Tax-Free Lump Sum
Treatment of Tax-Free (in UK) Pension Gratuities
Emigration is often coincident with other significant life-changes, such as leaving long-term employment, which have financial and tax implications. A good example is leaving the UK Armed Forces, typically around the age of 40: the forces' pension scheme provides a tax free (in UK) gratuity within a few weeks of discharge. The question that often arises is "if I am already in Canada by the time I receive my gratuity, will I pay Canadian tax on it?".
The short answer is yes. There is no concept of a tax free retiring allowance, gratuity, or pension payment in Canadian tax law. If you are resident in Canada for tax purposes when you receive such a sum you have to report it on your Canadian tax return and pay tax on it.
Tax-residency is the key. You are liable for tax on your world-wide income in the country where you are tax-resident. In other countries you are only liable for tax on income that is sourced in that country. If you can avoid being tax-resident in Canada when you receive the lump sum you will not have to pay Canadian taxes on it as it is UK source income. There is some more information about tax-residency here. The CRA's website tells you how they view the subject here. A more detailed description of the CRA's position is in Interpretation bulletin IT 221. Superseding domestic law the UK/Canada tax treaty also has guidelines in Article 4 on how to determine where someone is tax-resident.
Tax is mostly about law. In the UK there are several acts of parliament. In Canada it is the Income Tax Act. These laws specify what income is taxable and what expenses are deductible. The wording can be complicated at times but the essence is simple: if it says in the ITA income is taxable, it is taxable, and if you omit it from your return you are breaking the law. If you are found out you will be punished.
However, tax-residency is not a question of law, it is an interpretation of facts. These facts determine your residential ties. You are tax-resident in the country where you have the most residential ties. Principal amongst facts is the location of your spouse, dependent children, and where you have a home available for your use. If all three are in the same country then you are very likely to be tax-resident there. Usually the interpretation of facts is obvious. If you and you family move from the UK to live in Canada on an indefinite basis on July 1 then you become tax resident on July 1. However, sometimes the facts are not that clear cut.
There is one important rule. If you are a member of the British Armed Forces (or a British diplomat) you are tax-resident in the UK for the entire length of your service. However, the day after your discharge this may not be the case and, as the tax-free gratuity is paid some time after discharge, this requires some consideration.
1) Serving in the British Armed Forces but posted to Canada. Returns to UK on discharge. This person will be taxed according to UK law only.
2) Serving in the British Armed Forces but posted to Canada. Stays in Canada on discharge. This person will be taxed according to UK law up to date of discharge but if they have established residential ties in Canada they will likely be subject to Canadian tax law on discharge. A gratuity will be taxable in Canada.
The obvious question is, "why can't I just go back to the UK, get my gratuity tax-free, and come back to Canada?" Well, you can, but not for a short vacation. For this to work you will have to relinquish residential ties to Canada. For example, sell your home, sell your vehicles, withdraw children from schools, resign from the Provincial health plan, file the tax forms required of emigrants, and so on. The CRA are vigilant in looking for people going non-resident to avoid tax and who subsequently return once the tax liability has gone.
3) Serving in the British Armed Forces outside Canada (this will apply equally to anyone who has a tax-free lump sum component of their pension / retirement arrangements). The lump sum is not taxable in Canada as long as it is received, safely in your bank, before you establish residential ties to Canada. Generally, this means before you move here to live.
4) When facts are not that straightforward. One scenario that has been suggested is that a family buys a home in Canada, the wife and children move there in summer, and the husband joins them in the winter after being discharged from the army and having received his gratuity. Does the husband become tax-resident in Canada on discharge? The author's interpretation (and one that seems to be in accord with the advice other posters have received) is quite likely yes. However, this is not a given. If the husband continues to live a life centered economically in the UK, working for a British employer in the UK and owning or renting a house on a long-term basis there, it is possible they remain tax-resident in the UK despite having a family and home in Canada. As mentioned, there are no rules, just facts to be interpreted. If the husband asserts on his tax return that he did not become tax-resident in Canada until after his gratuity is paid he is making an assertion based on his interpretation of the facts. He is not breaking the law.
Of course, if the CRA decide to take a further look he will have to defend that assertion. The CRA have the power to determine someone's tax residency and once they have made that determination you have to live with it unless you have the energy and money to fight it through the courts. It is too late for tax planning at this stage. If they make the determination they will charge the tax owing plus interest as a minimum. Depending upon their view of the innocence of his "mistake" they can charge a range of penalties. They will take a dim view of someone who has made an unreasonable interpretation just to avoid paying tax. Ultimately they can prosecute though this is extremely unlikely.
However, there is also the chance the CRA will accept the return as filed.
Anyone who wants to make sure they stay completely on-side with their tax affairs should complete and file a form NR74 for any years in question. Note however that the CRA will not answer hypothetical questions. They will give a ruling based on current facts but not on "what ifs?"
The only option to be sure the gratuity is not subject to Canadian tax is for the taxpayer and his family to stay in the UK until it is received. If they are already living in Canada then all they can do is grin and bear it. If they are in the middle of a hybrid move then it is down to their conscience, ability to document and support their position, and willingness to take on risk.
As usual the above is to be considered as general information and is not tax advice anyone should rely on.