December 2001 volume 5, issue 3 

You have worked the numbers back and forth, and the results are the same...given present revenues, at least five of your employees are redundant. It is essential for you to start carefully planning the inevitable downsizing in your organization, starting now.

The Employment Standards Act
Every Canadian province, including Ontario, has an Employment Standards Act, a law that sets out the basic rules about managing employees. Every manager should be familiar with this legislation, as it governs most employment situations in the province.

Four Key Components
A severance package for an about-to-be terminated employee contains four components:

The termination component - a lump sum that is paid to employees when their employment ends without proper written notice. Also called “pay in lieu of notice”, the sum is equal to the wages they would have been paid during the required period of notice.
Ontario law is very clear about the notice period required for terminated employees. Employees must receive one week of written notice, or one week of termination pay, for each year they have worked for the company, to a maximum of eight weeks (companies with 50 to 199 employees) or 12 weeks (companies with 200 to 499 employees). There are exceptions to this rule for employees with less than three months’ service and for employers with less than 50 employees.
If your employees are unionized, different rules may apply.

The severance component - a lump sum payment in compensation for the years and effort an employee has invested in a company. Severance must be paid to employees who have worked at least five years with the company. It may include unused sick days that have been banked by an employee, as well as a “retirement allowance”.
A Retirement Allowance is defined in the Income Tax Act as “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 payment of damages pursuant to an order or judgement.”
Additional payments may be added to a severance because of the seniority of a terminated person’s position, length of service, age of the terminated employee and local job market conditions.

The pension component - the details in the package concerning the monthly pension that the employee will receive either now or in the future. This may also refer to the value of money that the pension is based on, known as the commuted lump sum value.

The benefit component - details concerning what happens to an employee’s benefits after he/she has left the employer.

Reporting Severance Packages
Employers must report retirement allowances and severances on T4A slips that should be filed with the Canada Customs and Revenue Agency (CCRA). The penalty for not remitting a T4A return on time is $25/day per return, to a maximum of $2,500.

Severance and termination payments should be classified as a payroll expense on the Income Statement. However, some companies may choose to group the costs under a category called “restructuring charges”.

Helping Terminated Employees Save Tax
An employer can roll all or a portion of the retirement allowance tax free into a terminated employee’s RRSP. The amount that can be transferred is based on the following formula:

$2,000 for each year of employment up to but not including 1996. Partial years of service count as full years.

For each year of employment prior to 1989 where employer contributions to a pension plan or deferred profit sharing plan were not made or were not vested, an additional $1,500 per year.

For example, suppose a terminated employee was awarded a retiring allowance of $26,000. If he/she took it in cash, they will pay tax on the full amount at their effective tax rate. If the tax rate was 40%, $10,400 would be deducted on the severance pay cheque and the employee would receive $15,600. However, if the employer transferred the $26,000 into the employee’s RRSP, no tax would be deducted or paid by the employee until the funds are withdrawn from the RRSP.

If an employee’s retiring allowance exceeds the maximum allowed for tax sheltering under the above formula, he/she has the option of taking in cash the difference between the retiring allowance and the maximum, subject to the appropriate taxes, or contributing the difference to their RRSP if he/she has allowable RRSP contribution room.

If the retiring allowance is greater than $40,000, the employee may also be subject to Alternative Minimum Tax (AMT), especially if their income drops significantly in the year the allowance is paid.

Your Client Services Partner would be pleased to discuss the tax implications of any planned employee terminations in your organization. Please call us for more information concerning the most tax effective strategies in these situations.

Dan Dickinson, CA, is a member of the Wilkinson Tax Group. He has been with the Firm since 1984, and became a partner in 1993. He completed the CICA In-Depth Tax Course in 1991. Dan specializes in tax planning (including GST) for corporations, individuals, and estates. His practice includes business start-ups, business planning, and the sale of owner/managed businesses.