One of the greatest embarrassments in payroll is to discover that employees have been overpaid. Recently, I wrote about limitations on the employer right to recover such amounts from subsequent gross pay. Now we look at how to treat overpayments, for reporting purposes.
Of course, not all overpayments are the result of payroll error. For example, employees may quit the employer after being given paid vacation time but before the right to it has been earned. Similarly, an employee may refuse to honour CRA year-end requirements related to non-taxable car allowances, such as reconcile these with the actual business-use kilometres travelled.
However, there are fundamental differences between the situations described above and the overpayments discussed below. The payments described above are clearly T4 Box 14 reportable and either treated as such at the time (the paid vacation time) or became so because of a subsequent event (the year-end failure to reconcile non-taxable travel allowances), but none of these payments were in any way errors or mistakes when made.
By contrast, the CRA recognizes that when employees are paid in error, the actual amounts concerned are not taxable income and are not subject to source deductions or T4 reporting. See the 1st paragraph under the heading ‘Clerical or administrative errors’ on page 27 of the T4 guide for the 2012 year-end. For example, when increasing an employee’s hourly wage to $15, someone inadvertently entered $18. For a 40-hour workweek, this would mean an overpayment of $120. No source deductions are owing on this amount, no remittances are required and the amount is not T4 reportable. The effect is as if the employee calmly pocketed 6 twenty-dollar bills found lying neatly on the sidewalk.
Does this mean there are no CRA reporting implications for such payroll errors? No, it’s not quite that simple. There are two separate reporting requirements that may apply to payroll errors.
The first relates to the gross amount of any error itself. The general rule, as noted above, is that such amounts are not taxable income, but this treatment may change if employees acknowledge the resulting debt. This could be as simple as an employee stating in an e-mail ‘I realize I owe you this money …’ or an acceptance of the debt as part of a settlement package with a former employer.
If an employee acknowledges debt resulting from a payroll error, there are 3 possible outcomes: all or part is repaid by the employee, is left outstanding or is written-off by the employer (debt ‘forgiveness’).
If an employee repays such debt, the employee may be entitled to an income tax deduction for the amount of the repayment. However, there are two conditions that must be met:
- The payroll error must relate to a period the employee was not actively employed; and
- The overpayment has to have been taken into income, either on the T4 by the employer or on the T1 by the employee.
The first of these conditions means, that the employee, in the example above, paid in error at $18 an hour, instead of $15, is not eligible for a deduction, whether or not the overpayment was taken into income, since the overpayment relates to a period of active service.
If the employer forgives all or part of debt, resulting from a payroll error, and the debt has been acknowledged by the employee, the forgiven amount is T4 reportable, in the year of forgiveness.For example, if the $120 overpayment above were made in 2012, the employee acknowledged the debt and the employer forgave it in 2014, as uncollectable, the employer would have to include the $120 in T4 box 14 for the 2014 tax year.
When an acknowledged debt is left outstanding, there are no T4 or income tax implications on the principal amount itself. This is the same as if the debt had not been acknowledged, whether or not forgiven by the employer. There are simply no provisions in the federal Income Tax Act that define the principal amount of such outstanding or unacknowledged debt as taxable income. Sub-section 6(3) doesn’t apply because a payment truly made in error is not consideration for services performed.
However, there is a second CRA reporting requirement that does apply in these situations. Employers have to treat outstanding employee debt, resulting from an overpayment made in error, as a low-interest loan. As with any other no or low-interest loan, employers must report a taxable benefit, calculated on prescribed interest rates.
Example: Vera received a payment in error from her employer. A bonus payment, intended for another employee, had been wrongly deposited into Vera’s savings account, on October 1, 2013. Since this wasn’t the account that Vera used for direct deposit purposes, or for her everyday expenses, the error went unnoticed until after Vera had quit her job, on December 31, 2013. Vera didn’t feel she had to repay the actual amount received, $20,000 net, since she claimed that over the years she had worked many unpaid overtime hours. On Vera’s 2013 T4, the employer added a taxable benefit for loan interest of $100.82 ($20,000 at 2%, the prescribed rate for the 4th quarter in 2013, times 92, the number of days from October 1 to December 31, inclusive, divided by 365). No other amount is T4 reportable in 2013 for this overpayment.
Alan McEwen is a Vancouver Island-based HRIS/Payroll consultant and freelance writer with over 20 years’ experience in all aspects of the industry. He can be reached at email@example.com, (250) 228-5280 or visit www.alanrmcewen.com for more information. This article first appeared on Canadian HR Reporter on November 25, 2013.