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Is severance pay required when an employee is terminated?

chequeWhen I speak at conferences, I am often asked the following question: “Is severance pay required when an employee is terminated?”

Before this question can be answered, we have to first confront the difficulty that some payroll terms traditionally used to describe both termination, as well as any payments resulting from this event, haven’t always been defined with the greatest of clarity. My preference has always been for those terms that convey the clearest meaning of the related employment standards and source deduction requirements.

Lets start with the event itself – the termination of employment. Generally, this term refers to the employer initiating the ending of employment, but it’s also sometimes used more broadly to refer to any ending of this relationship. Where this broader meaning is intended it’s better to use a term that’s not associated with who initiates or is responsible for it. Common usages for this broader meaning include separation, severance or loss – as in being separated from employment, severing the employment relationship or the loss of employment.

Sometimes the term layoff is used interchangeably with termination. This should be discouraged and the term layoff should strictly be used to refer to what the Ontario employment standards define as “temporary layoff”, meaning active employment has been suspended, but not completely ended. Persons on layoff are still considered to be in an employment relationship with the employer.

Termination is often paired with “terminated for cause”. There is no simple way to define what is “cause” for an employer to terminate an employment, but an employee terminated without cause will always be entitled to either notice, or wages in lieu of notice, under the applicable employment standards, providing the employee has the seniority required. For example, in Ontario, employees are entitled to notice after 3 months continuous employment. Generally, notice is required under employment standards when the employee is not at fault for the loss. For example, employees who are terminated due to economic conditions affecting the employer are terminated “without cause” and are entitled to notice.

The contrast to “with cause” is “wrongful dismissal”. An employee who has been terminated without cause has been wrongfully dismissed.

Other terms used to describe the loss of employment include quitting, resignation and constructive dismissal. Quit and resign mean the loss of employment is initiated by employees. Constructive dismissal is similar, in that the employee is the one who makes the final break with employment. However, “constructive dismissal”, for employees, is what “termination for cause” is to employers. In both, the party making the final break claims that this is only in response to the others actions that make it impossible to continue. For example, an employee who quits may claim that employer harassment was constructive dismissal. This harassment was such a breach of the employment contract that it was impossible for the employee to remain. Similarly, an employer who terminates an employee for theft is saying, in effect, that this theft has so broken the employer’s trust that the employment relationship was already over.

The loss of employment usually gives rise to payments to former employees. The best single term for all such payments is “payments on separation” or, more simply, separation payments. This phrase stems from the Employment Insurance requirement to report all payments arising from the loss of employment on an ROE. However, the term separation payments doesn’t clarify the source deduction and reporting treatment required.

Generally this source deduction and reporting treatment depends on whether payments are employment income, under sections 5, 6 or 7 of the Income Tax Act, or other income under section 56.

Earnings that are employment income and commonly paid on termination include:

  • wages in lieu of notice;
  • banked overtime;
  • accrued vacation pay;
  • statutory holiday pay for a substituted day not yet taken; and
  • any other wages that were owing under the employment contract, but not paid, prior to termination.

Payments on separation that are other income are either:

  • retiring allowances; or
  • death benefits.

A retiring allowance is a payment, either in respect of long service, on an employee’s retirement, or in respect of the loss of an employment. Despite the generic term “loss of employment”, the payment of a retiring allowance marks employees who have been terminated without cause. In other words, retiring allowances are compensation or damages for wrongful dismissal.

While this definition of retiring allowance would seem to include amounts that are paid as wages in lieu of notice, there are generally two distinctions between these. First, retiring allowances are owing under the common law, imposed either by the courts or agreed to in a settlement between employer and employee. By contrast, the source for the requirement to pay wages in lieu of notice is statute law, the employment standards legislation in the applicable jurisdiction. Second, retiring allowances are amounts paid for the loss of an employment in excess of those required as wages in lieu of notice.

However, there are also payments on termination, required by the Ontario and Federal employment standards legislation, that are retiring allowances, in addition to the wages in lieu of notice also otherwise required. While in both jurisdictions this additional payment is termed “severance pay”, the preferred term is “statutory severance”, to separate the statutory source of these from the common law source of most other retiring allowances.

Death benefits are retiring allowances paid to employees where the loss of employment results from employee death. The difference between the two is the status of the employment relationship at the time of death. If at the time of death, the person was still an employee, any payments resulting from the death will be a death benefit. By contrast, if the employment relationship has ended before an employee’s death, any payments after death retain their character as retiring allowances. However, retiring allowances paid after death become taxable income in the hands of the recipient, not the deceased employee or his or her estate.

With one exception, any amounts owing under the contract of employment and paid because of the loss of employment are employment income. This includes any regular wages unpaid since any prior pay date and accrued or banked amounts such as overtime, statutory holiday and vacation pay. The exception is accrued sick leave credits. Where these are paid out on termination, accrued sick leave credits are treated as a retiring allowance for income tax source deduction purposes.

Now that we have reviewed all these terms, the question can be rephrased and answered.

Where employees are terminated without cause, including through constructive dismissal, employers will be required to give either notice or pay wages in lieu of notice, depending on the length of employment. Again, based on this seniority, employees who are wrongfully dismissed may also be able to claim damages under the common law. However, the right to such a retiring allowance may be limited in the employment contract, so this has to be seen before any answer can be given. Lastly, in both Ontario and the Federal jurisdiction, there is also statutory severance that may be owing. In Ontario, statutory severance applies for employees with at least 5 year’s seniority, where either 50 or more employees are let go within a 6 month period or the gross wages paid on an annual basis, anywhere in the world, are at least $2.5 million. For this purpose, wages means as defined in the Ontario employment standards.

Alan McEwen
Alan McEwen & Associates

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Alan McEwen

Payroll consultant at Alan McEwen & Associates
Alan R. McEwen‘s involvement in payroll spans over 20 years. As a practitioner, he has implemented and managed outsourced payroll operations for both large and small employers. As a consultant, he has worked with many organizations, public and private, on HR/payroll process re-engineering, strategic systems decisions and forensic payroll audits. Read more
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