Income Tax Folio S2-F3-C1, Payments from Employer to Employee

Series 2: Employers and Employees

Folio 3: Employment Benefits

Chapter 1: Payments from Employer to Employee

Summary

This Chapter discusses the federal income tax treatment of certain payments to individuals such as inducement payments, and non-competition payments made to departing employees.

The Chapter also discusses amounts receivable by employees in respect of a covenant.

The Canada Revenue Agency (CRA) issues income tax folios to provide technical interpretations and positions regarding certain provisions contained in income tax law. Due to their technical nature, folios are used primarily by tax specialists and other individuals who have an interest in tax matters. While the comments in a particular paragraph in a folio may relate to provisions of the law in force at the time they were made, such comments are not a substitute for the law. The reader should, therefore, consider such comments in light of the relevant provisions of the law in force for the particular tax year being considered.

Table of contents


Discussion and interpretation

Introduction

1.1  Under section 5, an individual’s employment income includes salary, wages, and other remuneration, including tips and gratuities. Employment income is included in an employee’s income in the year it is received. The terms salary, wages, and other remuneration are not defined for purposes of section 5. Based on case law and the ordinary meaning of the words (for example, dictionary definitions), an amount paid for services performed by an employee is generally considered to be salary, wages, and other remuneration.

1.2 Subsection 6(3) deems certain payments to be employment income. Further, subsection 6(3.1) deems amounts receivable in respect of a covenant to be included in employment income when certain conditions are met. In this context, a covenant is generally an agreement between the employer and employee as to what the employee can or cannot do before or after employment ends.

1.3 Subsection 248(1) establishes that:

  • an office includes a position entitling an individual to a fixed or ascertainable stipend or remuneration;
  • an officer is a person holding an office;
  • employment is the position of an individual in the service of some other person. Civil or common law will generally determine whether an individual is in the service of another person; and
  • an employee is an individual holding employment.

Throughout this Chapter, a reference to employment includes an office and a reference to employee includes an officer.

Payments deemed to be employment income

1.4 Generally, subsection 6(3) applies to payments from employers to employees. However, it could also apply to payments to individuals who are not employees, such as future or former employees.

1.5 Subsection 6(3) provides that a payment from an employer to an employee is deemed to be employment income for purposes of section 5, when:

  1. the employee receives the payment during employment with the employer; or
  2. the employee receives the payment based on a written or oral agreement made with the employer either immediately before, during, or immediately after employment;
    unless it is reasonable to consider that the payment (in whole or in part) was received other than for:
  3. entering into the employment contract (for example, inducement payments);
  4. services provided during employment; or
  5. a covenant as to what the employee is, or is not to do, before or after the end of employment (for example, non-competition payments).

1.6 In addition to the conditions described in ¶1.5, the payment must have the nature and quality of salary, wages, commissions, or remuneration. The method of calculating the amount or any steps taken to enforce payment under the terms of the contract (including lawsuits) do not change how subsection 6(3) is to be applied.

Dual-purpose payments

1.7 Where a payment is made for more than one purpose and part of the payment does not have the nature and quality of salary, wages, commissions, or remuneration or is not in respect of a covenant, that part of the payment is not included in the individual’s employment income. However, if part of the payment is received for loss of employment, it may be a retiring allowance and included in the employee’s income under subparagraph 56(1)(a)(ii). For more information on the taxation of retiring allowances, see Income Tax Folio S2-F1-C2, Retiring Allowances.

Timing of the income inclusion

1.8 A payment from an employer that is deemed to be employment income is included in an employee's income in the earliest year in which:

  • the employee receives it;
  • the amount is paid or transferred to another person for the benefit of the employee or such other person, at either the employee’s direction or with the employee’s agreement (see subsection 56(2)); or
  • the amount is credited to an employee’s debt or account, set apart for the employee or otherwise available to the employee without being subject to any restriction concerning its use (constructive receipt).

Amount receivable in respect of a covenant

1.9 Where an amount in respect of a covenant (described in ¶1.5) is receivable by an employee at the end of the year, subsection 6(3.1) deems the amount to be received at the end of that year, if:

  • the amount receivable was not included in the employee’s income as part of a salary deferral arrangement as defined in subsection 248(1); and
  • the employee agreed to the covenant more than 36 months before the end of that year.

The amount is included in employment income in the year it is deemed to be received.

1.10 If an amount in respect of a covenant is included in the employee’s income as described in ¶1.9 and the amount becomes a bad debt in a later year, the employee may claim a deduction from income under paragraph 60(f) in that later year. An amount generally becomes a bad debt if it remains unpaid after the employee has exhausted all means to collect it or where the employer has become insolvent and has no means of paying it.

Example 1

 

As an inducement to a prospective employee to accept an employment offer, an employer agrees to make a payment when the individual signs the employment contract. The individual starts work immediately and agrees to work for the employer for a minimum of two years. Their arrangement is that if the individual does not meet all the requirements of the employment contract, the full amount of the inducement payment will have to be repaid. Since the payment is made based on an agreement signed immediately before the individual’s employment and is paid for entering into the employment contract, subsection 6(3) deems the payment to be employment income. 

 

Example 2

 

An individual receives a corporate-sponsored scholarship but does not work for the corporation at the time the scholarship is received. Several years later, after graduating, the individual accepts employment with the corporation that funded the scholarship. In this case, since the employer-employee relationship did not exist at the time the scholarship was received, subsection 6(3) does not apply to deem the scholarship to be employment income. However, the payment is considered scholarship income. For more information on the taxation of scholarships, see ¶3.10 - 3.16 of Income Tax Folio S1-F2-C3, Scholarships, Research Grants and Other Education Assistance

 

Example 3

 

An individual and an employer sign an employment contract that defines the rights and obligations of each party. The employment contract does not provide for any payments at or after the end of employment. After a few years, the employer terminates the employment contract. The individual sues the employer. The lawsuit is settled and the individual receives a lump-sum amount to compensate for the loss of employment. Since the lump-sum amount was not provided for in the employment contract, subsection 6(3) does not apply to deem the payment to be employment income. However, since the amount was compensation for the loss of employment, the payment is considered a retiring allowance and included in the individual’s income under subparagraph 56(1)(a)(ii). 

 

Example 4

 

Based on an agreement negotiated during employment, an employee receives a monthly payment from the employer for inventions and designs that the employee creates during employment. The agreement specifies that the employer will retain the rights to these inventions and designs. The employee quits, but continues to receive the monthly payments for several years. Because the payments are based on an agreement made during employment for work completed during employment, subsection 6(3) deems the payments received after the end of employment to be employment income. 

 

Example 5

 

At the time of hiring, an employee and an employer verbally agree that the employer will purchase, at the end of employment, any client list that the employee develops during employment. The purchase will ensure that the employee does not compete against the employer in the future. At the end of employment, the employer pays the employee an amount for the client list. Because the payment is provided for in an agreement made during employment in consideration for what the employee is not to do after the end of employment, subsection 6(3) deems the payment to be employment income. 

Application

This updated Chapter, which may be referenced as S2-F3-C1, is effective November 26, 2015.

When it was first published on April 14, 2015 this Chapter replaced and cancelled Interpretation Bulletins IT-196R2, Payments by Employer to Employee and IT-196R2SR, Payments by Employer to Employee .

The history of updates to this Chapter as well as any technical updates from the cancelled interpretation bulletins can be viewed in the Chapter History page.

Except as otherwise noted, all statutory references herein are references to the provisions of the Income Tax Act, R.S.C., 1985, c.1 (5th Supp.), as amended and all references to a Regulation are to the Income Tax Regulations, C.R.C.,  c. 945, as amended.

Links to jurisprudence are provided through CanLII.

Income tax folios are available in electronic format only.

Reference

Subsections 5(1), 6(3), and 6(3.1).

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