A number of recent postings to Canadian HR and payroll related LinkedIn groups, have raised questions about classifying earnings as either income from employment (wages in lieu of notice) or as other income (retiring allowance). In part, these postings also raise questions about the date recognized for the end of employment. For example, if an employee receives salary continuance, when does the employment relationship actually end?
One reason I find these questions interesting is that, as a programmer, you learn very quickly the importance of what are termed “boundary conditions”. For example, if an employee, who is being terminated, continues to receive the equivalent of their regular salary on an ongoing or pay period basis:
- Is this salary continuance?
- Or is this the payment of a retiring allowance on a periodic basis?
Salary continuance is income from employment under section 6 of the federal Income Tax Act. By contrast, a retiring allowance is other income, not from employment, under section 56 of that Act.
The distinction between the two matters in payroll:
- There are different formulas and rates for withholding income tax from ongoing employment income versus retiring allowances.
- Retiring allowances are not subject to other payroll taxes, such as CPP, EI, QPIP and EHT.
- Salary continuances are reportable in T4 Box 14, whereas retiring allowances are not.
- If a retiring allowance is paid as a series of payments, an ROE must be issued at the start of the series. By contrast, if a series of payments are salary continuance, an ROE is only required at the end of the series.
So what are the “boundary conditions” between ongoing employment versus an employment relationship ending? Similarly, how can we distinguish between ongoing income from employment versus the payment of a retiring allowance. The two questions are obviously related. If there is ongoing employment, ongoing payments can’t be a retiring allowance.
Whether or not an employee is still performing employment services is not itself a good measure of when employment ends. First, an employee may not be required to work the notice period. In other words, an employee’s regular salary or wages may continue to be paid, even though the employee is no longer expected to work. By contrast, a retiring allowance may be paid before the actual termination date. The definition of a retiring allowance is, in part, a payment “in respect of the loss of an office or employment”. So long as there is an actual loss, there is nothing in the Income Tax Act that says a retiring allowance has to be paid after the date employment has ended.
Probably the single most important factor in determining the date when an employment relationship ends is what the employer and/or employee intend. For example, it is perfectly legitimate for a settlement agreement to structure a series of ongoing payments, that match what was previously paid as salary or wages, as either salary continuance or as a retiring allowance. Consider the following example.
An employee is entitled to 8 weeks’ notice under the applicable employment standards. There are employer paid benefits that, under the applicable employment standards, such as those in Ontario, must be continued during the notice period. On top of this 8 weeks’ notice, the employer and employee agree on a further payment, equivalent to an additional 40 weeks, for a total of 48.
In these circumstances, the first 8 weeks should be classified as salary continuance, while the employer and employee are free to determine whether or not the remaining 40 weeks are salary continuance or are a retiring allowance, based on what the settlement agreement defines as the last day of employment.
This example also illustrates the point that where a settlement amount is specified, whether this is a lump sum or a series of payments, the following must first be carved out, before recognizing any remainder as a retiring allowance:
- Amounts earned from work performed prior to the last day of service;
- Any banked earnings, such as banked overtime;
- Any accrued earnings, such as vacation pay; and
- Any amounts owing under the applicable employment standards, such as wages in lieu of notice.
In other words the general rule is that if a settlement agreement specifies a single amount as payable to a former employee, any earnings that match the above have to be classified as employment income. Only after all these have been deducted, any remaining balance must be treated as a retiring allowance. The best practice is for the settlement agreement, or failing that the pay statement, to separately itemize each of any such amounts.
Using this logic, by first itemizing the amounts that must be treated as employment income, and then recognizing the balance as a retiring allowance, will help clarify how payments on termination must be classified. One difficulty that we in payroll inflict on ourselves, or is sometimes inflicted on payroll by HR, is the various names that we often give to payments on termination. Such names range from terms like: settlement pay, discretionary or gratuitous payments, severance pay, damages for wrongful dismissal, etc. The best practice in determining how such amounts should be classified for payroll purposes is as described above: first carve out any employment income owing either for actual work or under the applicable employment standards. The balance, if any, is a retiring allowance, whatever name is otherwise applied to these payments.
Alan McEwen is a payroll consultant and freelance writer with over 20 years’ experience in all aspects of the industry. He can be reached at firstname.lastname@example.org, (905) 401-4052 or visit www.alanrmcewen.com for more information. This article was first posted to Canadian HR Reporter and Canadian Payroll Reporter on March 26, 2013.