Severance Pay Cross-Border: How Canada and the US Tax Termination Packages

Severance pay creates a cross-border tax problem because the payment arrives after the employment ends, often when the employee has already moved to the other country. The treaty allocates employment income (including severance) to the country where the services were performed, not where the employee lives when the cheque arrives. A Canadian who moves to the US and then receives a severance package from their former Canadian employer still owes Canadian tax on the portion tied to Canadian employment, and must sort out the US reporting, the foreign tax credit, and (on the Canadian side) the retiring allowance rollover.

Where is severance taxed when I cross the border?

The treaty sources employment income (and payments derived from employment, including severance) to the country where the services were performed. This is Article XV’s basic rule. Severance is compensation for past services, so it follows the location of those services, not the employee’s residence at the time of payment.

• If all your employment was performed in Canada and you moved to the US before receiving the severance, Canada has the primary taxing right. The US also taxes it (because you are now a US resident taxable on worldwide income), but gives you a foreign tax credit for the Canadian tax. If you worked in both countries during the employment period, the severance may need to be allocated between the two countries based on the time spent in each.

• The allocation question matters most for employees who split time. A manager who worked 70% of their tenure in Canada and 30% in the US would allocate severance accordingly: 70% Canadian-source, 30% US-source. The IRS and CRA both expect a reasonable, consistent allocation method, typically based on days worked in each country during the relevant employment period.

How does Canada tax severance?

Canada treats severance pay as a “retiring allowance” under ITA 56(1)(a)(ii). A retiring allowance includes amounts received “in respect of a loss of an office or employment of a taxpayer, whether or not received as, on account or in lieu of payment of, damages or pursuant to an order or judgment of a competent tribunal.” This is broad enough to cover negotiated severance packages, wrongful dismissal damages, and settlement payments.

• For a non-resident receiving a retiring allowance from a Canadian source, Canada imposes Part XIII withholding under ITA 212(1)(j.1). The statutory rate is 25%, but the treaty may reduce this. Whether the treaty rate is 15% (periodic pension/annuity) or stays at 25% (lump sum) depends on the payment structure. A lump sum retiring allowance does not fit the “periodic payment” definition under Article XVIII(2)(a), so the full 25% may apply unless the employer structures the severance as instalments.

• For a Canadian resident receiving severance from a Canadian employer, the amount is included in income and taxed at marginal rates. The employer withholds income tax on the lump sum (using the lump-sum withholding rates, not the regular payroll rates). No special treaty issues arise if both the employer and employee are in Canada.

Can I roll severance into an RRSP?

Partially, and only if the employment pre-dates 1996. Under ITA 60(j.1), a portion of a retiring allowance can be transferred directly to an RRSP or RPP without using RRSP contribution room. The eligible amount is $2,000 per year of service before 1996, plus an additional $1,500 per year of service before 1989 if the employer did not vest any employer contributions to a pension or DPSP for that year.

• For employment that started after 1995, no retiring allowance rollover is available. The entire severance amount is taxable in the year received, with no special rollover to shelter it. This makes the rollover increasingly rare as pre-1996 service years shrink, but it still applies for long-tenure employees who started working in the 1980s or early 1990s.

• If you have moved to the US and are a non-resident of Canada, the RRSP rollover is still technically available on the eligible portion, but the mechanics are more complex. You need an RRSP account (or need to open one as a non-resident, which some institutions allow), and the direct transfer must be coordinated with the employer so the rollover amount is not subject to Part XIII withholding.

How does the US tax severance from a Canadian employer?

The US taxes worldwide income of US residents. If you live in the US and receive Canadian severance, you report the full amount on your US return (Form 1040), typically on line 1 as other compensation or on Schedule 1 as other income, depending on whether the Canadian employer issued a T4 or T4A. The key is that the US includes it in income, then gives you a credit for Canadian tax paid.

• The foreign tax credit on Form 1116 offsets the Canadian withholding. If Canada withheld 25% on a lump sum and your US marginal rate is lower, you may have excess FTC that carries forward. If your US rate is higher, the FTC covers the Canadian tax and you pay the difference to the IRS.

• Timing matters. If the severance is paid in a year when you have little other US income (because you just moved and haven’t started a new job), the FTC may be limited by the lower US tax liability. In that case, the excess credit carries forward for up to 10 years.

What about US severance paid to someone who moved to Canada?

A US employer paying severance to a former employee who has moved to Canada reports the payment on Form W-2 (if the employment relationship ended in the current year) or Form 1099-NEC/1099-MISC (if the payment is made in a subsequent year). The employer may withhold US federal and state income tax.

• The employee, now a Canadian resident, includes the severance in Canadian income (worldwide income of a Canadian resident). They claim the foreign tax credit on their Canadian return for any US tax withheld. If the US withholding exceeds the Canadian tax on that income, the employee may need to file a US return to claim a refund of the over-withholding, particularly if the treaty rate should have been lower.

• State taxes add a layer. Some states (New York, California) tax severance based on where the work was performed, not where the employee lives when paid. A former New York employee who moves to Ontario and receives severance six months later may still owe New York state tax on the portion attributable to New York employment. The state income tax guide covers the state-level rules.

Does the treaty help with double taxation on severance?

The treaty prevents double taxation through the foreign tax credit mechanism, not through an exemption. Unlike social security benefits (which the treaty assigns exclusively to one country), severance is not exclusively assigned. Both countries can tax it: the source country (where the work was done) withholds, and the residence country (where the employee lives when paid) includes it in income and gives a credit for the source-country tax.

• The practical effect is that you pay the higher of the two countries’ rates. If Canada withholds 25% and your US rate is 32%, you pay 25% to Canada and 7% to the US. If your US rate is 22%, you pay 25% to Canada, zero to the US on that income (because the FTC exceeds the US tax), and carry forward the $0.03-on-the-dollar excess.

• For structured severance paid in instalments, the treaty rate on periodic payments (15% under Article XVIII) may apply instead of the 25% lump-sum rate, depending on the payment terms and the CRA’s classification of the payment. Structuring severance as monthly instalments rather than a lump sum can reduce the Canadian withholding for a US-resident recipient.

What should I do next?

If you have been terminated (or are negotiating a severance package) and you live in a different country from where you worked, the sourcing, withholding, and credit mechanics all need to be sorted before the payment is made. The withholding rate, the RRSP rollover eligibility, and the payment structure (lump sum vs. instalments) can all be optimized if addressed before the employer cuts the cheque.

• Foreign tax credit on Form 1116, the mechanism that prevents double taxation
• State income tax for cross-border workers, state-level severance taxation
• Tax equalization for corporate relocations, when the employer covers the tax difference
• Leaving Canada permanently, the departure tax and residency severance
• Moving expenses deduction, deducting the cost of a cross-border relocation

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.