Tips on payroll: controlled tips, direct tips and what a Canadian restaurant must withhold

Tip rules in each province say who may share a tip and who may keep it. A second set of rules, from the Canada Revenue Agency (CRA), says what your payroll must do with it. The test is not how much the guest gave. It is who controlled the money. Many restaurants find that a single decision about how tips are collected changes their payroll duties.

What is a controlled tip?

The CRA defines controlled tips as tips that an employer controls or possesses and then must pay to the employee. Its examples include an employer that adds a mandatory service charge to a client's bill to cover tips, and cash tips deposited into the employer's account, which become or mix with the employer's property before being paid out. Another example on the CRA's page is a restaurant tip pool set up by the owner so that support staff also share the tips.

What is a direct tip?

Direct tips are paid directly by the customer to the employee, and the employer has no control over the amount or how it is distributed. The CRA's examples include a guest who gives a tip directly to a bellhop or porter, and a restaurant that returns the full credit or debit card tip to the server in cash at the end of each shift.

What must you withhold?

On controlled tips, withhold income tax, EI premiums and CPP contributions. The CRA says that because the employer controls the tips, the employer is considered to have paid them. On direct tips, withhold nothing: no income tax, EI or CPP. If an employee has a mix, withhold only on the controlled part.

Employees who receive direct tips can choose to pay CPP on them by filing Form CPT20 with their return. In Quebec, declared tips have their own treatment, with income tax and EI withheld but not CPP.

What goes on the T4?

Controlled tips are reported in box 14 (employment income), box 24 (EI insurable earnings) and box 26 (CPP pensionable earnings). Direct tips are not reported on the T4. Employees must still report all tips as employment income on their tax return: line 10100 if the tips are on a T4, line 10400 if they are not.

What does this mean in practice?

• A pooled service charge that you collect on the bill and share out is a controlled tip. It is on payroll.
• Card tips you collect through your till and pay out with wages are controlled tips, because they pass through your account.
• Tips guests hand to a server, which the server keeps, are direct.
• A tip pool that staff run themselves, with no control by you, may be direct. The CRA's test is control, so ask your accountant how your pool actually works.

Review what your point-of-sale system does with tips. Some systems add card tips to a paycheque automatically, which makes them controlled tips whether or not you meant them to be.

Do you need a payroll account?

The CRA says an employer who pays tips or gratuities must register for a payroll program account.

What about a tip pool run by the staff?

The CRA's test is control, not who writes the cheque. If staff collect tips and divide them among themselves, and you do not possess or control the money, it may be a direct tip arrangement. If you set the formula, hold the cash or run the distribution through your till, you control it. The CRA's own pool example is one the owner sets up so that support staff share the tips, and it sits under controlled tips. Because the label changes your withholding, write down who runs the pool and have your accountant confirm it.

What are the steps?

1. Write down how each kind of tip reaches staff.
2. Sort each into controlled or direct.
3. Set up payroll to withhold on the controlled part.
4. Report controlled tips on the T4 in boxes 14, 24 and 26.
5. Remind staff in writing that tips are taxable income.
6. Review the setup each time you change your till or your pooling rules.

For the provincial rules on who may share tips, read Ontario's tip law and tip pooling and gratuity rules in BC. For the sales tax on service charges, see GST/HST on tips and service charges.

More in the Canadian guides for food businesses.