It’s likely only a matter of time before a client comes into your office with a severance package, asking for advice. The Income Tax Act (ITA) provides that compensation received as a result of termination or loss of employment may be characterized as employment income, a retiring allowance, non-taxable damages or a combination of the three. The payroll withholding and income tax ramifications depend on which way the severance is characterized.
Employment income includes salary, wages and other remuneration. If the severance is treated as employment income, it will be subject to the taxpayer’s normal withholding rate based on their tax bracket and also subject to deductions such as Employment Insurance premiums and Canada Pension Plan contributions.
Where a former employee is provided salary continuation payments, the courts have held that the payments are employment income.
Retiring allowances are payments arising from or related to the loss of employment or the termination of an employment contract, including those paid as part of a settlement or an award of damages. The ITA sets out that a retiring allowance may include payments received by an employee either:
- on or after retirement in recognition of the employee’s long service; or
- in respect of a loss of employment, on account of or in lieu of payment of damages or pursuant to an order or judgment of a competent tribunal.
Retirement allowance payments in recognition of long service must be made on or after retirement and not before. However, there’s no similar condition for loss of employment. In fact, CRA has stated it’s possible for an employee to receive a payment specifically in respect of a loss of employment so long as:
- evidence shows that the loss of office isn’t speculative or contingent; and
- the employment relationship, including all benefits, will end on a specific date within a reasonable time frame.
To qualify a payment as a retirement allowance, the courts have developed a two-pronged test:
- But for the loss of employment would the amount have been received?
- Is the purpose of the payment to compensate a loss of employment?
If the answer to the first question is “no” and to the second question is “yes,” generally the payment is a retiring allowance, though each situation is fact-specific.
For instance, the courts have held that continuation in a health or dental plan doesn’t preclude an employee receiving a retiring allowance. However, continuation in a pension plan of a former employer indicates a continuing employment relationship, and a retiring allowance isn’t possible.
The determination of whether a payment is a retiring allowance is often difficult. Guidance is provided in the following table.
|Retiring allowances||Not retiring allowances|
If a payment can be classified as a retiring allowance, the minimum amount required to be withheld (the withholding tax) by the former employer is lower than it is for employment income, as shown in the table below.
|Lump sum amount||Tax rate||Tax rate in Quebec1|
|$5,000 and under||10%||5%|
|Over $5,000 and up to and including $15,000||20%||10%|
1As residents of Quebec file separate tax returns for federal and provincial purposes, rates shown are the federal portion. Additional rates apply for the provincial portion.
In effect, the ITA allows a brief tax deferral by applying a flat rate, which in most cases will be less than the actual tax rate on ordinary income. Note, though, that this withholding is simply a prepaid estimate of taxes owing on the payment and, subject to the following planning opportunities, the final tax liability would be determined when the taxpayer files their tax return for the year.
Transfer of eligible retiring allowance to an RPP or RRSP
The ITA permits an employee to make a tax-free transfer of a portion of a retiring allowance to a registered pension plan (RPP) or registered retirement savings plan (RRSP) where the employee is the annuitant. In effect, this allows the employee to defer payment of some or all of the income tax to a later time. Transfers to an RPP aren’t common because of the potential adverse effect on the employee’s pension adjustment or past service pension adjustment.
The transferred amount is limited to:
- $2,000 for each full or partial year of service before 1996; and
- $1,500 for each full or partial year of service before 1989 in which an employer made contributions to an RPP or deferred profit-sharing plan that hadn’t vested.
Things to consider:
- The employee can include years of service with a previous employer if that service is recognized in determining the employee’s pension benefits (i.e., the employee is registered in the same pension plan with both employers).
- Salary continuation payments are income and therefore can’t be transferred into an RPP or RRSP for the purpose of deferral.
- The deferral is available only if the employee makes the contribution in the year it’s received or within 60 days after that year.
Direct transfer to an RPP or RRSP based on available room
An employee may also direct that a retiring allowance be paid to their or their spouse’s RRSP, subject to the employee’s RRSP deduction limit.
Things to consider:
- Any excess retiring allowance beyond the deduction limit will be subject to withholding tax (amounts transferred directly to an RRSP from an employer are not subject to withholding taxes at source).
- The transfer must be made in the year the employee receives the payment or within 60 days thereafter.
Instalment retiring allowance payments
Payment by instalment is possible provided the terms of any agreement to do so clearly designate the payments as a retiring allowance. If an employer deducts EI premiums, benefits or other deductions, the payment can’t be designated as a retirement allowance.
Things to consider:
- Instalment payments are taxable in the year received and sometimes include an interest calculation. Interest is taxable as income as it doesn’t form part of the retiring allowance.
- A portion or all of an instalment payment may be transferred into an RPP or RRSP (subject to the above limits).
The Supreme Court of Canada has held that the tax treatment of a damage award or settlement relating to loss of employment is considered the same as that which the payment replaces. This means if a payment is meant to replace employment income, it’s taxed as income. An award for damages for some other cause is treated as damages and therefore isn’t taxable.
Damages arising from personal injuries, including mental anguish sustained before or after the loss of employment, that are separate and unrelated to the loss of employment aren’t subject to tax as they’re not income or a retiring allowance. However, damages for harassment and mental distress may be considered employment income if they can be traced to the dismissal.
Determining when a payment is related to the loss of employment as opposed to some other cause is complex. Complicating the matter is the new doctrine of awarding “moral damages” where the manner of dismissal caused mental distress. Although clearly such damages can be awarded, the tax ramifications from such a payment are unclear.
Thus, where a payment may include a damages component, it’s advisable to immediately refer the client to legal counsel.
The tax ramifications of amounts received from a severance package are complex. Understanding severance classification allows for potential, if limited, tax planning.