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Employment Law Update – Holiday Pay on Incentives and Bonuses

  • October 20, 2014

The Employment Court (Court) has provided clarification on the application of the Holidays Act 2003 (Act) to incentives paid to employees after termination.

The recent case of Howell v MSG Investments Ltd1 has clarified when holiday pay needs to be paid on incentive payments calculated and paid after employment has ended. There are significant implications for incentive schemes where employees are entitled to payment based on the increase in value of an organisation’s assets or shares. In this case, the employer had to pay an extra $256,000 as holiday pay on top of the incentive.

This update discusses Howell and another case, Adecco, an earlier Employment Relations Authority (ERA) decision that scrutinised the elements that are required for an incentive clause to be truly discretionary (and thus excluded from holiday pay calculations).

Shades of grey: when are incentives truly discretionary?

Whether an incentive is included in the calculation of holiday pay depends on whether it is a contractual entitlement or alternatively falls within the definition of a ‘discretionary payment’ under the Holidays Act 2003 (Act).

The starting point is the employment agreement. If there is no contractual entitlement to receive an incentive in it, then any incentive payment will not be included in holiday pay calculations. This is straightforward. Another example is where the employment agreement makes reference to an employee’s ability to participate in a discretionary incentive scheme coupled with the fact that the ‘mechanics’ of the incentive are at the company’s discretion too. The sort of wording that would fall into this category is ‘you may be eligible to participate in any incentive scheme that is operated at the company’s sole discretion from time to time. Your participation and the receipt, timing and amount of any incentive payment will be determined solely at the company’s discretion.’

But some apparently ‘discretionary’ payments will be included in the calculation of holiday pay. Two types of incentive fall into this category. The first is where the employment agreement creates a legal entitlement to receive an incentive but the amount is at the company’s discretion. The second is where the employer is required to make an incentive payment but only if certain conditions are met. An example of this is ‘You will receive incentives in accordance with the company’s incentive plan. If you satisfy requirements X, Y, Z you will be entitled to receive $X’ or ‘…you will be entitled to receive up to $Y’.

The examples outlined in the above paragraph occurred in Board v Adecco NZ Ltd2. The clause in question in the employment agreement was short and set out under the heading ‘Benefits’. It was worded ‘Annual bonus based on the Bonus Plan then in effect’. The employer announced the bonus plan each year. The ERA said that the bonus became a part of the employment terms and conditions once it was announced and the employer was bound to pay it if it was earned. As a result, the bonus was not discretionary and had to be included in holiday pay calculations.

A $3.2 million incentive plus $256,000 holiday pay?

The terms of Mr Howell’s employment were set out in an Individual Employment Agreement (IEA) and a Growth Incentive Agreement (GIA). The GIA contained a non-discretionary incentive payment that was payable on 1 April 2013 or at an earlier date if he was made redundant.

Howell was made redundant and his employment terminated on 3 February 2012. Under the GIA, in a redundancy the incentive payment would be calculated at 20% of the fair market value of the company’s shares and would be paid following termination.

Due to a dispute in calculating the fair market value of the company’s shares, it took some time for the parties to quantify the value of the incentive. Eventually Howell received an incentive payment of $3.2 million nearly a year after his employment had ended. No holiday pay was paid in respect of this payment.

The issue for the Court was whether the holiday pay calculation should have included the incentive payment. If so, the employer should have paid an additional $256,000 in holiday pay (less tax).

Under the Act, employees are entitled to four weeks’ paid annual holidays at the end of each completed 12 months of continuous employment. If, however, as in Howell’s case, the employment ends before they have worked a full second or subsequent 12-month period of employment, the employer must pay out 8% of the employee’s ‘gross earnings’ since the employee last became entitled to annual holidays (section 25(2)).

‘Gross earnings’ means all payments that the employer is required to pay the employee under the employment agreement. The definition includes productivity or incentive-based payments (section 14).

Did it matter that Howell was no longer an employee?

Since the incentive payment was not discretionary (and therefore within the definition of ‘gross earnings’) the issue for the Court was whether ‘gross earnings’ only included payments made to the employee up until termination. If so, payments within the definition of ‘gross earnings’ but calculated and paid after termination would not be earnings ‘since the employee last became entitled’ to annual holidays.

The employer argued that ‘gross earnings’ should be calculated up until the last day of employment. It said that the GIA incentive payment (both calculated and paid when Howell was no longer an employee and well after the employment ended), should not be included in the ‘gross earnings’ holiday pay calculation. Howell responded that the entitlement to the incentive was a term of his employment agreement and it did not matter that it was calculated and paid after the employment ended.

The Court agreed with Howell and held that whether a payment is included as ‘gross earnings’ for the purposes of calculating holiday pay depends on whether the employer was contractually required to pay the employee the incentive under the employment agreement. The Court held that the timing of the payment and its calculation was immaterial and the fact that the employee was no longer an employee was irrelevant. The Court said that ‘whether a payment is included in the employee’s gross earnings does not therefore depend on when the payment was made and received. Instead, it turns on whether the employer was required to pay it to the employee under the agreement.’

The Court looked at several scenarios to assess what the outcome that would have been if Howell had not been made redundant. One was the situation if Howell had not been made redundant and had worked until 1 April 2013. In those circumstances, the incentive would have been paid out to him and then, when he took his annual holidays, the incentive would have been accounted for in the average weekly earnings calculation.

The Court held that the fact that the contractual incentive was paid after termination was of no consequence. The company was ordered to pay Howell $256,000 gross holiday pay plus interest from the date the incentive payment was made until the date of the judgment.

Take home tips

  • When designing incentive schemes, be careful to understand whether payments will attract holiday pay.
  • ‘Gross earnings’ must include all payments that the employer is contractually obliged to pay to the employee on termination, regardless of when the payment is calculated or made.
  • Where a non-discretionary contractual incentive is paid after termination, employers need to pay holiday pay on that incentive. Where a contractual incentive is paid during employment, employers need to include that amount in gross earnings calculations too.
  • Check your incentive clauses against the ‘discretionary’ definition in the Act and take Adecco into account. Is your incentive clause truly discretionary?
  • Check that your payroll provider or in-house payroll team is calculating holidays in accordance with the Act. This is particularly relevant for employees who are entitled to bonus or incentive payments or other one off or variable payments (including commissions and overtime payments).
  • If an employee share scheme is an option, consider designing a scheme whereby the benefit to the employee arises from gains in the shares’ value rather than payments from the employer.

How bonus or incentive ‘payments’ are described in employment documentation is directly relevant to whether they are discretionary or not (and therefore whether they should be included in an employee’s ‘gross earnings’ when assessing holiday pay).

The only way to be 100% sure that incentive payments are not included in holiday pay calculations is to express them to be discretionary and to not refer to them at all in employment agreements and offer letters.  The problem with this is that employers and employees want incentives mentioned in employment agreements so that the employee has some assurance that incentives will be available. So how the clause is worded is vital.

Employers should word any references to incentive arrangements in clear discretionary terms, making it obvious that while the employer may choose to provide an incentive it is not contractually bound to provide either an incentive scheme, or make any particular payment.

1 [2014] NZEmpC 68
2 [2011] NZERA 406

Reproduced with the kind permission of DLA Phillips Fox