Payments for hurt and humiliation – asymmetric tax treatment

Q: When is a payment tax deductible to your business but tax free in the hands of your employee?

A: When the payment is for hurt and humiliation caused by the employer.

This may seem at first glance like an opportunity for tax arbitrage – notwithstanding the high price in terms of your reputation as an employer.

The IRD has confirmed in Public Ruling BR Pub 06/05 that genuine compensation for humiliation, loss of dignity, or injury to feelings is not taxable to the employee. It matters not whether the compensation is determined by the Courts or is an out-of-court settlement agreed by the parties.   Regardless of the payments being non-taxable to the employee, they are likely to be tax deductible to the employer.

Due to this one sided tax treatment, payments for hurt and humiliation have become an area of focus for the IRD. It is well worth having some background knowledge to the tax treatment of payments to employees who have a legitimate personal grievance.

Payments for lost income, redundancy entitlements, or exit inducements are taxable and are subject to PAYE just the same as ordinary salaries and wages are. Simply reclassifying a payment as being for hurt and humiliation and getting the settlement agreement signed by an independent mediator does not make the payment non-taxable.

In order to stack up as genuine compensation for humiliation, loss of dignity, or injury to feelings – and as such be legitimately non-taxable to the employee, the parties would need to be able to demonstrate to the IRD the following: 

1. That the employee had a genuine personal grievance , and;

2. That the amount paid to the employee was reasonable based on the level of compensation awarded by the Courts in similar scenarios.

The onus for getting this right is with the employer. If the IRD were to later investigate the transaction and deem that there was no genuine personal grievance – or that the payment was excessive, they would likely seek to “gross-up” the payment to calculate the PAYE liability. As a result, the employer would be assessed for the unpaid PAYE – plus penalties and interest.

Although the employee may be highly motivated to have payments classified in a not taxable manner, the costs of getting it wrong fall entirely on the employer’s shoulders – so care must obviously be taken in this area. Because of the asymmetrical tax treatment and opportunities for abuse, payments for hurt and humiliation will likely continue to be an area of focus for the IRD.