Tax free or Not Tax Free comes down to reasonability

Employee: Can I ask you to sign this GST 370 and a T2200?

Employer: But I paid you that km reimbursement tax free and I claimed the notional ITC (Input Tax Credit on my last GST/HST return because I'm allowed to.

Employee: The km reimbursement is too low, it's only 40 cents. I've done the math, and I want to claim my expenses on my tax return.

Employer: Then I have a choice to make. I can either include the allowance on your T4, in which case you can claim the full amount of expenses, but that income is subject to CPP, EI and Tax withholdings,

...or we include how much I paid you tax free on your T2200, and it will be necessary to reduce your expense claim by how much I've reimbursed you for.

Either way, including the amount in your income, or reducing your employment expense claim won't affect your net income, as either you'll report more income, or net employment expenses on T777. The change in your net income will be exactly the same.

Later conversation between Accountant and Employer:

Employer: CRA says I don't have to include the amount on the T4

Accountant: It does say that you may not have to include the amount on the employee's T4 in this post on the CRA website:
http://www.cra-arc.gc.ca/tx/bsnss/tpcs/pyrll/bnfts/tmbl/llwnc/klmtr-eng.html

If you add the allowance as income on the T4, you could trigger a PIER report. There is supposed to be CPP, EI and tax taken on allowances that are not paid tax free.

You could choose to disclose how much was paid tax free on the T2200 instead, and the employee will be required to deduct that amount from how much expense they can claim.

Look at Row 15 on the Calculation of allowable motor vehicle expenses calculation box on the T777 where you will find:
"Enter the total of all rebates, motor vehicle allowances, and repayments for motor vehicle expenses you received that are not included in income. Do not include any repayments you used to caluclate your leasing costs on line Line 11"

Either way, as the employer you won't be able to claim the ITC on that tax free allowance, as it's no longer tax free. There is something else you need to be aware of.

If you've added the allowance to the T4 or completed a T2200 and signed a GST370 Area C declaration swearing you didn't claim the ITC yourself, then you must re-pay any ITC's claimed for those tax free payments you've just agreed aren't reasonable by completing these forms for the employee.

It does all balance out from the gov't perspective, although you, as the employer likely won't agree. Only one person gets to claim the ITC.

If it's tax free, and it's reasonable, the employer claims the GST/HST.

If it is not reasonable, it's also not tax free. If it's not reasonable, the employee can claim the GST/HST rebate and the employee gets to claim it when they claim their expenses, net of their allowance received of course.

That's reasonable right?