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11 Mar 2016

Commissioner’s operational position on calculating PAYE on holiday pay

CIR's 2016 operational position clarifies the appropriate tax treatment of holiday pay when calculating PAYE deductions.

This item replaces an earlier version of the Commissioner’s operational position on calculating PAYE on holiday pay, published on 17 November 2015.  This does not change the Commissioner’s position as outlined in the earlier version, but provides more information and further explains the correct tax treatment of holiday pay under the Income Tax Act 2007.

This item clarifies the appropriate tax treatment of holiday pay when calculating PAYE deductions, as there has been uncertainty in this area. This item also sets out the operational position adopted by the Commissioner in relation to this matter.

The Holidays Act 2003 provides for an employee’s entitlement to paid annual holidays.

Holiday pay can be paid based on an employee’s annual entitlement or 8% of their gross earnings. The Holidays Act 2003 treats holiday pay as salary and wages that are subject to tax deductions (i.e. PAYE). The Income Tax Act 2007 (ITA) then determines the correct tax deductions.

For income tax purposes, holiday pay is a “PAYE income payment” which is classified and taxed as either “salary or wages” or “extra pay” – both of these terms are given specific meanings for income tax purposes, which do not necessarily align with the Holidays Act definitions or what would ordinarily be perceived as an “extra pay”. Further, the tax treatment of holiday pay is not dependent on the status of leave (e.g. accrued or entitled, paid in advance of the actual leave, during it or after it) under the Holidays Act or another enactment.

“Salary or wages” is defined in section RD 5 of the ITA as a payment of salary, wages or allowances made to a person in connection with their employment. However, any payment that is classified as an “extra pay” is excluded from the definition.

“Extra pay” is defined in section RD 7 of the ITA. It means a payment that:

  • Is made in connection with a person’s employment; and
  • Is not a payment regularly included in salary or wages payable to the person for a pay period; and
  • Is not overtime pay; and
  • Is made in 1 lump sum or in instalments.

Put simply, a payment that is not normally paid in a pay period will be an extra pay and would be taxed as such and not as salary or wages. Taxing the payment as an extra pay does not always mean that the person is receiving more pay – it merely means that the person is receiving an extra payment for that pay period.

The extra pay tax rules help to reduce overpayment of tax

There is a misconception that taxing a payment as an extra pay means the employee is taxed at a higher rate. In fact, the deduction rates for an extra pay are aligned with the personal income tax brackets and tax rates, and therefore depend on the annual income of the employee.

The extra pay tax rules are intended to ensure that any payments made in addition to an employee’s usual salary or wages for a pay period are taxed at the appropriate tax rate so that the employee is not over or under taxed. As PAYE deductions are calculated based on a person’s annual income, a one-off extra payment, added to the person’s regular salary or wages for that pay period, would otherwise lead to too much tax being deducted, based on the assumption that the employee would receive that extra amount each pay period.

For example: If an employee gets paid $900 per week, PAYE is deducted each week based on an annual salary of $46,800. If the employee were paid four weeks of holiday pay as a lump sum, and the lump sum were simply treated as ordinary salary or wages in that week, then PAYE would be erroneously deducted on the basis of a weekly assumed income of $4,500 (i.e. an annual salary of $234,000). This would result in the over deduction of PAYE in this instance.

Is it “salary or wages” or “extra pay”?

When deducting PAYE on holiday pay, we are concerned with when the holiday pay is paid to the employee, rather than how the holiday pay is calculated. To decide whether a payment of holiday pay is salary or wages or extra pay, regardless of the status of the leave (i.e. accrued but not entitled, accrued and entitled, or anticipated leave) or how the holiday pay has arisen (person takes leave or end of employment), the following general principles apply:

  • Salary or wages: Holiday pay that is linked to the work days within the pay period is treated as salary or wages (i.e. where holiday pay is paid in substitution of their normal pay in a pay period; or 8% of a person’s gross earnings is included in the person’s regular pay). This is how the majority of holiday pay is paid to an employee.

    For example, a person who is paid weekly goes on leave for two weeks. That person continues to be paid weekly while they are away, but instead of their normal salary, they are paid 5 days of holiday pay in each pay period. These are salary or wages and not extra pays. The gross amount of holiday pay should be allocated appropriately to the number of days/weeks of leave taken and then the PAYE tables applied.
  • Extra pay: A payment of holiday pay that is paid in addition to the regular pay for the pay period is treated as extra pay. These are payments that wouldn’t normally be paid in that pay period.

    For example, when a person takes leave and they request that their holiday pay is paid in a lump sum before their leave starts (i.e. the holiday pay is paid in an earlier pay period and not in the pay period to which the leave relates). For that particular pay period, the person would receive their normal pay plus the lump sum holiday pay. The regular pay should have normal PAYE deducted as usual by applying the PAYE table and the additional lump sum should have PAYE deducted using the deduction method for extra pay.

    The same applies when the remaining balance of a person’s leave entitlement (or 8% of gross earnings where there’s no leave entitlement) is paid as a lump sum in the person’s final pay at the end of their employment (i.e. the final pay consists of the person’s normal pay and an extra lump sum payment). The person’s normal pay should have normal PAYE deducted and the extra lump sum payment should have PAYE deducted using the deduction method for extra pay.

A different PAYE deduction method is required for an extra pay payment. Find out more information on how to calculate the PAYE deduction from an extra pay.

Commissioner’s Operational position

It is the Commissioner’s position that the above treatments will apply prospectively from 1 April 2016. This is due to the uncertainty in the treatment of holiday pay in the past caused by some incorrect material on Inland Revenue’s website. This may have caused some employers to over or under deduct PAYE from an employee’s holiday pay.

Further, the Commissioner has decided to not apply resources to correcting the incorrect deductions made by an employer prior to 1 April 2016. This is because any incorrect deductions would have been small for each employee and should, in any event, be reflected in the employee’s overall annual tax liability.

However, those employees who have been adversely affected by an incorrect amount of PAYE being deducted from their holiday pay prior to 1 April 2016 can have their taxes corrected by requesting a personal tax summary from us, and any over deductions refunded, in the normal manner.

Inland Revenue is in the process of updating the content of its website, including the relevant calculators and the PAYE deduction tables, to reflect the above positions, with application from 1 April 2016. Employers should also ensure that the correct PAYE deductions are made from holiday pay from this date onwards.

For completeness, this operational position does not affect the Commissioner’s position on the treatment of “cashed up” annual leave, which should continue to be treated as an “extra pay”.

Submissions received on Government discussion document

Submissions on alternative methods of calculating PAYE on holiday pay have been received as part of the consultation process for the Government discussion document Making tax simpler – Better administration of PAYE and GST. The issue of whether there are other or better means of deducting tax on holiday pay will be considered as part of this wider Government policy work.