Bonuses and Severance: Taxing Lump-Sum Payments – A Complete Guide by a Montreal CPA Firm Near You

Introduction

Bonuses, retroactive pay, severance, termination pay, and retiring allowances are some of the most misunderstood payroll items in Canada. Employers often assume that lump-sum payments follow regular payroll rules. Employees frequently believe that bonuses are taxed “too high,” or that severance should be tax-free. In reality, CRA applies strict withholding formulas, unique tax rates, and complex rules for RRSP transfers, EI impacts, and pensionable/insurable earnings. Miscalculating tax on lump-sum payments can trigger CRA payroll audits, penalties, and mismatched T4/RL-1 slips. Understanding how to properly tax bonuses and severance payments is essential for both employers and employees.

Legal and Regulatory Framework

The taxation of lump-sum payments is governed by the Income Tax Act, Canada Pension Plan Act, Employment Insurance Act, and — in Quebec — the Tax Administration Act and QPP/QPIP legislation. Employers must:

• apply CRA’s lump-sum withholding rates
• determine whether the payment is regular income, bonus, severance, or retiring allowance
• include or exclude CPP/QPP and EI/QPIP based on the type of payment
• report amounts properly on T4 or RL-1 slips
• remit payroll deductions by deadline
• maintain supporting documentation

1. Tax on Bonuses (Lump-Sum Method)

CRA requires using the special lump-sum withholding rates for bonuses:

• 10% — up to $5,000
• 20% — $5,001 to $15,000
• 30% — over $15,000
(Quebec applies provincial source-deduction formulas separately.)

These are withholding rates, not actual tax. The final tax is calculated when filing the personal return.

CPP/QPP and EI/QPIP apply because bonuses are insurable and pensionable earnings.

2. Tax on Severance Pay

Severance is taxable, but:
• it is not subject to EI
• it is not subject to CPP/QPP
• withholding rates follow the lump-sum method

3. Retiring Allowances (Special Rule)

Retiring allowances may be transferred tax-free to an RRSP:

• $2,000 per year of service before 1996
• plus $1,500 per year before 1989 where no pension existed

Amounts transferred directly to an RRSP avoid withholding tax entirely.

4. Vacation Pay on Termination

Vacation pay paid on termination is:
• taxable
• pensionable (CPP/QPP applies)
• insurable (EI/QPIP applies)

5. Retroactive Pay

Retro pay is treated like a bonus and follows lump-sum withholding rules.

These rules form the complete taxation structure for bonuses and severance in Canada.

Key Court Decisions

Courts have repeatedly upheld CRA and Revenu Québec’s treatment of lump-sum income.

1. Tsiaprailis v. Canada (Supreme Court)

Established that certain components of settlement payments are taxable while others may be exempt.

2. Hickey v. Canada

Clarified that employers must calculate CPP/EI correctly on bonus and termination amounts; errors result in penalties.

3. Williams v. The Queen

Confirmed that severance is fully taxable and must be included in employment income.

4. Prévoyance v. Revenu Québec

Upheld penalties where RL-1 reporting of lump-sum income was inaccurate.

These decisions reinforce strict payroll treatment for lump-sum payments.

Why CRA Targets This Issue

Bonuses and severance payments are heavily audited because:

• many employers use wrong tax rates
• CPP/EI/QPP/QPIP are often applied incorrectly
• severance is sometimes misreported as non-taxable
• retiring allowances are misclassified
• T4/T4A/RL-1 slips often contain errors
• employers fail to remit lump-sum withholdings on time
• employees dispute EI impacts due to incorrect coding
• settlement payments may include taxable portions not reported

CRA compares:
• payroll remittances
• T4/RL-1 slips
• ROEs (reason codes affect EI entitlement)
• bank deposits
• severance agreements

This makes lump-sum payroll a high-risk category.

Mackisen Strategy

At Mackisen CPA Montreal, we help employers handle lump-sum payments with complete compliance and audit protection. Our structured approach includes:

1. Identifying Payment Type

We determine whether the payment is:
• a bonus
• a retroactive pay adjustment
• severance pay
• pay in lieu of notice
• a retiring allowance
• vacation payout

2. Applying Correct Payroll Deductions

We ensure correct treatment of:
• CPP/QPP
• EI/QPIP
• federal and provincial income tax
• Quebec-specific rules (RL-1 codes, QPP/QPIP)

3. RRSP Transfer Optimization

For retiring allowances, we calculate:
• eligible pre-1996 service
• direct RRSP transfers
• tax-free rollover amounts
• withholding tax reductions

4. T4 and RL-1 Reporting

We prepare:
• correct employment income boxes
• special RL-1 codes for Quebec
• retiring allowance codes
• severance reporting
• reconciliation with payroll ledgers

5. Audit Defence

• responding to CRA or Revenu Québec payroll reviews
• preparing documentation for severance agreements
• correcting prior errors through amended slips

This ensures total compliance and eliminates payroll audit risk.

Real Client Experience

A Montreal software company paid large bonuses but used regular payroll tax tables. CRA found under-withholding and reassessed payroll. We corrected all filings and trained management on lump-sum rules.

A health clinic misclassified severance as a non-taxable settlement. CRA reversed the treatment and imposed penalties. We restructured the severance framework and corrected reporting.

A corporate executive received a retiring allowance but the employer failed to apply RRSP rollover rules. We amended the payroll reporting and arranged a retroactive direct transfer.

A construction company paid vacation and severance together in one lump-sum without separating CPP/EI. CRA required a full payroll correction. We rebuilt the entries and ensured proper coding.

Common Questions

Employers often ask whether lump-sum tax means employees “lose money.” No—the final tax is determined at year-end.

Others ask whether severance is EI-insurable. No—severance does not generate EI premiums.

Some ask whether severance can be paid tax-free. No—except eligible retiring allowance portions transferred to RRSP.

Another question: Does Quebec treat bonuses differently? Quebec has its own tax deduction formulas and RL-1 reporting rules.

Why Mackisen

With more than 35 years of combined CPA experience, Mackisen CPA Montreal ensures lump-sum payments—bonuses, severance, retro pay, and retiring allowances—are calculated, taxed, and reported accurately. We protect employers from payroll audits and ensure employees receive correct, compliant documentation.