May 2024 Newsletter

What happens for tax purposes if you leave your job — voluntarily or by being terminated — and your employer pays you money?

Typically, you might receive one or both of the following kinds of payments:

(1) An extension of your salary during a period while you are still officially employed. For example, you might be given 12 months’ notice of termination, and your salary and benefits continue during that period — whether or not you actually continue coming to the workplace.

(2) A severance payment. For example, you might get 12 months’ salary. This might come in one of several ways:

  • Your employer offers you an “early retirement” package which you accept.
  • You are fired and accept an offer of 12 months’ severance.
  • You are fired and you do not accept your employer’s offer. Instead, you consult a lawyer, who threatens to sue your employer for wrongful dismissal. Perhaps you even start a lawsuit. You eventually reach a settlement, with your lawyer’s assistance, and the employer pays you the equivalent of 12 months’ salary.
  • You are fired and you sue your former employer. The case does not settle before trial, and the Court awards you 12 months’ salary for wrongful dismissal.

Payments of type (1) above, which continue your salary, are treated as regular employment income, and are given the same tax treatment as your salary was before you were given notice. The same withholding at source applies as well — tax withholding that is approximately equal to the amount of tax you will have to pay on this income. Tax also continues to apply on any taxable benefits that continue while you are still receiving salary.

Payments of type (2) above — whether simply offered by the employer (and accepted), paid to settle a wrongful-dismissal lawsuit, or awarded by the court — fall into the definition of what the Income Tax Act calls a “retiring allowance”. This term also covers a payment genuinely made in recognition of long service when you retire.

A “retiring allowance” is taxable, and must be included in income on your tax return. So in some respects it does not matter whether you get a continuation of salary or a severance payment. However, there are a number of important differences between a “retiring allowance” and regular employment income:

  • If you began your employment with this employer (or a related employer) before January 1, 1996, then part of the retiring allowance can be transferred to your RRSP instead of being taxed this year. You can transfer up to $2,000 for each calendar year (or part of a year) during which you were employed with that employer (or a related employer) before 1996.

As well, if you were not a member of a pension plan or deferred profit sharing plan to which your rights have vested, you can add an additional $1,500 for each such year during which you were employed before 1989.

If the above money is transferred directly by your employer to your RRSP, then no tax will be withheld from the payment. However, if this is not done, you can still do the transfer yourself, provided you do it by 60 days after year-end (the same deadline as for regular RRSP contributions).

  • A “retiring allowance” is not considered employment income for tax purposes. (Technically, it is taxable under section 56 of the Income Tax Act, rather than under the employment-income sections, which are sections 5, 6 and 7.) This means that it does not create RRSP contribution room (except for pre-1996 employment described above), and does not count as “earned income” for purposes of the deduction for child-care expenses. It also means that you (and your employer) won’t have to pay Canada Pension Plan / Quebec Pension Plan contributions or Employment Insurance premiums on the “retiring allowance”, so if the payment is early in the calendar year when CPP/QPP and EI would be payable on employment income, a “retiring allowance” may be preferable.
  • The withholding tax on the retiring allowance (other than any amount transferred directly to your RRSP as per above) is 10% for amounts up to $5,000, 20% of the total for $5000.01 to $15,000, and 30% of the total for $15,000.01 and over. (In Quebec, the withholding is 21%, 30% and 35% respectively.) This is only a prepayment of your tax; the actual tax you pay will be calculated on your tax return for the year by including the retiring allowance in your income, and you will receive a credit for the tax withheld. So if you are in a 50% tax bracket, you may need to set aside an additional 20% of the pre-tax amount to cover the tax you will owe next spring.
  • If you become non-resident before you receive the retiring allowance, the only tax will be a flat 25% non-resident withholding tax, rather than the regular personal income tax at rates of up to 54%.
  • If you are considering leaving Canada, it may be a good idea to arrange to do so, and “cut your ties” with Canada sufficiently to become non-resident (see CRA Income Tax Folio S5-C1-F1), or become resident in the foreign country under Canada’s tax treaty with that country, before you receive the payment.

Is there any way to make the settlement tax-free?

Aside from the RRSP rollover described above, there are other ways in which payments for wrongful dismissal can become at least partially tax-free.

(A) If you sue your employer for an injury such as mental distress or for defamation (libel or slander), and the settlement or Court award explicitly allocates some amount to these kinds of damage, that amount can be non-taxable.

The CRA may challenge your failure to report such income, and could reassess you on the grounds that the payment really was for loss of employment, so the facts and the documentation have to be able to support the claim that the payment was for injury. Several taxpayers have succeeded with this argument in the Tax Court of Canada, however.

If you take this approach, you need to be prepared to live with some uncertainty for several years. There is always a good chance that your situation will not even be audited, let alone reassessed. Once three years have passed from the date of your Notice of Assessment for the year in which you receive the payment, the CRA normally cannot reassess you.

(B) Similarly, the CRA normally accepts that if you and your employer classify part of the award as damages for a human rights violation, then that portion will be tax-free (up to the maximum that could be awarded under the applicable human rights legislation).

(C) Along the same lines as above, it may be possible, in cases of severe wrongdoing by your employer, to have a Court classify part of your award as “punitive damages” or “exemplary damages”, which would be non-taxable.

(D) You can ask your employer to provide you with re-employment or retirement counselling services as part of the settlement. These are non-taxable benefits under the Income Tax Act.

(E) Amounts paid by the employer to your lawyer to cover your legal expenses are not taxable to you. Similarly, if you receive the funds and pay your lawyer yourself, the legal fees are deductible against the settlement, and so can reduce the “retiring allowance” or employment income on which you must pay tax.

Because of all the tax angles, it is crucial to do tax planning very early on in the process of making a claim for wrongful dismissal — right from the first letter you or your lawyer write to the employer. If you wait until the deal is done and a settlement is about to be paid to start thinking about income tax, it will probably be too late to stop the settlement from being fully taxable.

Last modified on May 8, 2024 12:00 am
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