How to protect “retiring allowances” from the tax man

What to do with money you get on leaving a job

In August, the Canadian unemployment rate dropped to 5.4% from 6% in August 2018. But although the rates have dropped considerably, it’s still fair to say that there will always be someone who is feeling the pinch of unemployment or termination of a job. In the latter case, the hope is that you can at least exit with a couple of extra dollars in your pocket in the form of a “retiring allowance” or severance pay. That’s assuming that you can shelter those extra bucks from the CRA, who seem only to want to kick you when you’re down by trying to scoop some of that excess cash from you.

What is a retiring allowance?

Essentially, a “retiring allowance” is defined under the Income Tax Act as either of the following: a) an amount received on or after “retirement” of a taxpayer from an office or employment in recognition of the taxpayer’s long service, or b) an amount received in respect of a loss of office or employment, including an amount received on account of or in lieu of damages. This specifically excludes superannuation and pension benefits, amounts received as a consequence of the death of an employee, and benefits received from counselling services paid for by an employer.

There is no requirement that a retiring allowance must be paid in cash. For example, the CRA has stated that the fair market value of a car transferred to an employee as part of a severance package was considered part of the retiring allowance and taxed as such. So if you’ve received a parting gift, think about whether this nice gesture on the part of your employer will land you with some extra tax liability.

However, CRA is of the opinion that retirement (or loss of a job) does not include a transfer from one office or position to another with the same employer. It also does not include termination of employment (other than mandatory retirement) with an employer followed shortly by employment with an affiliate of the former employer, or termination as a result of death.

In the past, the term “retiring allowance” has often been synonymous with job severance payments. However, CRA pronouncements and some court cases in the area have complicated the situation. In fact, when all of the CRA technicals are put together, the result can be pretty confusing.

What to do with a retiring allowance?

Under the Income Tax Act, if you receive an amount from an employer (or ex-employer) as a retiring allowance, that amount will be taxable as income to you in the year that the amount is received. However, the CRA does offer you a tax deduction if the funds received are transferred to a Registered Retirement Savings Plan (RRSP) or Registered Pension Plan (RPP) for certain years of employment.

In both cases, contributions of a qualifying retiring allowances will enable you to make additional contributions to the plan, over and above the standard annual limits for certain years. However, the CRA has confirmed that any excess amounts that are transferred to a retirement compensation arrangement (RCA) will not be eligible for a tax deduction.

If a direct transfer is not made by your employer to your RRSP or RPP, sadly the employer paying the retiring allowance must report the amount paid on Form T4A Supplementary and must deduct tax at source. So it might be beneficial to instruct your employer to make the payment directly to your deferred plan to avoid source deductions.

On the other hand, if your retiring allowance was received as a result of duking it out with your past employer, any legal fees incurred are deductible to the extent that the retiring allowance itself is not sheltered by transfers to a deferred income plan (i.e., the deduction is limited to the amount on which tax is paid).

So, if you are in this category and have legal expenses, in order to get a full deduction, it may be a good idea to “pass up” transferring some payments into an RRSP or pension plan for that year, since even if these payments are “rolled in” to these plans, you will eventually have to pay tax on them when they are received from the plan (although they will earn tax-sheltered income in the meantime). Note that if the legal fees are reimbursed to you, there is a corresponding inclusion in income.

Transfer to RPP or RRSP

If you worked with your employer prior to 1996, any amounts you receive on termination as a retiring allowance will allow you to enlarge your normal RRSP or RPP contribution limit and thus enhance your tax deferral.

For years of service prior to 1989, the maximum deferral available for a retiring allowance through a contribution to an RRSP or RPP is limited to $3,500 multiplied by the number of years during which you were employed. However, the annual deferral is decreased by $1,500 – i.e., to $2,000 – for years where your employer made contributions to a pension fund or plan, or to one of their deferred profit-sharing plans and those funds have vested with you at the time you receive the retiring allowance. Note that for years of service between 1989 and 1996, the tax-deferred ceiling is limited to $2,000 in all instances.

In order to be eligible for the offsetting deduction, the contribution to the RRSP or RPP must be made within 60 days after the end of the year in which you include the retiring allowance as income. Note, however, that in 1995, government eliminated the opportunity to enlarge RRSP and RPP contributions for retiring allowances for years of service after 1995. However, the opportunity to make contributions of retiring allowances for years of service before 1996 was not affected.

Next time: Severance pay, legal damages, and other case law about retiring allowances.

Samantha Prasad, LL.B., is a Partner with Toronto law firm Minden Gross LLP, a Meritas Law Firm Worldwide affiliate, and specializes in corporate, estate, and international tax planning. She writes frequently on tax issues, and is the co-author of Tax and Family Business Succession Planning, 3^rd Edition. She is also co-editor of various Wolters Kluwer Ltd. tax publications. Portions of this article first appeared in The TaxLetter, © 2019 by MPL Communications Ltd. Used with permission.

Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.