How Severance Pay Is Taxed In Canada: Guidance From A Canadian Tax Lawyer

Published: August 31, 2022
Last Updated: July 6, 2026

When you receive severance pay after losing your job, one of the first questions you’ll likely ask is whether it’s taxable. In Canada, the answer is yes in most cases—but how much tax you pay depends on how your severance is structured.

Different components of a severance package may be treated as employment income, a retiring allowance, or, in limited circumstances, non-taxable damages, with each category subject to different tax rules.

Understanding how the Canada Revenue Agency (CRA) taxes severance payments can help you negotiate a better settlement, reduce unnecessary withholding, and take advantage of tax-planning opportunities such as RRSP transfers.

This article explains how severance pay is taxed in Canada, the legal principles that determine its tax treatment, and practical strategies that may reduce your overall tax liability.

Severance Pay Tax at a Glance

• Most severance payments in Canada are taxable, but the tax treatment depends on how the payment is structured.
• There is no separate “severance tax.” Severance may be characterized as employment income, a retiring allowance, non-taxable damages, or a combination of these.
• Employment income and retiring allowances are taxed differently. For example, retiring allowances are generally not subject to CPP or EI deductions and may qualify for RRSP transfer opportunities.
• Non-taxable damages may be available for legitimate claims such as harassment, discrimination, or defamation that are separate from the loss of employment.
• The wording of your settlement agreement matters. How each payment is characterized can significantly affect your overall tax liability.
• Tax planning strategies, including RRSP rollovers, payment timing, and proper settlement structuring, may help reduce the amount of tax you ultimately pay.
• Obtaining legal and tax advice before signing a severance agreement can help maximize your after-tax proceeds and avoid costly mistakes.

How is Severance taxed in Canada: Severance pay may be taxed differently depending on how it is structured

When a Canadian employee loses their job through no fault of their own, they may be entitled to severance pay. The Canada Revenue Agency (CRA) defines severance pay as money an employer pays when an employee’s position is eliminated or their services are no longer required. What many terminated employees do not realize is that the tax treatment of that payment depends heavily on how the employer structures it — and on the legal character of each component. Effective tax planning at the negotiation stage can meaningfully reduce the overall tax burden.

Whether severance pay is taxable is governed by the surrogatum principle

The foundational legal rule for taxing severance pay in Canada is the surrogatum principle, confirmed by the Supreme Court of Canada in Tsiaprailis v Canada, 2005 SCC 8. Under this principle, a payment takes on the tax character of whatever it is intended to replace. If a severance payment is meant to replace employment income the employee would have earned, it is taxable as employment income. If it replaces something else — such as compensation for harassment or defamation — it may be entirely non-taxable.

The Tax Court of Canada applied this principle in Saunders v The Queen, 2020 TCC 114, holding that a monetary award from a public-sector grievance was employment income because it replaced overtime remuneration the employees would have received. Conversely, CRA’s own Income Tax Folio S2-F1-C2 confirms that damages for personal injuries unrelated to the loss of employment — such as damages for harassment during employment or defamation after dismissal — are generally non-taxable.

In practice, severance packages often blend taxable and non-taxable elements. The characterization of each component should be addressed explicitly in any settlement agreement, using language that accurately reflects the nature of each dollar paid.

CRA guidance on mandatory disclosure of employment settlements

A significant development for employment settlement tax planning came from CRA Tax Interpretation 2024-1006831E5, which addressed whether standard employment settlement agreements constitute “reportable transactions” under the mandatory disclosure rules introduced in the June 2023 amendments to the Income Tax Act. The CRA confirmed that, generally, they do not.

Specifically, CRA found that a standard indemnity clause protecting the employer does not constitute the “contractual protection” hallmark required to trigger reporting, and that a good-faith negotiated apportionment allocating a portion of a settlement to non-taxable general damages does not automatically constitute a tax avoidance transaction — provided that there is a legitimate legal basis for that characterization. Where there is no legal basis and the entire payment is labelled as non-taxable damages solely to avoid tax, reporting obligations and audit risk arise. Employers and employees structuring severance agreements should obtain legal advice to ensure each allocation is defensible.

Taxpayers who become the subject of a CRA tax audit as a result of an improperly characterized settlement may wish to explore whether a voluntary disclosure application can bring them into compliance before enforcement escalates.

Tax planning to structure severance pay: three possible characterizations

Severance pay can be characterized as employment income, a retiring allowance, non-taxable damages, or a combination. Each characterization carries different tax consequences.

Employment income

When severance is structured as employment income — including salary continuance — the employer must withhold income tax, Canada Pension Plan (CPP) contributions, and Employment Insurance (EI) premiums as it would on regular wages. For lump sum employment income payments, the CRA-prescribed flat withholding rate is 30% on any amount exceeding $15,000. However, withholding at the flat rate does not determine the employee’s actual tax liability: the amount is added to all other income for the year and taxed at the employee’s marginal rate, which may be higher or lower.

For an overview of source deduction remittance obligations on employers — including the consequences of failing to remit CPP, EI, and payroll income tax — see our article on director liability for unremitted source deductions.

Salary continuance has a meaningful advantage over a lump sum: it generates continued RRSP contribution room and, depending on the terms, may sustain EI-insurable hours — benefits a lump sum does not provide. A taxpayer who anticipates a lower-income year may also benefit from deferring receipt of employment income severance into the following calendar year, reducing the marginal rate applied.

Retiring allowance

Under paragraph 56(1)(a)(ii) of the Income Tax Act, a retiring allowance is an amount received on or after retirement or loss of employment, either in recognition of long service or in respect of a loss of employment (including wrongful dismissal damages, whether or not paid pursuant to a court order).

For a detailed analysis of the mechanics of transferring a retiring allowance directly to an RRSP, including the 60-day contribution window and the employer’s right to request proof of available room, see our companion article How to Transfer a Retiring Allowance to Your RRSP on Tax Law Canada.

The CRA’s Income Tax Folio S2-F1-C2 sets out three conditions that must be met for a payment to qualify as a retiring allowance received in respect of a loss of employment:

1. The payment must be in respect of the loss of employment;
2. There must be evidence that the loss of office is not speculative or contingent; and
3. The employment relationship, including all benefits, will be severed on a specific date within a reasonable time frame.

The Tax Court in Overin v The Queen, 1997 CanLII 159 (TCC), established the applicable two-part test: (1) but for the loss of employment, would the employee have received the payment? and (2) was the purpose of the payment to compensate the employee for the loss of employment? If the answer to the first question is no and to the second is yes, the amount is a retiring allowance.

Unlike employment income, retiring allowances are not subject to CPP or EI deductions. The prescribed flat withholding tax rates for retiring allowances are:

• 10% on amounts up to $5,000;
• 20% on amounts from $5,001 to $15,000; and
• 30% on amounts over $15,000.

(Quebec residents face different splits between the federal and provincial portions.) These are withholding rates only. The retiring allowance is reported on line 13000 of the T1 return and is fully taxable at the employee’s marginal rate when the annual return is filed.

Non-taxable damages

Applying the surrogatum principle, general damages for harassment, discrimination, defamation, or other personal injuries sustained before or after the dismissal — and unrelated to the loss of income — are generally not taxable. Damages for violations of human rights legislation are similarly excluded from the retiring allowance definition under CRA’s published position.

In a wrongful dismissal settlement, it is possible (and in some cases advisable) to negotiate an explicit apportionment that identifies the portion paid as moral or general damages separately from the employment income and retiring allowance portions. As noted above, CRA has confirmed that this type of apportionment, where grounded in a legitimate legal claim, is not considered tax avoidance — but the characterization must be genuine and consistent with the facts and the documentation in the file.

Pro tax tips for severance recipients

Pro tax tip: transfer severance directly to an RRSP or RPP to avoid withholding tax

One of the most effective strategies available to a terminated employee is the direct transfer of a retiring allowance to an RRSP or Registered Pension Plan (RPP). When the employer transfers the payment directly to the plan, no withholding tax is deducted at the time of payment; tax is deferred until the employee withdraws the funds, typically in retirement at a lower marginal rate.

There are two distinct transfer streams:

1. Eligible retiring allowance — pre-1996 service. Under paragraph 60(j.1) of the Act, the eligible amount is $2,000 for each calendar year (or part of a year) of employment before 1996, plus an additional $1,500 per year of service before 1989 during which the employer’s contributions to a registered pension plan or deferred profit-sharing plan were not vested in the employee. This portion transfers to the RRSP or RPP without consuming the employee’s existing RRSP deduction limit. The eligible portion cannot be transferred to a spouse or common-law partner’s RRSP, and employees who are 71 or older at the end of the tax year cannot make the transfer to their own RRSP. For a detailed breakdown of the mechanics, including the 60-day window and how to handle situations where the employer withholds tax on a direct payment, see our article on RRSP and TFSA over-contribution tax on Tax Law Canada.
2. Non-eligible retiring allowance. The non-eligible portion — attributable to service after 1995 — can still be transferred to an RRSP to the extent the employee has available contribution room. It may also be contributed to a spouse or common-law partner’s RRSP if that spouse has sufficient room. Taxpayers should be alert to over-contribution risk: contributing beyond available room triggers a 1% per month penalty.

The eligible and non-eligible portions are indicated in boxes 66 and 67 of the T4 slip, respectively. Reporting is completed on Schedule 7 of the T1 return.

Pro tax tip: Negotiate with your employer to transfer the retiring allowance directly to your RRSP or RPP rather than receiving cash. A direct transfer avoids withholding tax entirely at the time of payment and keeps the full amount compounding on a tax-deferred basis. If the employer insists on paying cash, you can still contribute the eligible portion to your own RRSP (not a spousal RRSP) within 60 days of year-end without affecting your deduction room — but you will need to source the funds net of withholding tax.

As David J. Rotfleisch, founding tax lawyer and CPA at Rotfleisch & Samulovitch P.C., explains:

“Severance pay is not a one-size-fits-all tax event. Whether a payment comes to you as employment income, a retiring allowance, or non-taxable damages can mean a difference of tens of thousands of dollars in after-tax proceeds — and that characterization is largely negotiated, not dictated. Getting qualified tax counsel involved before you sign the agreement is the single most important step a departing employee can take.”

Pro tax tip: Split severance across two calendar years to reduce marginal rates

• Where a termination occurs late in the calendar year, a taxpayer may negotiate to receive a portion of the severance in December and the balance in January of the following year. Because the retiring allowance is included in income in the year received under paragraph 56(1)(a)(ii), splitting the payment across two taxation years keeps each year’s income in a lower marginal bracket and avoids stacking the full severance on top of salary earned earlier in the year of termination.
• Any interest paid by the employer on a deferred balance is ordinary income — not part of the retiring allowance — and is therefore ineligible for rollover to an RRSP under paragraph 60(j.1). Ensure that deferred payment arrangements are structured clearly so that the deferred principal is identified as a retiring allowance and any interest element is separately documented.

Pro tax tip: Use Form T1198 for retroactive wrongful dismissal awards

• Where a severance payment includes amounts attributable to prior taxation years — for example, retroactive wage adjustments included in a wrongful dismissal award — the taxpayer may apply to the CRA for a special tax calculation using Form T1198 (Statement of Qualifying Retroactive Lump-Sum Payment). This mechanism allocates portions of the lump sum back to the years to which they relate and calculates the incremental federal tax that would have been payable had the amounts been received in those prior years, potentially reducing the effective rate. The calculation applies only to federal tax; provincial tax is determined separately. If a prior year’s return requires correction in connection with this calculation, our article on making changes to a filed Canadian tax return on Tax Law Canada explains the amendment process and its limitations.
• The Form T1198 averaging mechanism is most valuable for employees who receive large retroactive wrongful dismissal awards spanning several prior years. The analysis of which amounts relate to which taxation years should begin before the settlement is finalized — settlement language that clearly attributes amounts to specific prior years makes the Form T1198 application far more straightforward.

As David J. Rotfleisch notes:

“The Form T1198 averaging mechanism is one of the least-known planning tools available to severance recipients, and it is most valuable for employees who receive large retroactive wrongful dismissal awards that span several prior years. Missing it simply leaves money on the table — but it requires careful documentation of which amounts relate to which taxation years, and that analysis should begin before the settlement agreement is finalized.”

Pro tax tips: Layer the Lifelong Learning Plan on top of an RRSP rollover

• A terminated employee who decides to pursue full-time retraining or education may withdraw funds from their RRSP on a tax-deferred basis under the Lifelong Learning Plan (LLP). Annual withdrawals are capped at $10,000 per year, with a lifetime maximum of $20,000. Amounts withdrawn under the LLP are not included in income in the year of withdrawal; they must instead be repaid to the RRSP over a ten-year period beginning no later than the fifth year after the first withdrawal.
• A newly unemployed individual who transfers severance into an RRSP and then returns to school can layer the LLP on top of the RRSP rollover — sheltering the severance from tax through the rollover and then accessing a portion of it tax-free through LLP withdrawals during the low-income retraining period. This combination can produce meaningful tax deferral and, in some cases, avoidance of high marginal rates altogether.

Deductibility of legal fees incurred to recover taxable severance

Where a terminated employee incurs legal fees specifically to establish or enforce the right to receive a retiring allowance or taxable employment income (such as wrongful dismissal damages), those fees are deductible under paragraph 60(o.1) of the Income Tax Act.

The deduction is limited to the amount of the retiring allowance or employment income actually received in the year, less any amounts reimbursed by the employer. Legal fees related to the recovery of non-taxable damages are not deductible, and fees paid in connection with amounts rolled into an RRSP do not generate a deduction against the sheltered portion.

Proper allocation in the settlement agreement assists with claiming this deduction accurately. If CRA disputes the deduction and reassesses, taxpayers can seek CRA audit representation to challenge the reassessment through the objection process.

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.