Canadian Human Rights Tribunal Settlement Overview of Gross-up Methodology February 27, 2014 Updated April 28, 2014

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1 Canadian Human Rights Tribunal Settlement Overview of Gross-up Methodology February 27, 2014 Updated April 28, 2014 Background Under the terms of a Canadian Human Rights Tribunal settlement, individuals were paid $16,500 a year (or a pro-rated amount for a partial year) for Eligible Work for the period from December 1, 1999 to September 30, 2011 inclusive. Human Resources and Skills Development Canada (HRSDC) calculated the entitlement for each individual. As part of the settlement, all individuals receiving retroactive wage payments will receive an additional amount (a grossed up differential, or gross-up ) to achieve tax neutrality. Specifically, the gross-up is to be sufficient to compensate for any additional tax liability that might arise from the retroactive wage payments. A tax gross up is paid to individuals who received a payment under article 2.1 of the settlement ($ per year) to compensate for additional tax liability due to the payment being done in one particular year instead of being paid in the appropriate years. McLarty & Co Professional Corporation was tasked to develop a methodology to be used to determine the gross-up, if any, of additional compensation that should be paid to individuals who have received retroactive wage payments as a result of the settlement. As it was not feasible to prepare individual computations for each affected individual, certain assumptions were made so that on average the treatment was fair and equitable, in the spirit of the settlement. To assist individuals in understanding how the tax grossup was calculated, the assumptions and the methodology that was used, we provide the following questions and answers. Model Structure and Assumptions: Methodology Q: Can you explain the methodology used to calculate the grossup?

2 A: The methodology was built to calculate how much tax was paid on the lump sum received in 2013 and compare that to how much tax would have been paid had the individuals received the $16,500 in each of the earlier applicable years. We called this the differential. Since the differential was considered taxable, we needed to gross that up for income tax. The net payment we call the grossed up differential. As more than 800 individuals received retroactive wage loss payments under the settlement, it was not practical to obtain the precise information needed for each individual to compute an exact gross up. Therefore, it was necessary to consider what information could be obtained in order to compute an amount that would be fair and equitable on average. We were to obtain some specific information, such as the start and end date of the eligibility period and the actual lump sum payments made. We were also provided with the current province of residency. Using this specific information, we could then take more general information, such as pay levels for the population, and create a methodology that would give a reasonable approximation of each individual s employment income throughout the eligibility period. We were provided with the pay levels for the relevant period ( ) for each of the levels in the positions PM-3 and PM-4. We used a linear progression model to determine what pay level would apply to each individual for each of the relevant years. We then calculated the income tax that would apply to the employment income earned in each year and compared it to what the income tax would have been if we added the lump sum amount for that year to that income. This allowed us to then isolate the income tax that would have applied to the lump sum if it had been received in each of the relevant years. We then looked at 2013, the year in which the lump sums were actually received. Using the same analysis, we isolated the income tax that applied just to the lump sum amount, assuming the only other income in that year was the employment income. We compared that incremental tax in 2013 to the combined incremental tax we had calculated above, which would have been paid if the additional compensation had been paid out in the earlier years. That differential was then grossed up. We grossed it up so that the individual received the net amount after tax of the full differential. We used the 2014 income tax rates to gross the differential up, since these payments (the grossed up differential) are to be paid in General assumption on what was included in income Q: Will I be able to recalculate the grossup if I look at my past tax returns for all affected years? A: No. The computation for each individual is not specific to his or her own individual facts. For example, the methodology did not factor in personal credits, personal income A Correspondent Firm of MacKay LLP

3 such as investment income or other deductions, such as RRSP contributions or RPP contributions. Inflation was not considered, except to the extent salaries increased based on actual increments, and pension indexing was applied. The only income used in the calculation, for the eligibility period, was employment income. Q: Why not calculate the grossup specific to each individual? A: Each individual's tax circumstances are different - taking into account their employment income, other income, family circumstances, etc. That is why we have developed a methodology that approximates key variables related to the lump sum payment as well as province of residence where the tax will be applied. Linear Progression Q: How was the linear progression calculated? A: In order to build in the pay levels for each individual for each of the relevant years, a linear progression model was used. We were provided with the average career progression for employees in those positions. On average it would take an employee three years to move up to the highest pay level in a position. The population was broken down into three subgroups those that were hired before 2005, those hired between Jan 1, 2005 and June 21, 2006, and those hired after June 21, We did this since there was a significant shift in levels that occurred in For those hired before June 21, 2006, it was assumed they were hired as a PM-3 level 1, and for those hired after June 21, 2006, it was assumed they were hired as a PM-4 level 1. The following chart illustrates how the linear career progression was then applied: Year 1 year 2 year /21/ / year / year 2 year 3+ hired before 1/1/2005 hired 1/1/2005-6/21/2006 Hired after 6/21/2006 (in this example 2007 would be Year 1) PM3-1 PM3-2 PM3-3 PM3-3 PM4-2 PM4-2 PM4-3 PM4-3 PM3-1 PM4-1 PM4-2 PM4-3 PM4-3 PM4-1 PM4-2 PM4-3

4 If someone was hired prior to 2005, it was assumed they were hired as a PM-3 level 1. The next year they moved to level 2, and the following year to PM-3 level 3 where they remained until June 21, 2006 when they were converted to a PM-4 level 2. They remained there for 2 years, before moving to PM-4, level 3 and remained there for the balance of the time. If someone was hired in 2005 it was assumed they were hired as a PM-3 level 1. In 2006 they were converted to a PM-4 level 1 where they remained for 1 year, the following year to a PM-4 level 2, and the following year they moved to a PM-4 level 3 where they remained. If someone was hired after June 21, 2006, it was assumed they were hired as a PM-4, level 1. The following year they moved to a PM-4 level 2, and the following year to a PM-4 level 3 where they remained. We were provided with the eligibility period for each individual. It was assumed that the individual s start of employment coincided with the start of the eligibility period. For all years in the relevant period, the methodology assumed that regardless of where the eligibility start or end date fell, a full year of employment income would have been earned. It was assumed that the individual would have had employment elsewhere and the applicable marginal tax rate for that year would have been consistent with that of the pay level they were in. For example, if the eligibility start date was June 20, 2001, a full year of PM-3 level 1 income was used to calculate the base level of income tax for the 2001 year. This assumed the individual would have worked elsewhere earning a comparable level of employment income prior to this. Average annual pay raises post 2011 Q: How did you calculate income after 2011 and why did you do this? A: We were provided with the pay levels for the eligible period, which ended in Since the actual payments were made in 2013, the methodology needed an employment income figure to use as the base income for It was reasonable to assume that individuals would have received annual pay increase. Therefore, we were provided with the average annual increase over the period. The income levels for 2012, 2013 and 2014 were based on the last salary amount in the model and subject to a 1.24% average annual pay increase. A Correspondent Firm of MacKay LLP

5 Province of Residency Q: Why was my current (2013) province of residence used to calculate the tax gross-up if I worked in different provinces during the relevant period? A: The tax gross-up was based on your current (2013) province of residence since the 2013 tax rate has the greatest impact on the computation was the year you received the lump sum amount and would be the one with the largest income. If you no longer live in Canada, then your last known province of residence was used. If you received your payment in 2014, your province of residence in 2014 will be used. Tax treatment Q: Will I have to pay income tax on the differential? A: Yes, the grossed up differential, is considered to be employment income. You will be subject to tax on the payment; however, the purpose of the grossup is to ensure that you receive the amount of the differential after tax. For example, if the extra tax you paid on the lump sum in 2013 was $40,000 and the tax you would have paid all along in the earlier years was $25,000, then the differential is $15,000. This is what you should be compensated for and you should receive after tax. To achieve this we need a second step and must gross up the differential. Continuing on our example, if you were in a 30% income tax bracket in 2014, the grossed up differential paid to you would be $21,428. The $21,428 is taxable and will be reported as income on your T4 slip. You would pay $6,428 in tax in That leaves you with a net $15,000, after tax, the amount of the differential owed to you. Interest Q: Did you also grossup the interest that was paid on the settlement lump sum? A: No, the interest was not grossed up Q: Is there interest paid on the grossup itself? A: No, there has been no interest computed on the grossed up differential.

6 Retirees Q: How is the computation different if I retired before I received the settlement? A: If you retired from the public service prior to 2013, a reasonable pension income will be included in your income in lieu of the employment income. The maximum 2013 CPP and OAS will also be included as income if you are over 65 as it will be assumed that you are eligible for OAS and CPP. As we do not have access to actual pension data for the retirees, an estimate of pension income was used. Furthermore, the retirees will also receive an additional lump sum to compensate for their adjusted pension entitlements. This additional lump sum must also be grossed up. As the retroactive pension entitlement lump sum information will not be available for some time, in order to minimize further delays, an approximation was made of the retroactive pension lump sums to facilitate an earlier payment of the gross-up differential. Q: Does that mean the retirees are getting two gross-ups? A: If you were retired by 2013, you will receive one gross-up differential, however it will have two components to it. The first component will be computed on the lump sum payment received in 2013 or 2014 under the settlement, and the second component will be computed on the additional lump sum you will receive for your retroactive pension entitlement (i.e. pension adjustment). Q: How will you estimate my pension income? A: We will be provided with your continuous service dates as a proxy for years of service. We will also be provided with your struck off strength date as an approximation of your retirement year. ESDC (formerly HRSDC) is able to estimate your pension income based on your retirement date and years of service. Q: How do you estimate the pension adjustment I will be getting as a result of the retroactive $16,500 per year wage increment? A: To estimate your pension adjustment, we assume that you, the retiree, received the incremental $16,500 for all best 5 years of service to determine average salary for pension purposes, and was at the maximum level of PM-04 on retirement. This pension adjustment represents the additional lump sum to be paid to retirees.. A Correspondent Firm of MacKay LLP

7 Q: What if my pension income, and my ultimate pension adjustment, are different from the amounts you estimate I will be getting based on my retirement date and years of service? A: Given that the actual pension adjustment will not be known for some time and that roughly 320 retirees are due to have their pension adjusted as a result of receiving retroactive wage loss payments, it is not feasible to obtain precise information for each of the affected individuals. As a result, we used a reasonable proxy to ensure the tax gross-up for the retirees can be computed and paid in ; We did not apply any indexing to the pension payments as it was not considered material to the computation, therefore, the pension income remained static from retirement onwards in the methodology. Q: Which year will the gross-up be calculated in? I received my lump sum in 2013 and we are now in 2014 and I have not yet received my retroactive lump sum pension entitlement? A: The tax gross-up on the lump sum payments issued under the settlement will be computed using 2013 rates as that was the year you received it. The tax gross-up on the lump sum for the retroactive pension entitlement will be calculated using 2014 income and rates as it is assumed you will be paid this by the end of the year. The grossed up differential will also be computed looking at 2014 income and rates as that will be paid to you in Q: What about the fact that my OAS was clawed back in 2013 and likely will again in 2014? Will the methodology account for that? A: When the tax gross-up is computed, the OAS claw back is being considered an increment tax to you; therefore, the grossed up differential will include an amount for OAS that was clawed back. It is assumed that retirees over the age of 65 received OAS. Q: What about other income tested benefit payments, such as GST? A: We do not have sufficient information to be able to compute or assess what other income-tested benefit payments were affected; therefore they have not been accounted for in the methodology. It is not feasible to obtain information for each of the roughly 320 individuals affected, in order to compute the effect of other income-tested payments. They vary by province, and by family income; therefore it would not be possible to apply a methodology to address them.