Severance payments to employees are regularly regarded as retiring allowances, and subject to special rules under the Income Tax Act (the “ITA”). In consequence, employees may be able to take advantage of lower tax rates in a year when their employment may be lower than usual, and may be are able to roll in some or all of their severance payment into an RRSP or RPP, on a tax free basis.
What qualifies as a “retiring allowance”?
Whether an employee severance is considered a retiring allowance, or, alternatively, income from employment, for tax purposes, depends upon the nature of that payment.
The ITA defines retiring allowance in the following manner:
“Retiring allowance” means an amount received on or after retirement of a taxpayer from an office or employment in recognition of the taxpayer’s long service, or in respect of a loss of office or employment of a taxpayer, whether or not received as , on account or in lieu of damages or pursuant to an order or judgment of a competent tribunal, by the taxpayer or, after the taxpayer’s death, by a dependent or a relation of the taxpayer or by the legal representative of the taxpayer.1
CRA has taken the position that in order for a severance payment to qualify as an amount received on or after retirement, the payment must be made in recognition of the employee’s long service. Moreover, whether an employee is retired is a question of fact. Indicators of continued employment, such as the accrual of pension benefits (which occurs only to employees), would indicate that the employment relationship has not come to an end.
The second, more commonly employed branch of the definition requires that the payment be received in respect of a loss of office or employment. The loss of office or employment may refer to the abolition of a position, or simply to the loss of an income source for an employee who has been dismissed. A two-step test has been articulated by the courts, for determining if the amount has been received in respect of a loss of office or employment:
- But for the loss of employment would the amount have been received? (to which the answer must be “no”) and;
- Was the purpose of the payment to compensate a loss of employment? (to which the answer must be “yes”).
Amounts paid in respect of a loss of office or employment need not be made prior to or at the time the employee’s service ceases. The CRA has indicated that the payment in advance of the loss of employment, for example, in the case of working notice, may be considered a retiring allowance, so long as the employment relationship will be severed, and employment benefits will cease, on a specific date.
What are the exceptions?
Generally speaking, most severance payments will fall into the category of a retiring allowance. However, there are some notable exceptions, where the payment occurs in the context of:
- a transfer from one office to another with the same employer or an affiliate, in a different capacity; and
- termination of an employee followed by re-employment with the same employer, or an affiliate of the employer (pursuant to an arrangement made prior to the termination).
Whether a particular re-employment falls within an exception will be determined by CRA on a case by case basis.2 If the amount falls with an exception and is not considered a retiring allowance, the amount paid at the time of the transfer or termination, must be included by the taxpayer as income from employment, and taxed as such.
In addition, the following payments are not considered retiring allowances:
- a superannuation or pension benefit;
- an amount received as a consequence of the death of an employee;
- a benefit from counseling services;
- salary or wages;
- accrued vacation pay;
- an amount received under an employee benefit plan or salary deferral arrangement;
- a reimbursement for legal costs
- a retention bonus for reporting to work until the termination date; and
- an amount received upon or after retirement where a low (or no) salary was received before retirement.
What are the consequences of a severance payment being characterized as a “retiring allowance”?
Retiring allowances are treated as lump sum payments under the ITA, whether paid out in a single sum, or as a series of installments. Retiring allowances are not included in employment income and taxed at the employee’s marginal tax rate. Rather, unless paid directly into a Registered Retirement Savings Plan (“RRSP”) or a Registered Pension Plan (“RPP”), an employer is required to deduct income tax at the following rates:
- 10 % (5% for Quebec) on amounts up to $5,000;
- 20% (10% for Quebec) on amounts from $5,000 to $15,000; and
- 30% (15% for Quebec) on amounts over $15,000.
However, an employee who receives a retiring allowance, subject to these special tax rates, may be required to pay additional tax amounts when filing his or her income tax return at the end of the year in which the retiring allowance was received.
In addition, there are two circumstances under which a retiring allowance can be transferred to an RRSP or RPP on a “tax free” basis. First, if the recipient of the retiring allowance has unused RRSP deduction room, an amount up to the maximum of that room, can be contributed to the recipient’s RRSP or to a spousal or common law partner RRSP. Second, if the recipient has years of service with the employer prior to 1996, all or part of a retiring allowance may be included in his or her income and transferred to an RRSP or RPP under which the taxpayer is an annuitant. The individual receives a deduction for the eligible part of the retiring allowance. The eligible part of the retiring allowance is calculated as the sum of:
(a) $2,000 times the number of years before 1996, during which the former employee worked for the employer; and
(b) $1,500 times the number of years before 1989 during which the former employee was worked for the employer.
The employer has no obligation to withhold tax on these amounts so long as the employer has reasonable grounds to believe that the transfer is within those deduction limits, and/or has been advised that the employee has enough room in his or her RRSP to permit the rollover. In most instances, employees will elect to transfer a portion of their severance into their RRSP or RPP, providing tax relief in the immediate term. In addition, the remaining amount will typically be taxed at a lower rate than the recipient’s marginal tax rate. Accordingly, the tax treatment of retiring allowances allows dismissed employees to maximize the value of their severance payments.