Sharp as tax: Extra care urged in dealing with allowances

Let us reconsider the key principles underpinning when allowances paid to employees are either taxable (as remuneration) or tax free. This will become particularly relevant as the IRD's new view on accommodation allowances is applied.

The tax-exempt income of an employee includes an amount paid by an employer to the employee to the extent that the payment reimburses the employee for expenditure that would have been deductible to the employer if they incurred it directly. An example may be the use of a motor vehicle for business purposes.

Where there is a direct reimbursement (e.g. for the fuel to fill a work car of say $98 paid for by the employee), then there is generally no question the amount received is tax free as a reimbursement.

However, for ease, some expenditure/costs incurred by an employee are met by way of an estimation approach, in the form of an allowance. For example, the precise amount of the allowance paid to reimburse the employee may not be known at the time of payment. In that event, a reasonable estimate by the employer of the amount likely to be incurred by the employee becomes the tax-exempt reimbursing allowance. The key word in that sentence is ''reasonable''. It is incumbent upon the employer to have some basis upon which to justify the allowance. This may be as simple as determining over time the average cost of a expense so incurred (across time, and possibly employees).

In respect of reimbursing vehicle use by way of an allowance (such as a per kilometre rate), this calculation may be based on the employer's own experience/costs, or substituted by adopting a reputable proxy (e.g. AA's mileage rate calculations) or using the published IRD mileage rate. All these are approximations based on certain assumptions on usage, vehicle types and likely costs incurred over time.

The tax deductibility rules governing expenditure incurred in reimbursing ''entertainment expenditure'' on food, drink, recreation and accommodation (i.e. deductible to employer only to the extent of 50%) do not affect the employee's tax position regarding the allowance.

Employees in some industries receive a range of other ''allowances'' (e.g. a dirt allowance), many of which are taxable in their hands. As noted above, the key to non-assessability is the nexus to the business activity and the degree to which there are actual costs incurred by the employee which would otherwise be incurred by the employer.

For example, a general clothing allowance would probably be taxable to the employee, whereas a reimbursing allowance for mandated safety clothing or uniform could be tax free. It will be interesting to see if the IRD reconsiders its ''new and improved'' view on accommodation allowances, but in the expectation that there has been an interpretation change, this is one area we would suggest extra care be taken, including seeking professional advice.

- Scott Mason is the managing principal of tax consulting for WHK.