Inland Revenue’s Tax Counsel Office (TCO) issued Technical Decision Summary (TDS 23) 23/01 on 22 February 2023. TDS 23/01 concerns whether settlement payments received after an employment dispute were taxable employment income. This TDS highlights the importance of considering the tax implications of proposed payments received in settlement of employment disputes. Formerly the approach taken to determining the nature of settlement payments has been to look to the initiating document that led to the settlement, in usual circumstances that is the personal grievance. Public Ruling BR06/05 Assessability of Payments under the Employment Relations Act for Humiliation, Loss of Dignity, and Injury to Feelings (BR Pub 06/05) sets out that payments for hurt and humiliation do not intrinsically result from the employment relationship, they are based on the existence of a personal grievance therefore not derived in the course of employment and are capital in nature (not taxable).
The facts
a. The employee raised a personal grievance against the employer, who was a Crown Entity. The employee and employer entered into a Record of Settlement (RoS) under which the employee received settlement payments over time, PAYE was deducted by the employer. The RoS described the payments as salary and wages and also stated that the employee’s employment would be terminated after the final payment. The employee maintained that he had resigned prior to entering into the RoS, when the Personal Grievance was raised.
b. The employee was legally represented, and mediation was undertaken at the end of negotiations. The employee was not present during settlement The employee did not attend mediation but did receive legal advice and signed the RoS with the benefit of that advice.
c. As a Crown Entity the employer must comply with the Crown Entities Act 2004, act on guidance from the Auditor General, and is subject to public scrutiny. The employer was not prepared to make the settlement payments outside of its contractual parameters.
d. When the settlement payments finished, after a delay of 30 weeks, the employee looked to Inland Revenue (IR) to recover the PAYE deducted from the settlement payments, arguing that they were in the nature of payments for hurt and humiliation under section 123(1)(c)(i) of the Employment Relations Act 2001. The employee relied on BR Pub 06/05 which provides that the general starting point for determining the nature of settlement payments is the personal grievance document.
e. IR’s Customer and Compliance Services (CCS) reviewed the employee’s position and found that the Settlement Payments were amounts derived in connection with employment or exit inducements and. CCS came to that view after considering the terms of the RoS. CCS did not consider the RoS to be a sham.
Issues
f. There were two issues to be determined:
i. The nature of the settlement payments
ii. Whether there was a sham
What was the nature of the payments?
g. TCO considered all the evidence presented by the employee, including the personal grievance, medical evidence as well as correspondence between the employer and the employee’s legal counsel finding:
i. BR Pub06/05 applies to “payments that are genuinely and entirely for compensation for” hurt and humiliation. Despite having a valid personal grievance BR Pub06/05 must be read in context where tax consequences flow from the genuine nature of the arrangements the parties have entered into rather than the general character of the preceding discussions.
ii. The RoS replaced the parties’ prior legal rights, obligations and contractual arrangements under the employment agreement and therefore was the correct starting point to determine the nature of the settlement payments.
iii. The RoS should be interpreted objectively, by reference to its text and external evidence, on the basis of what a reasonable third party would deduce for the terms.
iv. The text of the RoS indicates that the settlement payments were not compensation for hurt and humiliation, but instead were payment for employment services or an inducement for the employee to leave their employment. This was because when the employee reached a negotiated settlement, they agreed to give up their personal grievance hurt and humiliation claim in exchange for no admission of liability on the part of the employer and along with that, no payment of compensation “for” hurt and humiliation.
v. The noting of a termination date after completion of payment in the RoS did not support that the employee had resigned earlier.
Was there a sham
h. The employee considered the RoS to be a sham on the basis that it did not record the intentions of the parties, which would require disclosure of the settlement payments by the employer to the Crown and the Auditor General.
i. The TCO concluded that :
i. A sham is a document designed to deceive third parties as to the true arrangements between the primary parties.
ii. The parties to a sham document must have common intention that the document does not give the legal rights it has the appearance of creating and may disguise a real transaction or no transaction.
iii. In determining a sham the parties’ subjective intentions, evidence and subsequent conduct are considered.
iv. The RoS was not a sham, despite the employees’ assertion that employer’s subjective intention was to make the payments as compensation for hurt and humiliation.
v. The employer could not make the settlement payments as anything other than salary and accrued holiday entitlements, based on guidance from the State Services Commissioner.
vi. The employee did not enter the RoS under duress despite not being present during negotiation with the employer and it’s lawyers. The employee took legal advice and did not bring any action in the Employment Relations Authority or Employment Court on the basis that the RoS was entered under duress.
vii. There was no evidence of contractual mistake, the employee’s failure to consider the tax treatment of the settlement payments is not a mistake and there was no evidence of common, unilateral or mutual mistake. Section 26 of the Contract and Commercial Law Act 2017 (CCLA) denies relief where the correct position is made known to a party before they enter into the contract and section 25 denies relief where the relevant mistake is a mistake in interpreting the agreement.
viii. There was no evidence of any misrepresentation that induced the employee to enter into the RoS. The meaning of the RoS was clear.