Introduction: Reporting Tips and Gratuities On Personal Income-Tax Returns
Outside the province of Quebec, the Canada Revenue Agency ("CRA") considers two types of tips and gratuities for tax purposes: controlled tips and direct tips. Controlled tips are tips and gratuities controlled or possessed by employers, who then distribute them to employees.
The CRA provides the following examples of controlled tips:
- the employer adds a mandatory service charge to a client's bill to cover tips;
- tips that are allocated to employees using a tip-sharing formula determined by the employer;
- tips that the employees turn over to their employers who then distributes them to the employee; and
- cash tips that are deposited into the employer's bank account and become, or are even commingled with, the property of the employer and then paid out to the employees.
Direct tips are paid directly by the clients/customers to the employees, with the employers having no control over the tip amount or its distribution. For example, if a customer leaves cash on the table at the end of the meal and the server keeps the whole amount in excess of the total bill or the distribution of tips is determined by the employees but not the employer, then the tips and gratuities will likely be categorized as direct tips.
Quebec is the only province in Canada with specific tax legislations requiring employees to declare their tips to their employers. Only declared tips exist in Quebec for tax purposes and all tips and gratuities received are included in the employees' insurable earnings. Consequently, information included in this article may not be applicable to employees and employers in Quebec. We recommend that you consult one of our expert Toronto tax lawyers for legal advice specific to your tax matters in Quebec or the rest of Canada.
Tips and gratuities that individuals receive from employment are considered income for the purpose of the Income Tax Act (the "Tax Act"). If the individuals who receive tips and gratuities are employees, their employers are also required to deduct Canadian Pension Plan ("CPP") contributions and employment insurance ("EI") premium for controlled tips. However, direct tips are not subject to CPP contributions or EI premiums. Instead, if an employee chooses to make CPP contributions on direct tips earned in the course of pensionable employment, the employee will need to fill out Form CPT20 Election to Pay Canada Pension Plan Contributions.
Defining Controlled Tips
The Tax Act does not define controlled tips and direct tips. Current CRA definitions of controlled and direct tips derive from a long-standing jurisprudence relevant to the issue.
The Supreme Court of Canada ("SCC") in Canadian Pacific Ltd. v Canada, [1986] 1 SCR 678, confirmed that tips and gratuities can be paid by the employer to its employees. The Federal Court of Appeal ("FCA") in Lake City Casinos Ltd. v Canada, 2007 FCA 100, articulated its view of the SCC decision in Canadian Pacific Ltd: In order to show that the tips were paid by an employer, "in the liberal sense attributed to this word," there must be a demonstration that the "tips came into the possession of the employer who then remitted them to the employees."
As a result, the current test to determine whether tips and gratuities received are controlled tips is not whether the employer had controlled the tips and gratuities but whether the employer actually paid the amounts. Nevertheless, although a mere system to distribute or to share tips set by the employer does not equate to an employer's control over received tips and gratuities, if an employer has "virtual control, even if not actual control" of the cash and credit card tips, the tips and gratuities received by employees will be considered "controlled tips". This position has also been accepted in a more recent case, Ristorante A Mano Limited v The Queen, 2022 FCA 151, where the FCA did not challenge the proposed applicable test.
In summary, the current test defining controlled tips is, simply, determining whether it was the employer who "paid" (liberally construed) the tips and gratuities to the servers.
Tips And Gratuities Are Taxable Income and Can Be Insurable Earnings
Subsection 5(1) of the Tax Act stipulates that a taxpayer's income for a taxation year from employment includes gratuities received by the taxpayer in that year. The Court has determined that the nature of tips and gratuities is tied to the employment but not the reasons why employees receive such tips and gratuities. In other words, as long as the tips and gratuities are received during the course of employment, they should be included in a taxpayer's employment income.
In Xia v The Queen, 2019 TCC 30, the Court ruled that tips received from casino winnings would not be considered windfalls and should be included in taxable income. The taxpayer in Xia was employed as a slot attendant at a casino. During the course of the taxpayer's employment, when patrons won a jackpot, they occasionally would give some of the winnings to a slot attendant like the taxpayer. Then these amounts would be pooled and distributed to the slot attendants by a "Slot Tip Committee" on the basis of certain criteria. The Court found that "the payments were not one-time windfalls, but were received as a result of services [the taxpayer] provided in carrying out his duties as an employee," despite that the taxpayer had no control over the amount that he could receive. As a result, since "the attendants could customarily expect to receive gratuities and these amounts constituted a large portion of their income in each year," the tips and gratuities received during the taxpayer's course of employment should be included in the taxpayer's income.
Even for purposes unrelated to Canadian tax laws, tips and gratuities are considered income. In Hoque v Canada (Citizenship and Immigration), 2018 CanLII 131145 (CA IRB), tips and gratuities are considered income for immigration purposes when calculating an applicant's financial status. However, unreported tips and gratuities that are not reflected in an individual's tax returns are not included in calculating an individual's income for immigration purposes, pursuant to Yang v Canada (Citizenship and Immigration), 2012 CanLII 1014408 (CA IRB). In other words, a Canadian taxpayer must report tips and gratuities he or she received for the payments to be included in his or her income.
Furthermore, controlled tips are pensionable and insurable earnings under the Employment Insurance Act and the Canadian Pension Plan. Direct tips, paid directly from the customer to the employee, are not insurable earnings, even though they may be considered income with respect to the Tax Act There are plenty of case laws that have distinguished the different tax treatment of direct and controlled tips. For example, in Andrew Peller Limited v MNR, 2015 TCC 329, the Court reaffirmed that tips and gratuities can be insurable earnings and contributory salary and wages, citing S&F Philip Holdings Ltd. OP Sooke Habour v MNR, 2003 TCC 384. The Court in Andrew Peller Limited further clarified that "only those tips that are 'received personally' by the employee would remain outside the scope of the term 'insurable earnings.'"
Calculating And Reporting Tips and Gratuities
With the understanding that Taxpayers have an obligation to report income from tips and gratuities on their tax returns, the next big question is how tips and gratuities are calculated and reported. A taxpayer should keep records of the tips and gratuities received and report the recorded amount on his or her income-tax returns truthfully. If a taxpayer is suspected of "knowingly, or under circumstances amounting to gross negligence, make or participate in, assent to or acquiesce in the making of a false statement or omission in a return, application, form, certificate, statement, invoice or answer," the CRA may impose a Gross Negligence Penalty ("GNP"). A taxpayer's background will also be taken into consideration when assessing GNP related to unreported income. You can read more about GNP here: A Canadian Tax Lawyer's Perspective on Gross Negligence Penalties and Net Worth Tax Audits.
Moreover, the CRA may be entitled to estimate a taxpayer's income from tips and gratuities based on relevant information available to the CRA. In Davis v The Queen, 1998 CanLII 491, the taxpayer was employed as a waitress at a restaurant who did not report tips and gratuities on her 1994 and 1995 income-tax returns. The CRA, based on the credit card sales records, estimated that the rate of gratuities on each sale by the taxpayer to be 10% and reassessed the taxpayer accordingly. This estimate was accepted by the court despite the taxpayer arguing that an average of 5% to 6% was a more realistic estimate of the tips, since the taxpayer could not provide evidence to rebut the CRA's reassessment. It is always important and crucial for all taxpayers to keep full records of the tips and gratuities they receive, even if the records are generated and maintained solely by the taxpayers themselves. For example, a bartender who receives cash tips on a regular basis can choose to keep track of his or her hours worked, total tips received, and records of bank deposits. These records can assist the bartender to rebut unreasonable CRA estimates when the CRA questions his or her actual income in a tax audit.
Pro Tips – Beware of The Penalties!
Failure to report part of your income often comes with penalties and interests. The CRA may even impose a Gross Negligence Penalty if the CRA finds you knowingly, or under circumstances amounting to gross negligence, make or participate in, assent to or acquiesce in the making of a false statement or omission in a return, application, form, certificate, statement, invoice or answer." As a taxpayer, you must be aware that the GNP is a severe penalty which can be up to 50 percent of the unreported income, in addition to the owed taxes, other applicable penalties, and accrued interest.
If you are facing CRA tax audits regarding your income from tips and gratuities, you should engage with one of our expert Canadian tax lawyers. Our knowledgeable Canadian tax lawyers can provide legal advice and assist you with fighting unreasonable CRA decisions.
FAQ
How Can the CRA Determine Or Learn About My Cash Income, Such As Tips And Gratuities?
The CRA is permitted to estimate a taxpayer's income based on relevant information, pursuant to Davis v The Queen, 1998 CanLII 491, even if there is no proof that such estimate is 100% accurate. For example, if your coworkers reported, on average, that 10% of their income come from tips and gratuities, the CRA may consider that 10% of your income should also be tips and gratuities, unless there are evidence proving otherwise. In addition, the CRA may choose to rely on your employer's tax returns to estimate the average amount of tips and gratuities distributed to the employees. It is always important and crucial for all taxpayers to keep full records of the tips and gratuities they receive, even if the records are generated and maintained solely by the taxpayers themselves.
What Should I Do When CRA Accuses Me of Underreporting My Income From Tips And Gratuities?
It is important for a taxpayer to keep track of their income and maintain proper records, especially when the income fluctuates and include tips and gratuities. If you are not in possession of a complete record, you may need to seek assistance from your coworkers or employer for supporting documents. However, there is no guarantee that the CRA will simply accept the evidence you provided. Therefore, it is best for any taxpayers to consult with an experienced Canadian tax lawyer before sending a response to a CRA inquiry or audit. If you require assistance with disputing CRA's decision or responding to a CRA tax audit, please contact our expert Canadian tax lawyers.
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