Tax Consequences of Lump-Sum Payments When Terminating an Employee

by Craig Anthony

2 min read

When terminating an employee, provincial and federal labor laws – as well as some individual employment contracts – dictate that you must give a notice period or a lump sum payment in lieu of a notice. The notice period varies from province to province and according to the employee’s seniority, but it usually ranges from two weeks to several months. Often, businesses choose to pay an amount in lieu of the notice period – usually the salary that would have been earned during the notice period – to avoid keeping potentially disgruntled employees within the company. If you do this, there are income tax and payroll tax consequences to consider.

Income Tax Considerations

When you pay an employee a lump-sum amount in lieu of termination notice under the terms of an employment contract or federal, provincial, or territorial employment labour standards, the amount is considered employment income. As such, you must include it on a T4 slip, and the employee will report it in his annual tax return. As with any salary, the employer must withhold income tax. However, instead of using the usual calculation method, you must use a special method based on the payment of bonuses. To determine how much income tax to deduct under the bonus method, take the employee’s total remuneration for the year minus union dues, pension contributions (including registered retirement savings plans), and, if applicable, the deduction for living in a prescribed zone. After subtracting these amounts, if the total remuneration for the year, including the lump-sum payment, is $5,000 or less, deduct 15% tax (10% in Quebec) from the amount paid to the employee. If it is more than $5,000, you will need to make further calculations based on the payroll deduction tables provided by the Canada Revenue Agency. The rate is different in Quebec because there is a separate provincial regime where you also need to calculate source deductions and remit the amounts directly to the provincial government.

Payroll Taxes

At the federal level, you must also deduct Canada Pension Plan contributions and employment insurance premiums. To determine the amounts to deduct, include the wages in lieu of termination notice with the regular income, if any, for the pay period and use the CRA’s free online payroll deductions calculator. When calculating these payments, you need to be aware of the applicable annual maximum contributions to make sure you don’t go over them. Also, don’t take into account any premiums that a previous employer deducted in the same year. Here also, the province of Quebec has a different regime. Employees do not contribute to the Canada Pension Plan but rather to its provincial equivalent, the Quebec Pension Plan, which also has mandatory source deductions. Calculating the various source deductions can sometimes result in the employee receiving less net wages than expected. In such cases, it is important to understand that these source deductions are not a final tax and that the employee may be entitled to a refund when he files his annual tax returns.

References & Resources

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