Issue No. 14
Fall 2000

EMPLOYEE TERMINATION PAYMENTS

Lawyers are often called upon to assist employees in negotiating severance payments relating to a voluntary or involuntary termination of employment. Income tax can be a major component of the planning and financial considerations impacting severance negotiations. While the relevant provisions of the Income Tax Act ("the Act") have been essentially unchanged for almost two decades, the taxation of termination payments continues to evolve as a result of court decisions and changing administrative practices of the Canada Customs and Revenue Agency ("CCRA"). Amounts received on the termination of employment may be

• taxable as retiring allowances,
• taxable as income from employment, or
• non-taxable receipts.

A. Retiring Allowances

A "retiring allowance" is defined in the Act as an amount (other than a pension benefit, a death benefit, or certain counselling benefits) 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 an office or employment of a tax-payer, 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.

A retiring allowance is included in income and taxed in the ordinary manner, subject to the RRSP contribution discussed below. Unlike employment income, it does not qualify as earned income for the purpose of computing the individual's Registered Retirement Savings Plan (RRSP) contribution limit. Where a non-resident is in receipt of a retiring allowance, there is a 25% withholding tax under the Act, which may be considerably less than the rates that would apply to ordinary employment income.

The following issues are relevant to the taxation of retiring allowances:

1. Contribution to RRSP

A major advantage of receiving a retiring allowance rather than employment income is that a deduction is available for all or a portion of a retiring allowance that is contributed to the individual's RRSP in the year it is received or within 60 days after the end of the year. The maximum contribution allowed is:

• $2,000 for each year before 1996 during which the individual was employed by the employer or a person related to the employer, plus
  
  
• an additional $1,500 for each year of such employment before 1989 during which the employee was not a member of, or not vested in benefits under, a Deferred Profit Sharing Plan or a Registered Pension Plan.

In determining the number of years, any portion of a year is counted as a whole year. This deductible contribution is in addition to the regular RRSP contribution limit. The significance of the RRSP deduction for retiring allowances is gradually becoming less relevant as no contribution is available in respect of years of employment after 1995.

2. What Constitutes Retirement or Loss of an Office or Employment?

CCRA is of the view that a retirement or loss of office essentially includes termination of employment for any reason except where,

• the employee is transferred from one position to anoth-er with the same employer or an affiliated person,
• the termination of employment with an employer is fol-lowed by re-employment with the employer or an affili-ate of the employer pursuant to an arrangement made prior to the termination of employment, or
• salary and benefits continue to accrue after the effective termination date until a later date (the loss of employ-ment would be considered to take place only at the later date).

3. Timing of Payments

In the case of retirement, the payment must be received on or after the date of retirement in order to qualify as a retiring allowance. There is no similar requirement for other types of termination payments. An individual will generally be taxed on a retiring allowance in the year it is received. Thus, the tax burden may be spread over a number of years provided there is no earlier "constructive" receipt of the retiring allowance. For example, CCRA takes the posi-tion that where the employee has the option of receiving either a lump sum or instalments over a number of years, the individual may be taxed on the lump sum, whether paid in the year or not, unless he "chooses the instalment option on or before employment is terminated". In a recent technical interpretation, CCRA concedes that the payment of a retiring allowance in instalments will be taxed as received if it is made pursuant to the terms of a settlement agreement or a court order.

4. Damages

Because of the broad definition of "retiring allowance" in the Act, damages for wrongful dismissal or other breaches of the employment contract are likely taxable as a retiring allowance where the employee loses his or her employment as a result of the breach. This will include general damages as well as damages for loss of self-respect, humiliation, mental anguish, hurt feelings, etc. Punitive damages received as part of a severance are also likely taxable.

5. Legal Fees

Legal fees paid to establish a right to or to collect a retiring allowance are deductible. The deduction is limited to fees paid in the year or the previous seven years, but only to the extent of the net amount of the retiring allowance included in income in the year (i.e. the retiring allowance minus the amount transferred to an RRSP). Any amounts received as an award or reimbursement of such legal fees must be included in income.

6. Deduction to Payor

A payment of a retiring allowance is generally deductible to the payor provided that the amount is reasonable in the circumstances. Generally the issue of reasonableness does not arise where the employer/payor deals at arm's length with the employee. In non-arm's length situations, reasonableness is an issue and the amount of the retiring allowance should be determined by taking into account factors such as length of service, remuneration received during employment, and the value of pension and retirement benefits arising from that employment. For a full-time employee, CCRA states that the amount eligible for transfer to an RRSP will be considered to be reasonable. In their published tax rulings, CCRA has conceded that amounts paid by full-time farmers to their spouses after the sale of the farm businesses could qualify as retiring allowances where the spouse had worked in the farm business, even though the spouse had been paid no salary for all or most of the employment period. The deduction of a retiring allowance incurred in one year, but paid in instalments will be deferred to the year of payment where the amount is paid more than 179 days after the end of the year in which it was incurred.

7. Withholding and Reporting

Federal tax at a rate of up to 30% must be withheld by the payor of a retiring allowance. No withholding is required on the portion of the amount eligible for transfer to an RRSP if it is paid directly to the RRSP. Form TD2 is no longer required to support the reduction in withholdings. It is not necessary to withhold Canada Pension Plan or Employment Insurance amounts from a retiring allowance. The retiring allowance is required to be reported on a T4 slip with details of the portion eligible for deduction on transfer to an RRSP. The recipient should ensure that the employer agrees to report the amounts in the correct manner, particularly where severance negotiations have not been harmonious. While it is possible to get CCRA to assess a return correctly where the T4 or T4A slip is incorrect, it can be a painfully difficult task.

B. Employment Income

While severance payments are generally taxed as retiring allowances, some or all of the amount may be taxable as ordinary employment income. No special deduction for transfer to an RRSP is available for that portion of the severance payment that constitutes ordinary employment income.

The CCRA generally regards a payment in respect of unused vacation leave as employment income (although payment for unused sick leave qualifies as a retiring allowance). A payment on or after retirement or loss of office, which is received pursuant to the terms of an employment contract, is normally viewed by CCRA as employment income. However, the Agency will consider the payment to be a retiring allowance if it can also reasonably be regarded as being in recognition of long service or as compensation for loss of office (e.g. "early retirement incentive plans").

CCRA generally regards payments in lieu of the minimum notice period required by employment standards legislation to be employment income and not a retiring allowance. However, they have recently refined their position and take the view that damages received for failure to give a period of reasonable notice will be considered a retiring allowance.

C. Non-Taxable Receipts

1. Payments After Death

Up to $10,000 of a "death benefit", defined as payment received on or after death in recognition of the individual's service as an employee, is excluded from income. The balance is fully taxable. Where the individual had not retired at the time of death, gratuitous or contractual payments in recognition of employment are taxed as death benefits. Where the deceased individual was retired, such payments after death normally will be taxed to the recipient as a retiring allowance. If an individual dies after employment has terminated and has not received all of the retiring allowance entitlement, any subsequent payments made to the deceased's dependents, relatives, or estate will be included in the recipient's income as a retiring allowance. Alternatively, CCRA will allow the value of the unpaid amounts to be included in the decedent's income for the year of death as a "right or thing".

2. Human Rights Awards

CCRA's position is that general damages awarded by a human rights tribunal are not required to be included in income. When a loss of employment involves a human rights violation and is settled out of court, a "reasonable amount" of the damages can be excluded from income. The determination of a reasonable amount is to be based on the amount that a human rights tribunal might award in similar circumstances. The maximum award under the Canadian Human Rights Act is $20,000. There are also maximum awards ranging from $2,000 to $10,000 man-dated by the legislation of some of the provinces.

3. Breach of Contract

Breach of contract amounts may not be taxable. In 1996, the Supreme Court ruled in Alan M. Schwartz v. The Queen that $400,000 received by Mr. Schwartz was not taxable. He accepted an offer of employment as a lawyer and, as a consequence, had resigned his partnership in a law firm. Before the employment commenced, the offer was withdrawn and, after negotiations, he received a settlement. Had Mr. Schwartz's employment commenced prior to the breach of contract, the settlement amount likely would have been taxed as either a retiring allowance or employment income.