When an employee is terminated, the question often arises about
the tax treatment of amounts paid to the employee. Structuring can
allow employers to provide different benefits to the employee
without increasing the overall cost to the employer. Possible
strategies include characterization and timing.
Treating payments as employment income can result in significant
deductions and therefore less immediate income to former employees,
particularly with lump sum payments. Characterizing payments as
"retiring allowances" can significantly reduce tax
withholdings. Retiring allowances are also exempt from Canada
Pension Plan (CPP) and Employment Insurance (EI) deductions.
Employers have an obligation to withhold a percentage of amounts
paid to former employees as "retiring allowances" for
income taxes – typically 10% for payments of $5,000 or less;
20% for payments of more than $5,000 but less than $15,000; and 30%
for payments over $15,000. Since not all amounts are captured as a
"retiring allowance", it is key to characterize every
dollar paid to a former employee. Payment in lieu of reasonable
notice will usually be the largest portion of payments to a
dismissed employee, and tax withholding will be required unless the
employee opts to transfer those amounts into a registered pension
plan or Registered Retirement Savings Plans. However, payments of
amounts already earned (such as salary/wages, bonus, or pay in lieu
of vacation), should be treated in the same manner as if those
amounts were paid prior to termination.
Amounts paid in compensation for humiliation, distress, pain and
suffering, or post-employment defamation are not subject to
withholding. These amounts must be reasonable and must be truly
separate from what was paid in lieu of reasonable notice. It is not
proper to treat all amounts as "general damages".
Payments for counselling, legal expenses and interest are also
generally exempt from withholding.
Finally, amounts paid under a disability insurance or pension
plan are not treated as a "retiring allowance" and are
taxable in accordance with income tax rules.
In some circumstances, the employee may prefer to have payments
characterized as income so that, for example, it may be counted
towards CPP or EI. Employers should also review any applicable
pension plans to determine how characterization may impact pension
The withholding requirement is calculated based on the amount
actually paid during a calendar year. If an employee was dismissed
in 2013, and a settlement was reached in 2014, it may be possible
to attribute some portion of the payment to 2013, thus spreading
out the total amount over two calendar years. Similarly, if it is
reasonable to do so, a large settlement can be paid out over a
number of years, again changing the amount actually paid out in
each calendar year, and possibly lowering that percentage that
needs to be withheld.
Prior to making any payments, an employer should confirm any
deductions required by legislation, including income tax, and, if
applicable, deduction of EI overpayment. Other deductions must be
authorized by legislation or the agreement of an employee, such as
any overpayments, amounts owing or reimbursement of training
Legislation varies from province to province. Employment income
earned after termination may be deducted with the agreement of the
employee. Pension benefits paid normally may not be deducted from
Every situation has nuances that can affect how these rules will
apply. As with any issue relating to the dismissal of an employee,
we strongly encourage employers to seek legal advice when
determining the tax treatment of payments made to terminated
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
To print this article, all you need is to be registered on Mondaq.com.
Click to Login as an existing user or Register so you can print this article.
Unfortunately, reasonable accommodation for employees in the workplace continues to be the source of significant litigation and even today we continue to see outrageous examples of employers behaving badly.
We are now beginning to see reported cases involving charges and subsequent fines laid against employers for failing to provide information, instruction and supervision to protect a worker from workplace violence.
On October 13, 2016, the Supreme Court of Canada denied leave to appeal an Ontario Court of Appeal decision which ordered an employer to pay a former employee 37 months of salary and benefits following termination.
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).