Terminating an individual’s employment can be a potential minefield — there is the human element involved and then there are the legal requirements.
Payroll departments play an important role in compliance. Since payroll processes severance pay, it is important they understand the rules for calculating, paying and reporting it.
Severance pay is different than termination pay (or wages in lieu of notice). Severance pay is paid when employees retire to recognize their service or for the loss of their job. Termination pay is paid to an employee who does not receive the amount of written notice required. It is usually equal to the employee’s wages for a regular workweek for the number of weeks of notice to which the employee is entitled.
One of the first things payroll needs to know is whether an employer is required to pay severance and, if so, what rules apply. It is a legislated requirement in Ontario and under the Canada Labour Code for federally regulated employers and employees. The federal code requires employers to pay severance if they terminate an employee with at least 12 consecutive months of service (except for dismissals for just cause). The amount of severance pay required is two days of regular wages (for example, excluding overtime) for each completed year of employment. The minimum amount is five days’ wages.
The Ontario Employment Standards Act requires employers to pay severance to an employee who has worked for a minimum of five years if the employer has a total annual payroll of at least $2.5 million or 50 or more employees are being terminated in a period of no more than six months because the employer is closing all or part of the business. The province’s labour ministry considers an employment relationship severed if: the employer dismisses or stops employing an employee (including because of bankruptcy or insolvency), constructively dismisses an employee, lays off an employee for 35 or more weeks in a consecutive 52-week period or lays off an employee because the business is shutting down.
It also includes situations where an employee gets written notice of termination and the employee resigns after providing two weeks’ notice, if the resignation takes effect during the notice period required. In Ontario, employees are entitled to severance of one week’s wages in a regular workweek for each year of employment (including partial years) up to 26 weeks.
Employers may still pay severance as part of an employment contract, collective agreement, out of a spirit of goodwill or to avoid potential lawsuits. When informed of a termination package with severance, payroll professionals should find out the date the employment relationship will end and what payments are included, says Kimberley Fiume, director of compliance/client services at LeadingEdge Payroll Group.
“Knowing the actual date that the relationship severs (is important) because that allows you to then separate the payments between employment income versus severance,” she says.
The end of the employment relationship is not always the employee’s last day at work, especially if the employer is continuing to provide benefits. If benefits are not mentioned, payroll should ensure there are no benefits being provided payroll does not know about, Fiume says.
“It becomes crucial to understand what the payment is and that we break it down appropriately.”
Payroll needs to know how much notice the employee is entitled to and how much was provided or whether a combination of notice and wages in lieu was used. Since wages in lieu of notice are required by law, payroll has to ensure the package has a sufficient amount to cover this.
In some organizations, HR will break down the amounts for payroll and explain it in writing, says Fiume. In others, payroll is given an amount that needs to be paid to the departing employee.
“It becomes the payroll professional’s responsibility to ensure, if they are just given a number, to follow up and say, ‘What is this number made up of?’” she says.
This is important because there are different source deduction withholdings. The Canada Revenue Agency (CRA) considers termination pay regular employment income, subject to Canada Pension Plan contributions, employment insurance premiums and income tax deductions. The CRA views severance pay as a retiring allowance — not pensionable or insurable, but taxable at the federal government’s lump sum tax rates. Revenu Québec has a different approach. It considers wages in lieu of notice payments to be severance pay and, therefore, to be a retiring allowance rather than employment income.
As a result, Quebec Pension Plan contributions do not apply to wages in lieu of notice. The payments are subject to premiums for the Quebec Parental Insurance Plan and provincial income tax deductions, and to the employer contribution to the Commission des normes du travail.
Since severance pay is a retiring allowance, employees have the option of transferring some or all of the payment to a registered pension plan (RPP) or to a registered retirement savings plan (RRSP) in which they are the annuitant if they have years of service with their employer before 1996. The portion transferred is not subject to income tax deductions.
“Sometimes, because we’re getting into the dollars and cents and the payout of those funds, HR removes themselves and says, ‘The ball’s in your court, payroll. You are the ones making these payments so you need to communicate that to the employee,’” says Fiume.
If an employee decides to transfer, payroll must calculate the amount eligible for tax-free transfer. The CRA limits the amount to $2,000 for each year or partial year before 1996 that the employee worked for the employer, plus $1,500 for each year or partial year before 1989 in which none of the employer’s RPP or DPSP contributions were vested in the employee when the employer paid the retiring allowance. The $1,500 amount can be pro-rated according to the percentage of vesting under the plan. To make the transfer process easier, Fiume suggests payroll professionals have departing employees use the CRA’s old TD2 form.
When it comes to paying out the elements of the termination package, payroll professionals have to make sure they comply with employment standards. Payroll should check the applicable legislation for the specific timeframes. The federal code requires employers to pay severance pay within 30 days of an employee becoming entitled to it.
In Ontario, employers have to pay no later than seven days after employment ends or on what would have been the next regular pay, whichever is later. Ontario law does allow employers to pay in installments over a period of up to three years if the employer gets the employee’s written permission to do so or the director of employment standards approves it. If the employer fails to make a payment on time, the amount still owing becomes immediately due.
Reporting severance pay on a T4, RL-1 and Record of Employment (ROE) should be straightforward if payroll properly separated termination pay from severance from the beginning, says Fiume. Since severance pay is not regular employment income, it is not reported in box 14 on a T4.
Payroll should report it in the Other Information area on the T4, using code 66 for the amount of a retiring allowance eligible for tax-free transfer and code 67 for the non-eligible amount (or codes 68 and 69, respectively, for Status Indians with tax-exempt income). For Quebec, severance pay is reported in box O of an RL-1, using code RJ.
When it comes to the ROE, it is important for payroll to remember to include severance payments in block 17C on the form, says Fiume. To help keep track, she recommends they follow a termination checklist if they don’t already have one.
Sheila Brawn is editor of Canadian Payroll Reporter, a sister publication to Canadian HR Reporter. For more information, visit www.payroll-reporter.com.
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