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Three tax tips for employers when settling disputes

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Given the majority of legal disputes that settle before going to trial, the role of a modern civil litigator has shifted from not only being a courtroom specialist, but also being an expert in negotiation. As Rubin Thomlinson LLP represents both employers and employees, we have somewhat of a unique perspective when it comes to negotiating settlements.

The main goal in almost all negotiations for an employee is to extract a large payout, while the goal for the employer is to settle the claim while paying out as little as possible. Though lawyers use different techniques for extracting these results for their clients, I wanted to share three simple tips that are often overlooked when employers are negotiating a settlement. Specifically,

  • Allocating a portion of the settlement to reimbursing the employee’s legal fees;
  • Obtaining an indemnity for the consequences of making improper CPP, EI and tax withholdings; and
  • Obtaining a statutory declaration and/or “Notice of Debt” regarding employment insurance.

Legal Fees

Employers are often more concerned with how much money they will be paying out of pocket than how those payments are allocated. However, in some circumstances, employers will take a principled approach and refuse to allocate any amount to legal fees even after the parties have agreed to a fixed amount for the settlement. Employers may choose to follow this approach with the hope of discouraging employees from seeking legal counsel upon dismissal.  However, this could cost the employer. Alternatively, settlement funds could be allocated to legal fees on condition that the employee agrees to keep the terms of the settlement confidential.

Employees are often encouraged by their counsel to allocate their settlement funds to their legal fees for the following reasons:

  • The payments are not taxed;
  • The payments have no CCP or EI deductions; and
  • The payments are not insurable income (i.e. it does not negatively impact an employee’s ability to receive employment insurance).

When employees pay legal fees, they are paying not only their lawyer’s hourly rate, but also HST on top of that. However, an employer receives input tax credits (i.e. a credit that can be used to offset outstanding HST remittance obligations, “ITCs”) when it pays HST on legal fees.

For example, consider when an employer agrees to allocate $5,000 towards an employee’s legal bill (inclusive of HST – i.e. $4,424 being legal fees and $576 being HST) as part of a settlement.  As a result, the employer will receive an ITC of $576 which can then be used to offset future HST payable. This means that while the employee receives $5,000, the employer’s net cash outlay is only $4,424.


In some cases, an employee will claim not only wrongful dismissal damages (i.e. income), but also an amount for general damages, which is often paid tax free and without CPP or EI deductions.  However, there is a risk that the Canada Revenue Agency will audit a settlement and determine that all or part of the general damages should have been categorized as income, requiring not only taxes to be paid, but also CPP and EI deductions/contributions to have been made by the employer.  As these audits can happen years after the settlement was entered into and long after all the payments were made, an employer could be hit with an unexpected liability on account of a failure to:

  • Withhold/deduct income tax, CPP and EI; or
  • Contribute to CPP/EI.

To mitigate this risk, the employer should insist that the employee provide an indemnity for any of the claims, interest or penalties arising from the failure to withhold or contribute the above-noted amounts. However, employers should be cognizant that in some circumstances, pursuing a claim under an indemnity may not always be cost effective (e.g. consider that an employer may not want to pursue a $1,000 claim against an employee).

Statutory Declaration and Notice of Debt

Between the time that an employee is dismissed and when their claim is settled, they have often received employment insurance payments. However, if the employee then receives a payment on account of a period during which they received employment insurance payments, both the employee and the employer become liable to repay the employment insurance overpayment.

Accordingly, an employer should:

  • Insist on a statutory declaration from the employee confirming they have not received employment insurance payments since the time of their dismissal; or
  • If the employee confirms that they have received employment insurance payments, the employer should ask them for a record of all payments and withhold the gross amount until the exact employment insurance overpayment is confirmed through a “Notice of Debt” from Employment and Social Development Canada.

Key Takeaways

In short, in all settlements, regardless of the issues at play in the dispute, employers should consider the following:

  1. Allocating settlement funds to legal fees and insist the employee agrees to keep the terms of the settlement confidential.
  2. Obtaining an indemnity from the employee for the consequences of any failure to withhold CPP, EI or tax or contribute to EI or CPP.
  3. Obtaining a statutory declaration confirming that the employee has not received employment insurance payments. If they have received employment insurance, withhold the gross amounts received until the exact overpayment is confirmed through a “Notice of Debt” from Employment and Social Development Canada.

David Witkowski

About the Author: Toronto employment lawyer David Witkowski supports both employee and employer clients with legal counsel in all areas of employment law, including employment contracts, wrongful dismissals, workplace policies, employment standards, workplace investigations and human rights in the workplace.