Severance And Income Tax In Canada

income tax and severance

Severance is taxed just the same as regular income from work in Canada.

However, there are ways to minimize paying regular taxes on severance pay, as discussed below.

How Severance Is Paid In Canada

Whenever an employee settles a severance package with their employer, there are three lawful ways an employer can pay the severance:

  1. as a lump-sum payment immediately; 
  2. as a salary continuance spread out over the notice period;
  3. as deferred payments, that is, where severance pay is paid next year or more. 

Generally, it is up to the employer to determine how severance is paid. However, an employer cannot choose to pay deferred severance payments without the employee’s permission. 

How To Choose How Severance Is Paid

For employees, salary continuance may be preferable to receiving a lump-sum amount if the employee is more comfortable receiving a regular source of income rather than one single large payment. In addition, a salary continuance usually includes participation in benefit plans over the notice period. Often, in my experience, a lump pay structure does not include benefits continuance. Instead, the value of future benefits is paid out immediately. This can be an issue because it is challenging to replace group rates for things like disability and life insurance.

For employers, salary continuance may be preferable to paying a lump-sum amount because it spreads out the costs of terminating an employee over a long period. It is not as much as “shock” to the cash reserves. Besides, employers may have negotiated a clawback in the severance package in which case salary continuance payments stop if and when the employee finds new employment. Such a clawback is extremely difficult in a lump sum severance transaction. It may be difficult to get the employee to pay the money back.

Another thing to consider is that salary continuance qualifies as earned income for creating new RRSP room the following year, but a lump sum payment does not.  

It is also important to note that lump sum and deferred severance payments may not qualify as “Hours” regarding calculating whether someone with short service is entitled to employment insurance (“EI”). However, this is not an issue for someone with enough EI “Hours” already, like employees with over a year of service already under their belt. Note: A salary continuance would count as EI hours. 

Nevertheless, as discussed below, there are various tax and payroll advantages a lump sum and deferred severance payment have that a salary continuance does not.

Income Tax and Lump Sum Payments

A lump-sum severance payment, also known as a retiring allowance, is when the employer pays the employee the total value of the employee’s income over the notice period in one large payment following the settlement of the severance package. 

If an employer pays a lump sum severance package, then the withholding tax rate is easy to calculate at the time of payment. Use the following lump-sum withholding rates to deduct income tax:

  • 10% on amounts up to and including $5,000
  • 20% on amounts over $5,000 up to and including $15,000
  • 30% on amounts over $15,000

The above rates include both federal and provincial income tax. However, Quebec uses a different system, and therefore this chart does not apply to Quebec. 

Employers should not deduct CPP contributions or EI premiums from lump-sum severance packages. 

Lastly, it is important to stress than an employee may or owe more or less than the above table’s tax rates once they file a tax return in the Spring. This is because severance lump sums are taxed as usual, while the withholding tax rate at the time of the transaction is capped as stated in the above table. To be clear, the above tax rate table is the withholding tax rate only; it is not the marginal tax rate on severance packages, which is different. At the end of the year, the employee will owe the marginal tax rate, not the withholding rate. To that effect, he may owe taxes or he may be entitled to a refund if the marginal tax rate is more or less than the above-noted withholding tax rate on severance.

To avoid owing additional taxes at the end of the year, the employee can direct the employer to withhold more than 30% of the lump sum. The Government of Canada says this is the method to calculate full marginal taxes from lump-sum severance packages if an employee decides to do that:

  • Calculate the annual tax to deduct from the recipient’s yearly remuneration, including the lump-sum payment (click here to see how much tax is deducted on an any employee’s yearly income). 
  • Calculate the annual tax to deduct from the recipient’s yearly remuneration, not including the lump-sum payment.
  • Subtract the second amount from the first amount.

Income Tax and Salary Continuance

Salary continuance is when the employee is paid his severance package as regular bi-weekly payments over the length of the notice period. For example, if the parties agree to a 12-month severance package, then on salary continuance, the employee would receive 12 months of paychecks just like usual even though they are not working anymore.  

With regard to income tax, there is no difference between salary continuance and receiving paychecks like normal. Salary continuance payments are subject to the exact same statutory deductions for income tax, CPP and EI as if the employee was working still. There is, therefore, no tax advantage for taking a salary continuance. 

Income Tax and Severance Deferral

Some employees may seek a lump sum severance payment spread out over the next year or more to minimize taxes. In this case, if an employee is terminated at the end of a full working year, it may save her taxes is she receives the lump-sum severance payment the following year so that the marginal tax rate this year is less. The next year, the marginal tax rate could be low too if the lump sum is worth less than a year’s normal pay, and the employee doesn’t plan on working again that year.  

However, deferred payments for severance are not without risk. For one, the employee loses any immediate benefit of income replacement in the short term. Second, there is a risk that the company will suffer financial difficulty and cannot pay the deferred payment next year. During Coronavirus, this was a legitimate issue as so many Canadian employers closed for good, so it is not like this is impossible.   

Income Tax Savings and Severance

There are several ways to minimize paying tax on severance.

01. The most popular way to minimize tax on severance is to direct all or a portion of a lump-sum severance into an RRSP account. The lump-sum payment is then not subject to any tax withholdings, and RRSP contributions are deductible from income, allowing individuals to minimize taxes at the end of the year. Note: this method not possible with a salary continuance.

02. The second way to minimize taxes on a severance package is to deduct legal fees incurred in securing the severance package on the tax return. This is a deduction that makes income in the tax year lesser, meaning individuals who take advantage of this will have a lower tax bill. 

03. The third way to minimize taxes on a severance package is to structure some of the settlement as “general damages” which are not income and therefore not taxable. 

With regard to the third way to structure a settlement package for tax purposes, if an individual settles their severance package for $100,000, they can call some of that, for example, $35,000 as general damages (while the remaining is $65,000 is severance). This would mean the employee only owes income tax on the $65,000. 

General damages include various legal remedies like human rights damages and tort damages like intentional infliction of emotional distress.  

Carving out a portion of the settlement as general damages is legitimate and entirely lawful if the terminated employee has a reasonable claim. Lawyers can protect their client form audits by the CRA by ensuring they plead facts supporting general damages in any correspondence like a demand letter or pleadings like a Statement of Claim before the settlement is reached.

Just because the general damages are not proven in court does not mean someone is not allowed to claim them to minimize taxes if there is a settlement before trial. 

Contact Dutton Employment Law for a free consultation about severance.