CRA provides clarity for employers on mandatory disclosure

On November 2 the Canada Revenue Agency (CRA) updated its online guidance regarding new mandatory disclosure obligations under the Income Tax Act (Canada). The welcomed message for employers is that, in most cases, employment agreements and severance agreements will not be reportable to the CRA.

The reporting obligation

In June of this year the reportable transaction rules in the Income Tax Act were amended to expand the scope of transactions that taxpayers and, in certain circumstances, their advisors, including lawyers, may be required to disclose to the CRA. The consequences of failing to report are significant.  As a result, this potential obligation is one which all taxpayers, including employers, must not take lightly.

In technical terms, a reportable transaction arises where one of the main purposes of a transaction or series of transactions is to obtain a tax benefit (an avoidance transaction) and the transaction has one of three legislated hallmarks – a contingent fee arrangement, confidential protection or contractual protection (such as an indemnity). 

For employers and their advisors, confusion arose given the lack of certainty whether arrangements entered into with employees or former employees were captured by the scope of the reportable transaction rules.

In particular, settlement agreements with employees often provide for payments that are structured in a tax efficient manner. This can include direct RRSP contributions or legal fee reimbursements, treating of all or a portion of a settlement payment as a retiring allowance, payment timing (e.g. deferred payments) and allocations to non-taxable damages. An allocation to non-taxable damages might arise, for example, where there are allegations of harassment, discrimination, or bad faith conduct. These settlement agreements also often include an indemnity obligating the employee to indemnify the employer for certain tax liabilities of the employer as a result of the settlement.

In short, an employee settlement agreement could have been viewed as having the necessary elements for a reportable transaction – a tax benefit and a contractual protection in the form of an indemnity.

New CRA guidance

The updated guidance issued by CRA on November 2 included, among other things, additional examples of activities that would generally not, in and of themselves, be considered by the CRA as meeting a legislative hallmark.  In the context of the “contractual protection” hallmark, the CRA guidance included the following statement:

“The contractual protection hallmark will not apply in a normal commercial or investment context in which parties deal with each other at arm's length and act prudently, knowledgeably and willingly, and does not extend contractual protection for a tax treatment in respect of an avoidance transaction. Without providing an exhaustive list of examples, these can include: …

Tax indemnities in employment agreements and severance agreements.”

In other words, the CRA will not generally consider a tax indemnity in most employee settlement agreements as contractual protection where those settlements make common, reasonable allocations and the employer and employee deal at arm’s length. As a result, the updated CRA guidance should eliminate the uncertainty around mandatory reporting for most employee settlements.

That said, settlements that are abusive of allowable allocations (e.g. damages allocations where there is no reasonable factual basis for settlement on that basis), or where the parties do not deal at arm’s length, may still be subject to the reportable transaction rules.