.
The damage award or settlement for damages for personal suffering and a future income loss are both likely non-taxable but the claim for lost income is taxable. In addition, the onus rests upon the taxpayer to show that the settlement of the non-taxable sum was a “claim as existing apart from the loss of employment” in each case.
Where the employer has provided disability insurance as an employment term and a successful claim has been made against the employer or the disability insurer for lost disability, this situation again raises tax issues.
A claim for past disability sums due will be taxable, whereas a claim for a future loss of disability sums will be non-taxable.
Employment Termination Prior to Start Date
In the rare situation where employment has been offered and accepted, yet this agreement has been terminated before the actual commencement date, the resulting payment for the lost employment opportunity will be non-taxable income.
Underlying Good Faith
All of the above non-taxable situations require an underpinning of good faith. Claims cannot be invented strictly to improve upon tax consequences.
Gross-up for Tax
In certain situations, a court may award an incremental sum to compensate for additional tax which is payable because the damage sum was obtained by court order. One example is a claim for the loss of the profit on a company’s share plan which normally would be taxed at the lower capital gains rate but has been taxed at the normal rate of tax as it was acquired by a lawsuit.
Setting Out the Deal
Typically, legal counsel will set out the terms of settlement by an agreement which designates the total sum to be paid and further allocate this amount to various headings, as may be appropriate. This agreement will likely define that no tax will be withheld on any sums to be paid as non-taxable and further may state that no T-4 or T-4A will be issued with respect to this particular damage amounts.
Even if all of the above has been completed meticulously, there is no impediment to Revenue Canada reviewing the transaction to confirm that the non-taxable sums have been bargained in good faith and not based on inventive tax planning. Revenue Canada may not only re-assess the claims but also impose penalties where it believes that the claims are fictitious. In such an event, the responsibility for the tax payable is that of the employee.
Tax Can be Taxing
Employers need to be careful to be sure that tax is deducted at source when required to do so. Companies should not allow fictitious claims to result in settlement of sums which are unfairly labeled for tax purposes.
Employees are obviously tempted to seek damage allocations to their favour for obvious reasons. When acting in good faith, they may be able to reduce their tax burden and even the EI repayment sum.
Let Legal Advice Guide Your Actions
Whether you be employer or employee, it is important to know the complexities of the law on this important subject. For advice on this issue from either side, contact the offices of Toronto employment lawyers Grosman Gale Fletcher Hopkins. We regularly advise workplace parties on a wide range of legal workplace issues. Contact us online or by phone at 416 364 9599 to schedule a consultation.
 in Fawkes v R.,  5 CTC 2430 at paragraph 24., which dealt with an assertion that the severance sum paid was higher than that which would be normally expected in view of the alleged human rights violation asserting reinstatement and “ambiguous additional damages”.
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