From a tax perspective, the principal concern when an employment termination matter is resolved is whether the appropriate withholding has been made from the settlement amounts. The basic questions to be asked are:
- What is the settlement for the purposes of the Income Tax Act (Canada) (the “Act”)?
- What withholding applies to the settlement?
- Are there any applicable exemptions from withholding?
- When is the settlement to be paid?
Although its name would appear to limit it to instances of retirement, a “retiring allowance” refers to both amounts in recognition of long-service on retirement and amounts generally in respect of a loss of office or employment received by a taxpayer.
This includes damages and/or settlement amounts that a taxpayer receives when their office or employment is terminated.
For the purposes of withholding, retiring allowances are treated as lump-sum payments under the Act.
As such, retiring allowances are subject to withholding for income tax at lump-sum rates.
The common exemption for this withholding, which is discussed below, is when a part or all of a retiring allowance can be transferred into a Registered Retirement Savings Plan (“RRSP”).
Miller Thomson Analysis
On settlement amounts up to and including $5,000, the lump-sum withholding rate is 10 per cent.
On amounts over $5,000 and up to $15,000, the applicable withholding rate is 20 per cent.
On amounts over $15,000, 30 per cent must be withheld. The timing of payments is important because the applicable withholding rate is based on aggregate payments made in a calendar year, not with respect to the settlement itself. This means that two equal settlement installments totalling $20,000 paid in different calendar years each would be subject to 20 per cent withholding, rather than 30 per cent had the installments been paid in the same year.
This issue is relevant because withholding may impact negotiation and affect the ability of employers to ensure that proper withholding is made and remitted.
To the extent that a recipient has RRSP deduction room available, a portion of the retiring allowance equal to that available room may be transferred to the recipient’s RRSP without withholding.
The Act also provides that for years of employment prior to 1996 and 1989, certain additional amounts in excess of the available deduction room may be transferred into the recipient’s RRSP.
While these provisions of the Act are becoming less relevant as time goes by, it is worth noting that for years of employment prior to 1996, an additional $2,000 per year of employment may be transferred into an RRSP without withholding.
For years prior to 1989, the limit is $1,500 per year of employment.
The Canada Revenue Agency has accepted that retiring allowances may be paid in installments over a reasonable amount of time. However, it is important to draw a distinction between retiring allowances paid in installments and salary continuation. The importance of this distinction is highlighted by the CRA’s own comments regarding the often misleading reference of periodic payments of retiring allowances as “salary continuation payments.”
While any determination is always based on a review of all the facts and surrounding circumstances, the basic distinction between the two types of payments is how the employer treats the payments. If the employer treats the payments as income for the purposes of computing employment insurance premiums and benefits, computing Canada Pension plan pension accruals, or computing eligible years of service under a registered pension plan, then such payments would be treated as employment income and treatment as a retiring allowance would be unavailable.
If a retiring allowance in installments is intended, basic things like taking the recipient off payroll, changing the timing of payments to differ from employment pay periods and withholding at the lump-sum rates instead of the withholding rates that would otherwise apply at source, would support the characterization of a retiring allowance being paid in periodic installments, rather than salary continuation payments.
The flexibility to pay retiring allowances in installments may be of particular interest to employers, whose businesses may not be able to withstand the burden of having to pay all settlement amounts at once.
The general framework itself is relatively straightforward; however, the nuances of particular settlements can raise issues that go beyond the scope of this article.
On that note, some advice:
- As a practical matter, when in doubt, be sure to withhold, this will more often than not save employers from any downside risk of not making appropriate withholding;
- Better yet though, when in doubt, ask your lawyer.