Income Tax & Your Settlement Agreement: 7 Things to Consider

No matter what kind of employment problem you are facing—e.g. a claim for wrongful dismissal, constructive dismissal, or a human rights complaint—you may ultimately decide to settle your case for some form of compensation, rather than proceeding to a hearing. In that case, it is worth taking the time to think about the best way to structure your settlement agreement because different kinds of agreements and different kinds of compensation can lead to a wide range of tax consequences.

Seven key considerations in structuring a settlement agreement:

  1. Compensation for lost income is fully taxable under the Income Tax Act because it is treated like any other employment income.
  2. Compensation for the loss of employment, such as severance pay or reasonable notice (see: What is reasonable notice? ), is also fully taxable under the Income Tax Act. Unless certain limited exceptions apply, these kinds of compensation are considered “retiring allowances” under the Income Tax Act.
  3. If part of your employment with your employer took place prior to 1996, you can roll a portion of a retiring allowance payment into an RRSP. The roll-over is tax-free, and you do not need existing room in your RRSP to roll-over eligible amounts. Similar rules exist for any part of your employment that took place prior to 1989.
  4. Compensation for damages, such as for mental distress or pain and suffering, are not subject to tax. Damages must be reasonable, however, and there must be some proof to support the claim for damages. The claim for damages also has to be independent from the loss of employment. If the mental distress was caused by the loss of employment, then any damages for mental distress will be considered part of employment income or a retiring allowance and will be taxable.
  5.  Damages for human rights violations are also non-taxable. Like damages for mental distress, they must be reasonable and similar to what a human rights tribunal might award. Be especially careful because, in some jurisdictions, legislation puts a maximum cap on damages for human rights in a tribunal’s award. In those cases, the amount characterized as human rights damages in the settlement agreement cannot go over the cap.
  6.  Compensation for counselling services is not subject to tax. “Counselling services” have been defined to include job placement, re-employment, and retirement counselling services.
  7.  Compensation for legal fees is deductible for employees. Where the payment is made directly from the employer to the employee’s legal adviser, this amount is non-taxable.


Both employees and employers need to take time to consider the structure of the settlement agreement and how to characterize any compensation changing hands. While the parties can reach agreements that maximize the benefits of the settlement for both sides, any settlement must be reasonable and grounded in the facts of the case. An unreasonable settlement agreement may be reviewed by the Canada Revenue Agency. For help determining the best structure of your settlement agreement, you should seek advice from an employment lawyer.

We are here to help: Consult one of our experienced employment lawyers at Raven, Cameron, Ballantyne and Yazbeck LLP to assist you in developing or reviewing a settlement agreement for your employment claim. 

[This article is for informational purposes only and does not constitute legal advice, which cannot be given without consideration of your individual circumstances.]




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