Nitty-gritty of settlement awards
Column written by Dunedin Partner John Farrow, published in the business section of the Otago Daily Times on Friday 27 November.
It has become commonplace to read about employers having to pay large settlement sums awarded by the Employment Relations Authority (ERA) for unjustified actions and dismissals. However, often there is no explanation about how those awards are made up. There are a number of remedies available to an employee who succeeds with a personal grievance. The primary remedy is reinstatement. The employer is also entitled to reimbursement of wages or other money lost as a result of the grievance. This is usually for a minimum of three months’ lost remuneration, but the ERA has discretion to pay a greater sum. In addition, an employee can claim loss of any benefit, whether or not of a monetary kind, which they might reasonably have been expected to receive if the personal grievance hadn’t arisen. On top of lost wages and lost benefits is compensation for humiliation, loss of dignity and injury to feelings. This is commonly known as a tax-free payment.
The remedies available can be reduced if the employee has contributed to the situation that gave rise to the personal grievance. By far the majority of personal grievances are settled by negotiation or at mediation. Generally, they are documented in a record of settlement signed off by a mediator from the Ministry of Business, Innovation and Employment. This not only records the full and final nature of the settlement, but also means that any breaches of the settlement are immediately enforceable in the ERA.
Because genuine compensatory payments are not taxable, there is a real attraction to employers paying as much settlement monies under this heading as possible and therefore avoiding having to pay tax. Compensatory settlements are also attractive to employees for the same reason. But if the settlement includes lost wages and contractual obligations, such as payment of notice periods, then these payments will attract PAYE. The IRD has issued a public ruling about payments under the Employment Relations Act for humiliation, loss of dignity and injury to feelings. Where these payments are genuinely made under the Employment Relations Act they are not income and therefore do not attract PAYE. Out-of-court settlements can similarly include payments for humiliation, loss of dignity and injury to feelings. These are made in return for the employee surrendering their rights under the Employment Relations Act.
The public ruling states that there should be no difference in the tax treatment of payments dependent on whether or not the parties used the Employment Relations Authority or Employment Court. A payment can be for humiliation, loss of dignity and injury to feelings of the employee whether the authority or court is involved or not. But the ruling cautions against shams. Shams include excessive allocations for compensation or characterising a payment as being compensation for humiliation when, in reality, it is for lost wages.
The IRD has search powers to access documents for the purposes of collecting any tax or carrying out any function lawfully conferred on the commissioner. Where the commissioner has some doubt about the amount attributed to compensatory payments, they may ask the parties to an agreement what steps they took to objectively evaluate the amount of the compensatory payment. This is regardless of whether or not the settlement was signed by a mediator under the Employment Relations Act.
The IRD can also inquire whether a personal grievance has been raised; whether the employer acted fairly and reasonably; how the compensatory amount was assessed and whether it is consistent with comparable cases. The IRD can request supporting documentation, such as copies of personal grievance letters and evidence of how the compensatory amount paid was assessed against comparable cases. If the IRD forms the view that the payments have not been genuine then there is a very real risk to the employer. This includes a requirement to pay the tax component on the compensatory payment, along with penalties and interest. If the IRD enforces this, then the employer may need to advise the other party to the settlement that the payment has been assessed by the IRD as taxable. This may create issues for the other party as it can impact their overall tax position.
Eligibility for family support and payment for child support, student loans, et cetera, will be impacted. Imagine having to inform a disgruntled ex-employee not only that the terms of the record of settlement they thought were confidential have become known to the IRD but, worse, that their tax position has been negatively impacted. The Chief Employment Court Judge has issued guidance on the amount of compensation a successful personal grievant should expect to receive. Low-level damages may range as high as $10,000. Moderate damages span between $10,000 and $40,000 and significant damages justify payments over $40,000. Employers making compensatory payments would be wise to reference the court’s guidance and to consult with their financial advisers on the potential tax ramifications of making such payments.
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