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No agreement on the tax treatment of funds may mean there is no settlement agreement

When negotiating a settlement, many employers (and employees) may not realize that, even if both parties have agreed on the same general number, they may not have actually agreed on the same settlement amount if the parties have different understandings about how the settlement should be taxed.

The failure for parties to agree on how the settlement funds will be taxed may mean that no settlement was actually reached. This was demonstrated in the British Columbia case of Brink v Xos Sevices (Canada) Inc., 2025 BCSC 658 (“Brink”).

Background

In Brink, both parties agreed on a settlement amount of $441,667 USD. However, in their email communications, the company proposed that such amount was to be “less applicable deductions” whereas the employee’s counsel responded that such amount should be paid as income without employment deductions. The company never agreed to pay the amount without deductions, with the company’s counsel only responding that they were confirming payment details with the company and would be preparing a draft release.

No formal minutes of settlement and release were entered into, and no payment of settlement funds was made.

The employee (i.e., the plaintiff) commenced a legal action, taking the position that a binding settlement had been reached. The Court identified that the issue to be determined was whether the above email exchange constituted a binding settlement agreement.

The employee took the position that a settlement had been reached, and the issue of the release and the method of payment would go to the performance of the agreement rather than being an essential element or condition being negotiated as part of the agreement.

The company took the position that the employee’s response requesting that the settlement funds be paid without source deductions was a counter-offer, where the requirement for the funds to be paid in a tax effective manner was a new essential term of the settlement, and thus the employee’s response had not been an acceptance of the company’s settlement offer. The defendant noted that paying the settlement funds without deductions would expose them to liability for the misclassification of the payment and for the failure to make source deductions.

The Court’s decision

The Court determined that there had been no binding settlement agreement.

The judge noted that the tax treatment of the settlement funds was a “condition of fundamental importance to both parties.” Whether or not the settlement amount was subject to source deductions would result in a difference of $143,300, which was a significant gap that could not be overlooked.

Tax treatments in wrongful dismissal settlements

The following are some common tax treatments that may arise in a wrongful dismissal settlement:

Termination pay or pay in lieu of notice: Any amount that an employee receives as pay in lieu of notice (i.e., “termination pay”) is considered “employment income” for the purposes of taxes and source deductions. That means normal employment income deductions such as taxes, EI, CPP, and other typical deductions will apply.

Direct RRSP contribution: If the departing employee has contribution room available in their RRSP, the employer may permit the employee to direct some of the termination pay directly to the employee’s RRSP account. The amount being directed cannot exceed the employee’s available contribution room, and the employee must be able to show that they have at least that much room available (usually by providing the most recent notice of assessment). No source deductions are taken from the amount that is being directly deposited into the RRSP account.

Lump-sum retiring allowance: If the termination pay is being paid as a lump-sum, it may be possible for the amount to be characterized as a lump-sum retiring allowance, where instead of the typical source deductions, a flat withholding rate would be applied. If the lump-sum is for $5,000 or less, the applicable withholding rate would be 10 per cent; if it is between $5,000 and $15,000, the rate would be 20 per cent; and if it is over $15,000, the rate would be 30 per cent. To note, these lump-sum withholding rates are slightly different if the employee is located in Quebec.

Legal fees: It may be possible to allocate a portion of the settlement funds as legal fees (i.e., a reimbursement of some or all of the legal fees an employee has incurred in connection to the matter), which would not be employment income and therefore would not be subject to source deductions. The employee’s legal counsel will likely be required to produce documentation confirming that the employee has incurred at least the amount being allocated as legal fees.

General damages: Where there has been a reasonable claim for a human rights violation, or for bad faith conduct that would give rise to other tax-free damages, a reasonable portion of the settlement funds may be allocated as general damages. General damages are not considered employment income and therefore are not subject to employment source deductions or income tax. If an amount is being allocated as general damages, employers should ensure that the settlement documents and/or release contain a provision whereby the employee will indemnify the employer if the Canada Revenue Agency (CRA) disagrees with the allocation to general damages.

Lessons for employers

It is important for employers to always keep in mind that agreement on how the settlement funds will be taxed is just as important as agreeing to the amount of settlement funds.

Similarly, it can be useful for employers to be aware of various tax treatments, and the associated risks and limitations, such that offering various tax treatments can be incorporated into settlement negotiations.

Importantly, make sure that the terms of the settlement, including the tax treatment, are put in writing and that there are solid grounds for any favourable tax treatment (e.g., allocation as general damages) to limit liability to the CRA.

John Hyde is the managing partner at Hyde HR Law in Toronto. He advises management on all aspects of employment and labour law, including representation before administrative tribunals, collective agreement negotiation, arbitrations, wrongful dismissal defence and human rights.