Employers have an obligation to deduct tax from income paid to
an employee. But what about an employer's tax obligations when
the employer and the employee enter into a settlement agreement to
resolve issues arising from the employment relationship?
Humiliation, loss of dignity, injury to feelings and loss of
If payment is made pursuant to section 123(1)(c)(i) of the
Employment Relations Act 2000 ("ERA"), then the payment
is tax free. Payments under section 123(1)(c) include compensation
for humiliation, loss of dignity, and injury to the feelings of the
The Inland Revenue Department ("IRD") has issued a
Public Ruling (BR Pub 06/05) to this effect stating that such
Are not income under section CE 1 of the Income Tax Act
Are not gross income under ordinary concepts under section CA
1(2); and that
There is consequently no liability under section NC 2 for
employers or former employers to deduct PAYE from these
The Ruling does not apply to payments which are akin to sham
payments. If the parties to an agreement agree to characterise or
describe payments as being for humiliation, loss of dignity, or
injury to feelings when they are in reality for lost wages, this
transaction would be deemed to be a sham and would be open to
challenge by the Commissioner of IRD.
Employers should expect scrutiny and penalties from the IRD if
they attempt to re-package redundancy compensation and other
contractual entitlements as tax-free payments for hurt and
humiliation. If a re-packaged agreement is discovered by IRD, the
employer may be compelled to pay PAYE on the payment which they may
not be able to recover from the employee. It is likely they will
have to pay a penalty and interest as well. Overall, an employer
who attempts to re-package other payments as tax-free compensation
incurs greater financial costs as a result.
IRD will look closely at the amount of any payment characterised
in this way. Payments that are well above $15,000 are likely to
attract attention. Such sums are rarely awarded in the Employment
Relations Authority and Employment Court, and therefore the facts
of the case will need to be sufficiently exceptional to justify the
Public sector guidelines on severance
Severance payments are payments over and above what a person is
entitled to under their employment agreement. They are made by the
employer as part of an exit agreement to help resolve an
unsatisfactory employment situation.
In February 2012, the Office of the Auditor General released a
guide to assist public sector employers in making severance
payments. The degree of scrutiny and accountability for severance
payments in the public sector is much greater than in the private
It is important that public sector employers follow a clear and
transparent process in relation to severance payments. Payments
should, where possible, be negotiated with the help of legal
advice. Written advice may be needed if the employer is later asked
to explain the basis for a payment. The amount paid must be
reasonable in the circumstances and able to be justified as a
proper use of public money. Payment should be based on careful and
well documented assessments. The agreement itself must be
documented correctly with sufficient information as to nature and
basis of the payment, the timing of the payment and any obligations
on behalf of either party.
Complete confidentiality should not be promised in a settlement
agreement because of statutory disclosure requirements. The
disclosure regimes applying to public entities are more onerous
than those applying to the private sector. Local Authorities and
Crown Entities, for example, have specific disclosure obligations
under the Local Government Act 2002 and the Crown Entities Act 2004
respectively. Public entities are required to disclose termination
benefits paid to "key management personnel", essentially
all senior staff, in accordance with financial reporting
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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