Appendix C: The Tax Implications of Payments for Hurt and Humiliation

C.1
It was common ground among the employment lawyers and human resources advisers we spoke to that the average size of payments for hurt and humiliation in employment settlements is much higher than what the Employment Relations Authority and the courts commonly award in cases which they determine.

C.2
This may be a justifiable cost of a system which encourages parties to resolve their disputes voluntarily and on a “full and final” basis – thus foregoing their right to have their legal entitlements determined judicially. There is also a view that structuring a settlement around a large payment for hurt and humiliation tends to reduce the total size of the settlement package.

C.3
However, the practice raises an important question, namely:

what is the benchmark for deciding whether a voluntary payment is acceptable from a probity and tax point of view?

C.4
We think this question should be addressed by reference to:

• the Employment Relations Act itself – in particular, the need for the employer to be satisfied that there is genuine humiliation, loss of dignity, and injury to feelings which justifies a payment for hurt and humiliation; and
• what is acceptable from a tax point of view.

C.5
To explore these issues further, we:

• examine the amounts typically awarded under section 123(c)(i) by the Employment Relations Authority and the courts, and paid under employment settlements;
• consider the possible reasons for the different practices;
• discuss the approach of the Inland Revenue Department (“IRD”); and
• consider the implications for public sector employers – with illustrations from cases we have seen.

Levels of Payments for Hurt and Humiliation

C.6
The trend in judicial decisions is for limited amounts of damages to be awarded under section 123(c)(i) of the Employment Relations Act (previously section 40(1)(c)(i) of the Employment Contracts Act). In each case, the relevant court or tribunal has considered the nature and extent of the harm suffered by the employee, and awarded damages accordingly.³¹

C.7
The following table shows that payments for hurt and humiliation made under employment settlements – especially those negotiated without the involvement of the Mediation Service – tend to be higher than what the Employment Relations Authority is willing to award as damages under section 123(c)(i).

Hurt and Humiliation Payments Under the Employment Relations Act: 2 October 2000 to 20 March 2002

Source: Department of Labour.

C.8
The employment lawyers we spoke to about their experience with employment settlements confirmed this picture. Payments between $20,000 and $60,000 were said to be common, and there was said to be frequent anecdotal evidence of much larger amounts.

Possible Reasons for the Divergent Practices

C.9
There is little or nothing in the way of a principled explanation for this divergence between adjudicated awards and employment settlements. In much of the professional advice we have seen, the nexus between the alleged grievance and the size of the compensation payment is either not readily apparent or completely lacking.

C.10
In some cases, employers were advised without question to make a payment for hurt and humiliation on the basis of a threatened personal grievance rather than an actual one, or even on an assumption that a personal grievance might be raised in response to an attempt at dismissal. In others, there was no scrutiny or consideration of (or advice about the employer’s need to investigate) an alleged grievance.

C.11
Instead, some advisers appear to assume that a payment for hurt and humiliation will form part of an employment settlement, and base their advice as to the amount of such a payment on what they think would be acceptable in tax terms. However, there are no reported tax cases on what is acceptable.

C.12
We think it more likely that:

• most advice is simply based on recent experience;³³ and
• the result is determined by what the employer is willing to pay.

C.13
The lack of a principled foundation to the practice is therefore not surprising.

IRD’s Approach

C.14
A payment for hurt and humiliation awarded to an employee by the Employment Relations Authority does not form part of an employee’s gross income under the Income Tax Act 1994. The reason is that the payment is in the nature of damages, and is too remote from the employment relationship to be “monetary remuneration”.

C.15
IRD also accepts that, if a voluntary payment for hurt and humiliation is genuinely based on an employee’s right to compensation under section 123(c)(i), it will be treated in the same way. This position has recently been confirmed in a Public Ruling.³⁴

C.16
However, the Ruling also makes it clear that payments that are in reality for lost wages or other income – but which are merely characterised by the parties as being for humiliation, loss of dignity, or injury to feelings – are open to challenge. This is so, irrespective of whether a settlement agreement has been signed by a mediator.³⁵

C.17
When investigating a payment for hurt and humiliation, IRD would need to be satisfied that the employee’s grievance was genuine and that the transaction was not a sham. For this purpose, it is likely to focus on the cause of the humiliation, loss of dignity, and injury to feelings, and consider:

• the link between the cause and the amount awarded; and
• the proportion of the compensatory amount against the total payment.

C.18
The onus would be on the parties³⁶ to prove both that the grievance was genuine and that the amount of the payment was justifiable in relation to the nature of the humiliation, loss of dignity, and injury to feelings suffered.

Implications for Public Sector Employers

C.19
An employer is entitled to rely on professional advice that a proposed payment for hurt and humiliation is both justifiable under employment law and acceptable for tax purposes. However, the payments for hurt and humiliation we have seen in recent years in the public sector range from $25,000 to over $240,000. In most cases, the payment for hurt and humiliation comprised a significant proportion of the total settlement. In several cases, the entire settlement was expressed as a payment for hurt and humiliation, despite the amount being apparently calculated on the basis of a (taxable) contractual entitlement on termination.

C.20
Payments at the higher end of this scale (whether absolutely or as a proportion of the total settlement) are not only out of step with what an employee might be awarded by judicial determination, but are also inconsistent with what we have identified as common practice in respect of employment settlements. In some cases, we have doubted whether the payment was genuinely for compensation arising from a personal grievance.

C.21
The following examples illustrate this point.

1. A majority of the governing body of Entity E in the local government sector wished to replace the chief executive, who had one year to run on a fixed-term agreement. The agreement did not provide for automatic renewal at the end of the term, but the parties were to meet one year from the end date to negotiate a new agreement. If the negotiations failed, the agreement would end and the chief executive would be paid 6 months’ salary.
   
   The chairperson of the governing body obtained legal advice to the effect that the entity should not enter into renewal negotiations if it did not intend to renew the agreement. The governing body decided (by a majority vote) not to negotiate a new agreement, and to terminate at the end date – one year away. The chief executive’s lawyers threatened court action in relation to the entity’s process, but said that the chief executive was willing to explore early departure on mutually agreeable terms. (It was common ground that it would be difficult for the chief executive to work out the remaining year of his contract under the circumstances.)
   
   After negotiation, the parties entered into a full and final settlement, under which the chief executive received over $240,000. This appeared to represent roughly one year’s salary, but was expressed entirely as a tax-free payment for hurt and humiliation. Lawyers acting for both parties advised that there was no tax liability.
   
2. In considering options for negotiating the employment settlement with its chief executive, Entity A received advice from an employment adviser that, under the particular circumstances, any payment for hurt and humiliation would need to be within the upper limit for such payments. The advice was that the employment adviser would be “comfortable” with a tax-free payment of $35,000, and that the entity should be aware of the potential tax liability if it paid above that limit.
   
   The governing body authorised the chairperson to proceed with settlement, and specified financial parameters which appeared to contemplate a taxable payment for lost remuneration as well as a payment for hurt and humiliation. However, as negotiations progressed, the entity appears to have lost sight of the need to distinguish between taxable and non-taxable elements of the settlement package. The chief executive received a tax-free payment of over $80,000 – which was within the authorised parameters but well above the employment adviser’s “comfort zone”.

31: See the Court of Appeal’s recent decision in Charta Packaging Limited v Howard et al (unreported, 22 February 2002, CA12/02) in which the Court substituted awards of $7,000 for compensation for humiliation, distress and injured feelings in place of the Employment Tribunal’s awards of $11,000-$15,000. The Court of Appeal emphasised that awards of compensation of this type are confined to compensation for unjustifiable elements of the employer’s conduct and that, under this head, an employer is not required to compensate an employee for the loss of the job.

32: These statistics continue the picture of decisions of the Employment Tribunal under the Employment Contracts Act.

33: Under both the Employment Contracts Act and the Employment Relations Act.

34: Inland Revenue Department Public Ruling – BR Pub 01:04 Assessability of Payments Under the Employment Relations Act for Humiliation, Loss of Dignity and Injury to Feelings.

35: Mediators are not necessarily qualified to take an active role in advising parties on any consequences of the structure of settlements: see Appendix A on pages 29-31.

36: The tax liability – including any shortfall penalty – could fall on either the employer (by virtue of its PAYE obligations) or the employee (as the recipient of the payment).