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.
Characterization
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 benefit accrual.
Timing
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.
Making Deductions
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 costs.
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 termination payments.
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 employees.
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.
