Severance pay may be taxed differently depending on how it's structured
A taxpayer may be entitled to severance pay due to termination of employment and each province stipulates how much notice the employer should give. According to the Canada Revenue Agency (CRA), severance pay means money your employer pays you when you lose your job through no fault of your own. Severance pay may have different tax implications depending on how a taxpayer's employer structures the payment or the type of payment it's meant to replace.
Whether severance pay is taxable is governed by the surrogatum principle.
The governing principle to determine whether severance pay is taxable is the surrogatum principle, which is set out by the Supreme Court of Canada in Tsiaprailis v Canada, 2005 SCC 8. In essence, it means whether the payment is taxable depends on what it was intended to replace. Generally speaking, if the payment is intended to replace employment income, then it is taxable. On the other hand, special damages for pain and suffering are generally exempt from tax.
Tax planning to structure severance pay
Severance pay can be characterized as employment income, a retiring allowance, non-taxable damages or a combination of two or three. Still, the tax treatment may be different based on whether the settlement is employment income or retiring allowance. A taxpayer can also choose to receive the severance pay as a lump sum payment, a salary continuance to be spread out over the notice period or deferred payments.
When a taxpayer chooses to receive a lump sum payment of employment income, the employer is required to withhold 30% in tax, and the taxpayer may also be subject to additional tax up to his or her marginal tax rate. Therefore, it may make sense for a taxpayer to ask the employer to defer severance pay to the following year in order to reduce tax. Salary continuance may provide certain benefits such as creating RRSP contribution room and EI hours, while a lump sum payment or deferred payment will not qualify for such hours.
Under the Income Tax Act, for an amount to be a retiring allowance, it must have been received by the employee either:
- On or after the retirement of the individual from an office or employment in recognition of the individual's long service, or
- In respect of a loss or employment of the individual, whether or not received as, on account or in lieu of payment of, damages or pursuant to an order or judgement of a competent tribunal.
According to the CRA, it is possible for an employee to receive a payment in respect of a loss of employment so long as:
- The payment is respect of loss of employment;
- There is evidence the loss of office is not speculative or contingent; and
- The severing of the employment relationship, including the severing of all benefits, will occur on a specific date within a reasonable time frame.
The Tax Court of Canada in Overin v The Queen, 1997 CanLII159(TCC) set out a two-step test to determine whether a payment qualifies as retiring allowance:
- But for the loss of employment, would the employee have received the payment?
- Was the goal of the payment to compensate the individual for the loss of employment?
If the answer to the first question is no and the answer to the second question is yes, then the amount should be considered as retiring allowance. Unlike employment income, the withholding tax rates for retiring allowance are generally lower:
- Up to $5,000, the tax rate is 10%;
- From $5,000 to 15,000, the tax rate is 20%;
- Over $15,000, the tax rate is 30%.
Pro tax tips - A taxpayer can avoid withholding tax by transferring severance pay directly to RRSP
A taxpayer can avoid the withholding tax by transferring the severance pay directly into an RRSP or RPP. As for the portion of severance pay received for employment services prior to 1996, it is considered as the eligible portion that can be directly transferred to a taxpayer's RRSP without affecting the RRSP deduction limit. For the portion that is not eligible to be transferred this way, it may still be transferred into an RRSP if the taxpayer has extra contribution room left.
Overall, severance pay may require careful planning for a taxpayer to reduce tax, and it is highly recommended to consult with an experienced Canadian income tax lawyer to structure the payment in order to achieve the best tax result.
What is the surrogatum principle?
This is the principle that the payment takes on the attributes of what the payment is meant to replace and is taxed (or not) accordingly. For example, if a settlement was reached paying the litigating party for a breach of contract which resulted in the loss of business income, then the settlement amount essentially replaces the lost income and would thus be taxable as business income. On the other hand, if a settlement amount is paid for a breach of contract that results in damages to an income-producing property, then the settlement amount would generally be considered a capital amount.
What are the withholding tax rates of severance pay for employment income and retiring allowance?
Employment that pays severance pay to replace employment income as a lump sum payment to its employee must withhold 30% of the payment, while the tax rates for retiring allowance vary from 10% to 30% based on the amount of payment.
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.