Severance Across the Border: Sourced to the Job, Not the Address, and Why a Package Paid After the Move Is Still Taxed at Home

Severance is compensation for the employment that ended, and both countries and the treaty treat it that way: it is sourced to the country where the employment was performed, over the period it was performed, not to the country where the employee lives when the cheque arrives. A Canadian who is laid off from a Toronto job, moves to Florida, and receives the severance in Florida has Canadian-source employment income, taxed in Canada by withholding and reported in the US with a credit. An American who leaves a New York job for Toronto and receives severance in Toronto has US-source wages, taxed in the US and reported in Canada with a credit. The address on the cheque is irrelevant; the job is what is taxed.

Key takeaways

• Sourcing (Article XV): severance is remuneration in respect of employment, sourced to the country where the employment was exercised. If the employee worked in both countries during the employment, the severance is apportioned by the working days in each over the relevant period.
• Canadian retiring allowance: severance, termination pay in lieu of notice beyond the statutory minimum, and damages for wrongful dismissal are a retiring allowance; taxable in the year received; paid to a non-resident, subject to 25% Part XIII withholding (the treaty does not reduce it below the domestic rate for employment income, but the employee can file a section 217 return or a non-resident T1 to be taxed at graduated rates on Canadian-source employment income if that is lower).
• RRSP transfer: a retiring allowance for service before 1996 is eligible for a direct transfer to an RRSP ($2,000 per year of pre-1996 service plus $1,500 per year before 1989 without a vested pension) without using contribution room; a non-resident can still make the transfer.
• US treatment: severance received while a US resident is income on the 1040 (wages, subject to the treaty sourcing); the Canadian tax is a foreign tax credit in the general basket. FICA does not apply to a Canadian employer's severance for Canadian employment.
• Timing: severance paid before the move is taxed in Canada as a resident at marginal rates with no US involvement; paid after, it is taxed in Canada at 25% withholding (or graduated rates by election) and in the US with a credit. The employee's marginal rate versus 25% decides which is better.

The sourcing rule

Article XV(1) provides that salaries, wages, and similar remuneration derived by a resident of one country in respect of an employment are taxable only in that country unless the employment is exercised in the other. Severance is remuneration in respect of the employment, and the CRA and IRS both treat it as sourced to where the employment was exercised. A Toronto job produces Canadian-source severance; a job that involved work on both sides of the border produces severance apportioned by working days. The employee's residence when the severance is paid determines which country is the residence country (taxing worldwide income with a credit) and which is the source country (taxing by withholding or on a non-resident return).

The Canadian retiring allowance

A retiring allowance is an amount received on or after retirement from an office or employment in recognition of long service, or in respect of a loss of office or employment (including damages). Statutory termination pay and severance under employment standards are employment income (T4); amounts beyond the statutory minimum, and negotiated packages, are retiring allowances (T4A). Both are fully taxable in the year received. The employer withholds at source: for a resident, the lump-sum withholding rates; for a non-resident, 25% Part XIII.

A non-resident recipient can elect under section 217 to file a Canadian return including the retiring allowance at graduated rates with personal credits, if Canadian-source income is substantially all of their income for the year; or, because a retiring allowance for Canadian employment is Canadian-source employment income, file a non-resident T1 reporting it at graduated rates. For a large package to a high earner, 25% may be lower than the graduated rate; for a smaller package, graduated rates with credits may be lower.

The RRSP transfer

An eligible retiring allowance ($2,000 for each year of service before 1996 with the employer, plus $1,500 for each year before 1989 in which the employee had no vested pension or DPSP benefits) can be transferred directly to an RRSP without affecting contribution room. Long-tenured employees with pre-1996 service can shelter a meaningful portion. A non-resident can still make the transfer; the RRSP then holds the amount under the treaty deferral. The employer transfers directly and withholds nothing on the transferred portion. The rest of the package can be contributed to an RRSP using existing room, again by direct transfer.

The US side

A Canadian who receives severance after becoming a US resident reports it on the 1040 as wages (converted at the payment-date rate). It is foreign-source under the treaty sourcing (employment exercised in Canada), so the Canadian tax (25% withholding or the graduated-rate result) is a foreign tax credit in the general basket. FICA does not apply to a Canadian employer's payment for Canadian employment. State tax follows federal for most states; most give no credit for Canadian tax.

Severance received before the residency start date on a dual-status return is not US-taxable (non-resident period, foreign-source income). This is the timing lever: a package paid in the resident period is taxed in Canada as a resident with no US tax; one paid after the move is taxed in Canada by withholding and again in the US with a credit.

The reverse direction

An American who leaves a US job and moves to Canada, receiving severance in Canada, has US-source wages (employment exercised in the US) taxed in the US on the 1040 (and by the state) with FICA; the severance is also income in Canada as a resident, with a foreign tax credit for the US tax. A Canadian who worked in the US and returns, receiving US severance after the return, files a 1040-NR on the US-source wages and a T1 with a credit.

Worked example

A Toronto bank vice-president is terminated on May 31 with 18 years of service, a $300,000 package (statutory portion $40,000, retiring allowance $260,000), and starts a Miami job July 1. Her pre-1996 service is 0 years.

• Paid in June (before departure). Taxed in Canada as a resident at her marginal rate (about 53.5% on most of it): roughly $150,000 of tax. Not US-taxable (pre-residency). RRSP room used by direct transfer for part.
• Paid in August (after departure). Retiring allowance to a non-resident: 25% withholding on $260,000 ($65,000); statutory pay withheld as employment income to a non-resident. She can file a non-resident T1 at graduated rates (likely higher than 25% on this amount; she keeps the withholding). US: $300,000 reported on the resident portion of the dual-status return; US tax roughly $95,000; the $65,000 plus statutory withholding as a credit; net US tax roughly $25,000. Total tax roughly $95,000 versus $150,000.
• Timing. The August payment costs about $55,000 less because 25% withholding plus the US rate with a credit is lower than Ontario's marginal rate on a lump sum. For a lower earner or a smaller package, the resident-rate result could be better; run both.

Official sources

"The entire retiring allowance must be included in income in the year received." Amounts eligible to transfer to an RRSP are limited to "$2,000 for each year or part of a year before 1996" of service, plus "$1,500 for each year or part of a year before 1989." — Canada Revenue Agency, Retiring allowances, https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/payroll/calculating-deductions/determining-tax-treatment/retiring-allowances.html

"Subject to the provisions of Articles XVIII (Pensions and Annuities) and XIX (Government Service), salaries, wages and other remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State." — Canada-United States Tax Convention, Article XV(1), https://www.canada.ca/en/department-finance/programs/tax-policy/tax-treaties/country/united-states-america-convention-consolidated-1980-1983-1984-1995-1997.html

Practitioner note

Severance timing is one of the few places where paying after the move is cheaper: a large package to a top-bracket Ontario earner is taxed at 25% withholding as a non-resident, and the US tax with a credit is less than Ontario's marginal rate. For a smaller package the answer flips. We ask the employer for the payment date and run both before the client signs the release.

See also: Planning a move? Start with the Canada-to-US tax checklist and browse every corridor by city, province, and state.

Next step

Fairlight prepares the severance sourcing and timing analysis, the RRSP transfer of the eligible retiring allowance, and the returns in both countries reporting the package. See cross-border pricing or book a call.