Beware Sham Tax Free Payments

Under Section 123(1)(c)(i) of the Employment Relations Act, payments made by an employer to an employee for humiliation, loss of dignity, or injury to feelings, are generally tax free. Being able to make tax free payments as part of an employment dispute settlement has benefits to both employer and employee. The employee receives more in the hand than they would have if they had received the same amount of wages or salary as a settlement. From the employer’s point of view less cash is payable.

In order for such payments to be tax free they must be genuine and not a recharacterisation of lost wages or salary. If the settlement contains a section 123(1)(c)(i) payment that in reality is wages/salary renamed as payment for hurt and humiliation this is a sham and the Inland Revenue Department can apply tax to the amount in question plus penalties and interest. The IRD can ask the parties to justify how they calculated the amount agreed under section 123(1)(c)(i). The onus of proof is on the parties to justify their position – not on the IRD.

In order to avoid later issues with settlements it is important for a personal grievance claim to be actually raised, and that the parties are represented so that careful consideration can be given to any tax free payment. The parties should avoid section 123(1)(c)(i) amounts that are almost the same as a month or two of salary as it makes the tax free amount look like a sham even if it is not.

Please ask us if you have any questions.