16 December 2005 External T.I. 2005-0135831E5 - termination payment paid to non-resident

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Tax implications of a termination payment received by a resident of the U.S. from a Canadian corporation where no employment services were performed after the start date of employment contract due to illness of the individual.

Position: Provided general comments on the applicable law.

Reasons: As per legislation.

2005-013583
XXXXXXXXXX Catherine Bowen
(613) 957-8284
December 16, 2005

Dear XXXXXXXXXX:

Re: Termination payment received by a U.S. resident

This is in response to your e-mails dated June 10 and September 28, 2005 wherein you requested our comments on the Canadian income tax implications relating to a termination payment received by a resident of the United States of America (the "U.S.") from a Canadian corporation. We apologize for the delay in responding.

Your e-mail described a situation involving a Canadian corporation (the "Employer") that offered a three-year employment contract to an individual who was a resident and citizen of the U.S. At the time the offer was accepted, no compensation or remuneration was paid to the individual. The employment contract, which was to come into effect on a subsequent date, required the individual to perform services in both Canada and the U.S. for a contract that the Employer had entered into with one of its clients. On the date that the employment contract was to become effective, the individual was ill and was unable to provide any services under the employment contract. Two weeks after the effective date of employment, the individual was still unable to provide the contracted services. Due to the nature of the contract with its client, the Employer decided to terminate the employment contract because it needed to have the services performed immediately. The individual did not provide any services to the Employer and did not receive any remuneration or salary pursuant to the employment contract.

Following discussions with their respective legal counsel, both parties reached a financial settlement for an amount to be paid to the individual in respect of the Employer terminating the contract. This settlement was not pursuant to any terms contained in the employment contract, as the contract did not address the possible termination of employment by the Employer. During this entire period, the individual did not enter Canada and had no ties with Canada other than the employment contract.

Our Comments

The situation outlined in your letter appears to relate to a factual situation involving a specific taxpayer. We note that written confirmation of the income tax implications arising out of a particular fact situation are given by this Directorate only where the circumstances or events are the subject matter of an advance income tax ruling request as described in Information Circular 70-6R5 dated May 17, 2002 issued by the Canada Revenue Agency (the "CRA"). There is a fee for this service. Should your situation involve a specific taxpayer and a completed transaction, your inquiry should be addressed to the relevant Tax Services Office. However, we are able to provide the following general comments that may be of assistance to you.

Employee/employer relationship

It is a question of fact as to whether an individual would be considered to be an employee of an employer where the date of the employment contract had commenced but no services were performed pursuant to that contract. Such a determination could only be made after reviewing the relevant employment contract and all of the facts of the situation.

The word "employment" is defined in subsection 248(1) of the Income Tax Act (the "Act") to mean the position of an individual in the service of some other person. In the Supreme Court of Canada decision Schwartz v. The Queen, 96 DTC 6103, the court provided comments on the meaning of the word "employment" when looking at the issue of the nature of damages awarded to an individual in a situation where an employee/employer relation never commenced. In this case, the individual had signed a contract for employment but before the date his employment was to begin, the future employer cancelled the contract. The parties concluded a settlement pursuant to which the individual received a lump sum payment, which was not specific as to whether the amount was for loss of income for future services or for damages relating to anxiety, embarrassment and inconvenience. The Court held that "...when one considers the ordinary meaning to be given to the definition of "employment" in the Act, a distinction must be made between the start of the contractual relationship agreed upon by the employer and the employee and the moment, according to the terms of the contract, at which the employee is bound to start providing services to the employer." The statutory requirement that one must be "in the service" of another person to be characterized as an "employee" excludes any notion of prospective or intended employment. An employee is thus only "in the service" of his employer from the moment he becomes under obligation to provide services under the terms of the contract. It follows that "loss of employment" cannot occur before an employee becomes under obligation to provide services to his future employer because he cannot, before that moment, be "in the service" of that employer.

Nature of payment

A) Employment income vs. retiring allowance

The determination of whether a lump-sum amount or a portion of a lump-sum amount received by an employee upon or after termination of employment is

i) pay "in lieu of notice" and included in employment income, or

ii) a retiring allowance and included in other income is a question of fact that can only be determined after a review of the employment contract, any other agreements (including a settlement agreement) and other information related to the termination of the employee's particular fact situation.

B) Employment income

Where a payment is received on the termination of employment and the contract of employment either expressly or implicitly provides that the payee is entitled to receive such payment on account of the employer's obligation to pay the employee salary remaining under the contract of employment or for a period coincident with a reasonable period of notice of the termination of the employment, that payment will be deemed by subsection 6(3) of the Act to be employment income for the purposes of section 5 of the Act. This position is stated in paragraph 4(c) of Interpretation Bulletin IT-196R2, Payments by Employer to Employee, as well as paragraph 14 of Interpretation Bulletin IT-337R4, Retiring Allowances. However, paragraph 14 in IT-337R4 also states that in circumstances where the payment can also reasonably be regarded as compensation for loss of an office, it will be considered to be a retiring allowance instead of employment income. This position is generally relieving in nature as it may permit an individual to transfer such amounts to a registered retirement savings plan. Both of these publications are available on the CRA's web site www.cra.gc.ca under the heading Forms and Publications.

C) Retiring allowance

As discussed in paragraphs 5 and 6 of IT-337R4, where an amount is received because of the loss of employment and to compensate for that loss, that amount will generally, be considered a retiring allowance. "Retiring allowance" is defined in subsection 248(1) of the Act to include, among other things, an amount received by a taxpayer in respect of a loss of employment of a taxpayer. A loss of employment usually refers to the elimination or expiration of a particular office or employment and includes the loss of an income source of an employee who is released from employment whether unilaterally or not. A retiring allowance is considered to be "other income" under the scheme of the Act and is included in the income of an individual resident in Canada in the year it is received under subparagraph 56(1)(a)(ii) of the Act.

Where an amount may be viewed as being both employment income and a retiring allowance, paragraph 13 of IT-337R4 indicates that the amount will be treated as a retiring allowance on the premise that the specific treatment as a retiring allowance under the Act should override the more general treatment as income from employment. If a settlement agreement directs that a payment is to be made to an employee with reference to the unfulfilled terms of the employment contract, then the payment will not be a payment made pursuant to that contract but will be a payment made pursuant to the terms of the settlement agreement and will be treated as a retiring allowance.

In our opinion, the situation described in your correspondence appears different from that considered in the Schwartz case in that the effective period covered by the contract of employment had commenced. Under the terms of the employment contract, the employee had an obligation to start providing services to the Employer, but was physically unable to do so. Based on the limited facts provided, it appears that the termination payment is a retiring allowance paid to an individual who would not be considered resident in Canada because he has no significant residential ties to Canada.

Tax implications of payment of a retiring allowance to a non-resident

Where a retiring allowance is paid by a person resident in Canada to an individual who is resident in the U.S. in the year, the payer is normally required, by virtue of paragraph 212(1)(j.1) of the Act (Part XIII tax), to withhold 25% (as permitted under Article XXII of the Canada-U.S. Income Tax Convention) of the retiring allowance and to forward that amount to the Receiver General on behalf of the non-resident. However, under subparagraph 212(1)(j.1)(i) of the Act, no amount of Part XIII tax is required to be withheld by a payer on the portion of the payment that may reasonably be regarded as attributable to services rendered by the person in taxation years

i) during which the person was not at any time resident in Canada, and

ii) throughout which the person was not employed, or was only occasionally employed, in Canada (i.e., was not physically present in Canada performing or rendering the services).

Other than Part XIII tax, there are generally no other Canadian income tax consequences to a non-resident individual who receives a retiring allowance from a person resident in Canada.

Our comments are provided in accordance with the practice outlined in paragraph 22 of IC 70-6R5. We trust that our comments are of assistance.

Yours truly,

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Planning Branch