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|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:
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.
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.
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:
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.
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 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.