Introduction
Severance pay is compensation provided to employees upon termination of employment. While it offers financial relief during job loss, its tax implications can vary based on its structure and purpose.
Understanding how severance pay is taxed in Canada can help taxpayers make informed decisions and potentially minimize their tax burden.
Taxation of Severance Pay in Canada
What Is Severance Pay?
According to the Canada Revenue Agency (CRA), severance pay refers to the money an employer provides when an employee loses their job through no fault of their own. Its tax treatment depends on the nature of the payment, often determined by what the severance pay is intended to replace.
Governing Principle: The Surrogatum Principle
The surrogatum principle, established by the Supreme Court of Canada in Tsiaprailis v. Canada (2005 SCC 8), is fundamental in determining the taxability of severance pay. Under this principle:
- If severance pay replaces employment income, it is taxable.
- If severance pay compensates for special damages, such as pain and suffering, it is generally non-taxable.
Structuring Severance Pay for Tax Efficiency
Severance pay can be structured in various ways, each with distinct tax implications:
1. Employment Income
- When severance is paid as employment income, it is subject to a 30% withholding tax by the employer.
- Taxpayers may face additional taxes up to their marginal tax rate.
- Deferral Options: Taxpayers can request their employer to defer severance pay to the next tax year to lower their taxable income.
- Salary Continuance: Spreading payments over the notice period allows taxpayers to:
- Accumulate RRSP contribution room.
- Qualify for EI hours.
2. Retiring Allowance
Severance pay classified as a retiring allowance is subject to lower withholding tax rates:
- Up to $5,000: 10%
- $5,001 to $15,000: 20%
- Over $15,000: 30%
A payment qualifies as a retiring allowance if it is:
- Made due to loss of employment.
- Compensation for long service or damages related to employment loss.
Key Considerations
- Retiring allowances related to pre-1996 employment services are eligible for direct RRSP transfer, bypassing withholding taxes.
- Non-eligible portions can also be transferred to an RRSP, provided sufficient contribution room is available.
3. Lump Sum Payment
- Severance paid as a one-time lump sum often incurs higher taxes due to the flat 30% withholding rate.
- Planning ahead, such as deferring the payment or splitting it into installments, can mitigate tax liabilities.
Tax Planning Tips for Severance Pay
1. Direct RRSP Transfers
To avoid withholding tax:
- Transfer the eligible portion of severance pay directly into an RRSP or Registered Pension Plan (RPP).
- This method reduces immediate tax liability and secures long-term financial benefits.
2. Leverage the Surrogatum Principle
- Understand what the payment replaces.
- Consult with tax professionals to determine whether parts of the severance pay can be classified as non-taxable damages.
3. Salary Continuance
- Opt for salary continuance instead of a lump sum payment to spread taxable income over multiple years.
- This approach may also help with benefits like EI hours and RRSP contribution room.
FAQs
What Is the Surrogatum Principle?
The surrogatum principle determines whether severance pay is taxable based on its purpose. Payments replacing employment income are taxable, while those for pain and suffering may be exempt.
What Are the Withholding Tax Rates?
- Employment income severance: Flat 30% withholding tax.
- Retiring allowance:
- 10% for payments up to $5,000.
- 20% for payments between $5,001 and $15,000.
- 30% for payments over $15,000.
Conclusion
Severance pay offers financial support during job transitions, but its tax implications require careful consideration. Structuring severance pay strategically - whether as employment income, retiring allowance, or a combination - can significantly impact tax liabilities. To maximize benefits and minimize taxes, consulting a knowledgeable tax professional is essential.
If you have questions about severance pay or need help with tax planning, reach out to an experienced advisor to ensure your financial goals are met.
This article is written for educational purposes.
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