When an employee is dismissed from their employment without cause, they are entitled to reasonable notice or pay in lieu of notice. In some circumstances, the reasonable period of notice awarded can range as high as 24 months (and in some provinces even higher in special circumstances). If a dismissed employee is paid for two years worth of compensation all in one lump sum, and therefore in a single tax year, then their tax burden will be substantially higher than it would have been if that employee had worked for those two years (since their compensation would have been paid gradually over two tax years). Through no fault of their own, a dismissed employee is therefore effectively compensated less if they are given pay in lieu of notice rather than working notice because their tax burden is significantly higher. Who, then, is responsible for the additional tax burden the employee will bear?

Early Case Law – Fixation on Inapplicable Prior Law

Generally, Courts have held that the impact of income tax on damages awards should not affect damages in wrongful dismissal cases:

In dealing with this question, it is important to recognize that the action is one for damages for wrongful dismissal. There has, in effect, been a breach by the employer of the contract of employment. The employee may accept that repudiation and sue for damages. In R. v. Jennings, [1966] S.C.R. 532, 57 D.L.R. (2d) 644 [Ont.], the Supreme Court of Canada held that it was inappropriate to take account of the incidence of income tax on an award of damages for loss of earning capacity. In Harte v. Amfab Prod. Ltd. (1970), 73 W.W.R. 561(B.C.), Mr. Justice Ruttan applied the reasoning in R. v. Jennings, supra, in a case where damages for wrongful dismissal were sought.
For those reasons, I would reject the plaintiff’s submissions on the third issue.[1]

The decision in Harte, cited in the quotation above, relied on the decision of the Supreme Court of Canada [SCC] decision in Jennings that found that an injured individual’s damages should not be reduced by virtue of the fact that those damages were exempt from taxation. The insurance company in Jennings had tried to argue that since the damages they were to pay to the plaintiff were non-taxable, they should only have to pay the gross amount less the tax that would normally apply if taxes were actually applied to the damages award. The tax exemption, it was argued, resulted in the insurance company over-compensating the injured party. The SCC rejected this argument on the grounds that the government’s tax policy should not result in the defendant gaining a benefit.[2] The Court in Harte then held that the same should also apply in wrongful dismissal cases. That is, an employer who wrongfully dismisses an employee should not be allowed to pay the damages amount less taxes to the dismissed employee, the employer must pay the gross amount. The case law relied on by the Court in Harte specifically stated that the defendant should not be able to benefit from a consequence of tax policy.

In Antonacci, the Court dealt with the employer’s argument that because Workers’ Compensation Benefits (WCB) received during the notice period were deductible from the damages awarded for the dismissal, those WCB payments should be grossed up to account for the taxes that had been removed when paid to the employee (thereby increasing the deductions made to the damages award in favour of the employer). If the WCB payments to be deducted from the damages award were not grossed up, the employer argued, then the employee would be overcompensated. Both the trial judge and the appellate court rejected the employer’s argument and held that:

[19] The trial judge rejected A & P’s argument on the basis that the tax treatment of Workers’ Compensation Benefits rests on a tax policy of the federal government and any resulting benefit to the employee cannot be claimed by the employer. The matter is best left to the legislature.

[20] I agree with the trial judge’s conclusion. The result is consistent with the general approach adopted in personal injury cases whereby damages for loss of income are calculated on the basis of the before-tax income lost: Jennings v. Cronsberry (1966), 57 D.L.R. (2d) 644(S.C.C.). Much the same reasoning applies here.

[21] Damages should restore Mr. Antonacci to the position in which he would have stood but for A & P’s wrongdoing. However, what Mr. Antonacci would have done, or would have been required to do, with the employment income he would have received from A & P, in so far as A & P is concerned, is irrelevant. The “loss” resulting from any resulting overcompensation is to Revenue Canada, not to the employer. The rule against double recovery is not absolute. It admits of certain exceptions, particularly where there are competing policy considerations. In a case such as this one, it would be against public policy to make it more profitable for the employer to pay damages for the breach of contract than to perform the contract. Further, to require an assessment of the plaintiff’s liability to pay tax in every case where deductions are made from a damage award would give rise to considerable practical difficulties that would result in an unwarranted increase in the cost of litigation. Indeed, as the trial judge concluded, the tax treatment of Workers’ Compensation Benefits and any resulting benefit to the recipient is a question better left to the legislature.[3]

The cases discussed thus far, therefore, had essentially held that the party causing the harm was not entitled to gain a benefit from their wrongdoing by reducing the damages award, but they provide no comment on whether the employee should have the damages award increased due to the additional tax burden.

In Peet, however, the Court of Appeal for Ontario dealt with a situation in which the employee was terminated, elected early retirement under the employer’s pension plan, and sued for loss of pension benefits, requesting the difference he received under early retirement versus what he would have received if he retired at the end of the notice period. The Court of Appeal in Peet held that courts should not treat pensions differently from awards for loss of salary with regard to tax implications in wrongful dismissal cases:

The function of the court is simply to determine the commuted value of the pension loss and then to award a corresponding lump sum in damages. If the respondent wants to use the damages award to purchase an annuity, he is entitled to do so. However, the court is not entitled, for tax purposes, to treat a pension loss award any differently from an award for loss of salary… The amounts received under the proposed annuity should be taxable in the hands of the annuitant, as would be the amounts received under the pension plan which it is intended to supplement.[4]

The court in Peet relied on the SCC decision in Red Deer College to state that an employee is only entitled to be put in as good of a position as s/he would have been in had there been proper notice.[5] Because it is helpful to quote, the SCC in Red Deer College specifically stated, when discussing the duty to mitigate:

The primary rule in breach of contract cases, that a wronged plaintiff is entitled to be put in as good a position as he would have been in if there had been proper performance by the defendant, is subject to the qualification that the defendant cannot be called upon to pay for avoidable losses which would result in an increase in the quantum of damages payable to the plaintiff.[6]

The comment in Red Deer College that the employee is entitled to be put in as good of a position as if there had been proper notice is a reframing of the classic test in Hadley v Baxendale and becomes an important part of this author’s argument later on. Further, Red Deer College only addressed the plaintiff’s avoidable losses. Surely, income tax is not an “avoidable” loss in the sense contemplated in Red Deer College.

Modern Case Law – A Return to Fundamentals

Rejecting the application of taxation to dismissal cases entirely can produce significant problems with the quantification of awards. If reasonable notice is found to be 24 months, then all financial gains from that employment, if working notice was provided, would have been received gradually over that 24-month period. This distributes the tax burden across at least 2 years (depending on the timing of the notice of dismissal). If notice is not given, pay in lieu of notice is required. Payment in lieu of notice provides the entirety of damages for that 24-month period in one lump sum all in one tax year. Because of this, an incredible tax burden is imposed upon the dismissed party which would not have been imposed had they been given working notice. As is standard in contract law, it is the breaching party that bears the costs of its breach. The Ontario Court of Appeal has recently summarized this concept:

The basic principle in awarding damages for wrongful dismissal is that the terminated employee is entitled to compensation for all losses arising from the employer’s breach of contract in failing to give proper notice. The damages award should place the employee in the same financial position he or she would have been in had such notice been given: Sylvester v. British Columbia, [1997] 2 S.C.R. 315(S.C.C.), at para. 1.[7]

If the increased tax burden on the employee is not considered, the employee will end up with less money than they would otherwise have received due to the increased tax burden. Indeed, excepting situations with substantial mitigation, some employees that are granted 24 months of notice in a lump sum would approach, or exceed, the top tax bracket with their award when they may never have been taxed at that top bracket but for that lump sum payment occurring in a single tax year. Therefore, a fairly substantial cost of dismissal in such situations would be borne by the dismissed party, which is contrary to fundamental principles of contract law (namely, the Hadley v Baxendale principal). The law now appears to be shifting to address such an issue.

The general trend of courts refusing to account for the implications of taxation was altered in obiter in a decision of the Court of Appeal for Ontario in Dowling, when that Court stated that a gross up was acceptable when used to counteract the adverse tax consequences of a lump sum award. The Court in Dowling specifically identifies its decision in Peet and distinguishes from it:

The trial judge was alive to the jurisprudence of this court expressing doubt about the propriety of grossing-up pension awards. However, after referring to the relevant passages in Peet v. Babcock & Wilcox Industries Ltd. (2001), 53 O.R. (3d) 321 (Ont. C.A.), he rejected the notion that the disputed sum was a “gross-up”. He recognized the adverse tax consequences that would result from Mr. Dowling’s receipt of the damage award as a lump sum and, in my view, correctly included a “gross-up” to offset the additional tax liability occasioned by receipt of the funds all at once, as opposed to over time. To fail to take into account the adverse tax consequences occasioned by a change in the timing of their receipt would be to restrict a person from realizing the full benefit of the damages awarded in a wrongful dismissal case.

The Board’s reliance on principles underlying the gross-up of future pecuniary losses in personal injury actions is misplaced, in my view, as it fails to recognize the important distinction between the income tax treatment of personal injury awards, being non-taxable on receipt, and damages resulting from a wrongful dismissal action which are subject to taxation when received.

Consequently, I see no reason to interfere with the trial judge’s acceptance of the actuarial evidence that he found to be the most reasonable and that made appropriate allowance for tax consequences. [Emphasis added].[8]

The Ontario Court of Appeal’s above comments were essentially a rephrasing of the finding of the trial judge and they agreed with the trial judge’s rationale. Unfortunately, the Court of Appeal did overturn the trial judge’s decision on appeal on the grounds that the employer did have just cause to dismiss the employee, thereby making the Court of Appeal’s agreement with the trial judge on the tax gross up issue obiter.

Dowling has since been cited, with respect to the tax gross up issue, in a 2018 decision by the Court of Appeal for New Brunswick [NBCA] called Schram. The NBCA in Schram supported the idea that there ought to be compensation for the tax related losses of employees in dismissal cases where lump sum awards are granted. The NBCA stated that there is “widespread recognition of the validity of such claims by courts and non-judicial tribunals” and goes on to cite 12 such decisions and a text involving “an interesting discussion of the situation in Australia”.[9] The Court’s only issue on appeal in Schram was with regard to compensation for income tax consequences of the damages award to which the employee was entitled. The Court in Schram relied on the oft-cited rule in Hadley v Baxendale to find that the additional tax consequences were in the reasonable contemplation of both parties and that the additional tax consequences were sustained due to a lump sum payment of damages by reason of the employer’s breach of contract.[10] The Court states:

[O]ne can readily assume Nunavut was aware a heavier tax burden would result from the payment of damages by way of lump sums for the loss of benefits it originally expected would accrue over multiple taxation years.[11]

To put this another way, the NBCA in Schram recognized that the lump sum payment of all the damages resulting from the employee’s wrongful dismissal, including, inter alia, wages, allowance payments, bonuses, CPP contributions, overtime, group insurance benefits, and pension, resulted in a greater tax burden than if the employee had worked over the notice period and received the value of all these damages incrementally, as she would have while employed. Core to the Court’s reasoning was the rule in Hadley v Baxendale that “damages for breach of contract should, as far as money can do it, place the plaintiff in the same position as if the contract had been performed”.[12]

Schram has since been cited in support of a finding by the Superior Court of Ontario that an employee was entitled to a gross-up for tax purposes on the grounds that “he held the majority of his shares in an RRSP account and that there were going to be tax consequences given that the award of damages will be taxed differently than those shares”.[13] For context, this gross up award was related to the fact that he was losing his share bonus pursuant to a Shareholders’ Agreement due to his dismissal. On a fundamental level, the Superior Court of Ontario was applying the same rationale as the NBCA in Schram: that additional tax consequences only incurred due to the defendant’s breach are compensable.

Further, the Ontario Grievance Settlement Board has ruled in a similar fashion to Schram in that a grievor who was reinstated after a two year period, and was to receive back pay, endured an additional tax burden as a result of receiving his lump sum damages award and thus he was entitled to a gross up so that “the net amount [would be] sufficient to compensate him for the aforementioned tax differential”.[14]

While earlier cases held that courts should not adjust damages awards to account for taxation, those cases rely on previous law discussing personal injury damages rather than wrongful dismissal (and therefore contractual) damages. Further, the earlier decisions that denied tax adjustments to damages awards for wrongful dismissal primarily dealt with employers trying to pay less money, not employees seeking an amount of damages equal to what they would have received if they were given working notice, rather than pay in lieu of notice. These earlier decisions appear content to lean on a loose application of past law rather than engaging in a more thorough analysis as was done in Dowling and Schram. The objective as per Hadley v Baxendale is to put the individual in the same position they would have been in had the employer not breached the contract and courts should always go back to this core rule when assessing damages awards for breaches of contract.

Closing

It is yet unclear how courts across the country will address tax gross ups in dismissal cases due to the limited amount of grappling courts have done with the topic thus far. The reasoning in Schram is sound, though, and accords with the prime axiom of breach of contract cases found in Hadley v Baxendale. This topic is ripe for argument in the right cases and I expect we will see more lawyers on the employee side pushing for such gross ups in the future. Employers and employees alike should be aware of these developments so that they can be prepared to respond to this novel approach.