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 any benefit

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 employee.

The Inland Revenue Department ("IRD") has issued a Public Ruling (BR Pub 06/05) to this effect stating that such payments:

  • Are not income under section CE 1 of the Income Tax Act 2004;
  • 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 payments.

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 amount.

Public sector guidelines on severance payments

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 sector.

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 standards.

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.