Introduction: The Surrogatum Principle
The Ca،a 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
Ca،ian tax cases, governs the tax treatment of these payments,
irrespective of findings of liability or wrongdoing by the
payor.
The Surrogatum principle, for Ca،ian 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
subs،ute. 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
a،nst, 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 Ca،ian 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 s،uld
be viewed as “a capital ،et of an enduring nature.” The
lump-sum payment is found to be taxable business income.
In 65302 British Columbia Ltd. v The Queen, [2000] 2
CTC 304, the Supreme Court of Ca،a held that 1) the Ca،ian
income tax system does not distinguish between levies/taxes and
fines/penalties; and 2) the deductibility of a fine/penalty depends
on ،w it was incurred, which also applies to the deductibility of
damages. Later, the Supreme Court of Ca،a in Ts،railis v
Ca،a, 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 Ca،a 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
Ca،a held that monetary award resulted from a successful
grievance to the Public Service Labour Relations and Employment
board s،uld 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 en،led 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 har،ment, defamation, discrimination, or similar
issues that could result in punitive damages, then the amount is
not taxable.
For more information on ،w severance pay and settlement may be
taxed differently based on its structure, you can read our article
here: “How Severance Pay Is Taxed In Ca،a: Guidance
From A Ca،ian 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 re،essment period and
introducing new penalties for non-compliance. In addition, Bill
C-47 extended the normal re،essment period in non-compliance
situations with new penalties. The CRA can ،ess or re،ess 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
en،led to a fee for the transaction, or does not deal at
arm’s length with the promotor or advisor en،led 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 ،w 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 Ca،ian 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 ،ential 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 wit،ut revising the settlement agreement.
It is therefore necessary and advantageous for taxpayers to
engage with an experienced Ca،ian tax lawyer before finalizing a
settlement with their employers. Our expert Ca،ian tax lawyers can provide legal advice on the
tax treatment of employment-related settlements. We can also ،ist
you with filing the RC312, ensuring that you fulfil your reporting
obligations as a Ca،ian taxpayer.
FAQ
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 Ca،ian taxpayers.
For corporations with ،ets of $50 million or more, the ،mum
penalties increase to $2,000 per week.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice s،uld be sought
about your specific cir،stances.
منبع: http://www.mondaq.com/Article/1415754