Under current economic conditions, more disgruntled employees seem to be taking action against their employers. Unfortunately, many settlements are reached based on legal advice that the cost of fighting the battle is less than the immediate punishment, as opposed to the relative merits of the claim.
One can appreciate the pragmatic nature of this approach, although some employers quickly develop the reputation for being an easy touch, which clearly leads to further claims.
Irrespective of how you end up at the point of writing out a cheque, then there are some tax consequences which the employer needs to take account of in terms of structuring the settlement.
At the least, it is fundamental that any settlement with an employee (whether through mediation services or otherwise) be recorded in writing.
Quite often, particularly in a mediation situation where the parties have been at it hammer and tongs all day and there is a degree of tiredness creeping in, there is often a late push for a settlement amount to be labelled as being for humiliation, loss of dignity, or injury to feelings, under s 123(1)(c)(i) of the Employment Relations Act 2000 (or a similar provision under the Human Rights Act 1993).
One reason for this (from the employee's perspective) is that a payment of this nature is not income under the Income Tax Act 2007 and, therefore, is a tax-free amount to the employee.
However, if a payment is made under this heading, but in reality is for lost wages, holiday pay or other income (thus, merely characterised in the agreement as being for humiliation, loss of dignity, or injury to feelings), then the IRD clearly has the ability to revisit this categorisation, and conclude that a settlement payment contains lost wages etc.
Such payments are taxable income, and should have PAYE deducted.
Thus, an employer does run some risk in simply agreeing to a payment under this heading if that is not entirely genuine. Common sense and balance needs to prevail.
It is important to note that even if the agreement is signed off under mediation, the IRD can still challenge it on these grounds, with reference back to the original claim documents which invariably have every category of claim listed for completeness, and bargaining position.
At the least, an employer should ensure that the written agreement records any such payment under this heading as a gross payment.
This puts them in the best position to argue that, should the IRD disagree at a later date about the true nature of the payment, any PAYE/tax obligation should fall to the employee.
Otherwise an employer could be left paying both the amount to the employee, plus PAYE on top of that.
From an employer's perspective, ordinarily we would consider that any payment made to an employee of this nature should be a deductible expense on the basis that it is a cost of doing business.
However, recent comments by the Courts with regard to non-deductibility of fines may suggest that ultimately, over time, this type of expenditure may evolve towards non-deductible under a public policy view.
There is not necessarily any legislation to support this position, but in this politically correct world, it would not be surprising if this is where we get to.
In conclusion, if you are an employer in this situation whereby an agreement is presented to you to sign, and you just want to get home for dinner, do make sure that you are comfortable that the allocation of damages consideration to humiliation, loss of dignity, and injury to feelings is appropriate in the circumstances, and that there is not an element of lost wages or holiday pay contained therein.
Furthermore, ensure that the agreement clearly records that all payments to the employee are gross payments.
Scott Mason is the tax principal of WHK Otago.
