Part 4: Common pitfalls

Severance payments: A guide for the public sector.

Public sector employers can encounter problems (financial penalties, public or political scrutiny, or poor audit outcomes) if they fail to follow a good process or do not have a principled basis for a severance payment. This Part gives some examples of the errors public sector employers sometimes make, which can be avoided by obtaining proper advice when necessary. The examples are drawn from real experiences but do not represent particular cases.

We discuss:

Promising confidentiality

Promising complete confidentiality in a settlement agreement is a common mistake. Complete confidentiality should not be promised because it will be overridden by the statutory disclosure requirements. Figure 3 provides examples of problematic promises.

Figure 3
Examples of promises to keep a severance payment confidential

An employer negotiates a severance payment with a senior employee, including strict confidentiality terms. A member of Parliament and a local newspaper make requests under the Official Information Act 1982 about the events that lead to the departure.

Information other than the settlement agreement (which is generally withheld because the prejudice to individual privacy outweighs the public interest in disclosure) must be disclosed under the Official Information Act, which in effect breaches the confidentiality of the severance arrangement.

The former employee claims there has been a deliberate breach and seeks damages. The employer must spend legal fees on exchanges between lawyers, so that the employee understands that there is a legal requirement to disclose and no basis for issuing proceedings.

The better course of action would have been to explicitly include in the settlement agreement the limits to confidentiality. In some circumstances, the parties might agree that the settlement cannot be confidential.
An employee suspected of fraud is dismissed after a serious misconduct process. The employee raises a personal grievance and, because of a procedural flaw in the process, has an arguable basis for a personal grievance. A settlement is reached that includes a confidentiality clause. The fraud then becomes a criminal matter, and there is public and political outcry when the employer has to disclose that a severance payment was made.

This could have been better addressed as a non-confidential settlement, to make it plain that the payment was only for the procedural failing. Alternatively, if the failing was minor and the degree of employee fault high, the employer might have been better advised to defend any proceedings and pay any award made by the Employment Relations Authority or court.

In many such cases, the Employment Relations Authority or court determines that no payment is warranted.*

* See section 124 of the Employment Relations Act.

Bundling payments together as a “tax-free” package

A common cause of problems is the “repackaging” approach to severance payments, under which the employer agrees to treat notice periods, payments for lost income, redundancy payments, or other contractual entitlements as tax-free compensation payments. This can appear fiscally neutral for the employer and, because PAYE is not deducted at source, it maximises the payment in the employee’s hands.

The risk of agreeing to pay an excessively large sum or contractual entitlements as a tax-free compensation payment is that the employer can subsequently be reassessed for PAYE, penalties, and interest.

There is a tendency for parties to expect that the settlement agreement will never be subject to scrutiny, but this is incorrect. The Inland Revenue Department can and does request access to Employment Mediation Services’ records of settlements, and has statutory powers to compel disclosure by employers and taxpayers of all forms of settlement agreement. The employer must then justify why a payment was made without tax being deducted. Auditors will also query apparently excessive severance payments.

There are many examples of repackaging arrangements that cause employers problems. Some public organisations have paid a senior employee the equivalent of between six months and a year’s salary, sometimes explicitly stating in the agreement that the amount represents “[x] months’ salary”. These arrangements will be scrutinised because the payments are potentially excessive and because some part of such a payment could be seen by the Inland Revenue Department as lost income or contractual notice periods and entitlements (from which PAYE should have been deducted).

MBIE’s mediators are aware of these matters and might guide parties during mediation to help ensure that the agreements reached can withstand scrutiny. However, the fact that a settlement agreement is signed by a mediator does not mean it is valid from a tax law point of view.

Figure 4
Example of a severance payment that does not properly allow for tax

An employee raises a personal grievance, challenging a restructuring process. The employer agrees to “re-package” the employee’s contractual redundancy entitlements as a tax-free compensation payment. The employer pays the employee the full amount of the payment, rather than the net amount after PAYE has been deducted.

The Inland Revenue Department requests a copy of the agreement, along with any background information. The Department concludes that the payment should have been taxed. The employer is compelled to pay PAYE on the payment, but cannot recover that from the employee. The employer also has to pay a penalty and interest. The result is that the settlement costs the employer considerably more than the original redundancy entitlement.