Termination Pay - The Issues for Payroll to get right

Termination pay is one of the higher-risk areas of payroll processing. This is because termination pay can include several different types of payments not part of normal payroll processing while using various calculations that can impact other payments being made in the same pay.

I have written on several topics that will be covered in this article, but I wanted to link them up into a termination pay focus for this article (a one-stop shop as such). I will only cover some of the main points for each as some of these areas can have a range of alternative options, so as always, let’s keep it simple.

The areas for termination pay I will cover in this article are:

As part of each section, the following will also be mentioned:

8% for leave termination

In any termination pay, you will always be dealing with the 8% accrual for holiday pay, whether this is for an employee who leaves before 12 months (start date to end date before 12 months, Section 23) or after 12 months (last entitlement date to end date after 12 months, Section 25). The 8% is based on the taxable gross less any annual holidays paid in advance. One extra point here is if the employer gave an employee an agreed extra week of annual leave (a 5th week), the 8% does not automatically change to 10%. As stated, the extra week was agreed, so the 10% would also have to be agreed, and if not, the 8% is law, and that is what is used.

Notice period worked and paid in lieu

Notice is an agreed term, so payroll should be clear on what notice periods are present within their business. The two main types of notice are when the employee works their notice and when notice is paid in lieu. When an employee works their notice, the termination pay is paid at the end of the notice period as part of the employee’s final pay, so this would include the payment of the notice period, outstanding leave (entitled and accrued (8%)), along with any other agreed payments (as per the employee’s employment agreement).

Sometimes, the employer may decide they don't want the employee to work their notice. The choice to do this could be in the form of a clause in the employee's employment agreement or even by agreement with the employee at the time. Payment in lieu is a frequent question we get through to the NZPPA PayTech Adviceline, asking when the actual termination date is. So, think of payment in lieu as paying out the obligation of notice, so the notice is paid out on the date paid and does not extend forward. For example, the employee’s final day is a Friday, and they are not working notice of four weeks as the employer has advised it will be paid in lieu, so the employee’s final day is the Friday. In tax terms, notice worked is taxed as salary or wage, and notice paid in lieu is taxed as extra pay. Notice is included in the 8% on termination and the gross for KiwiSaver.

Redundancy compensation, if agreed to be paid

Nothing in current legislation provides redundancy compensation to an employee when made redundant. So, if this is seen, it is an agreed term. For payroll, you clearly need to understand what has been agreed (what calculation is being used over what period). Redundancy is one type of extra pay (lump sum payment) that no earner levy is included, so it is taxed at the flat tax rate. If the employee has a student loan, this is deducted but is not included in the gross for KiwiSaver or leave on termination (the 8%).

Public holidays paid after termination

One of the quirks with the Holidays Act is that when the employee does not use an outstanding annual holiday entitlement, it gets paid out on termination and will extend forward from the termination date (only entitlement extends forward, not accrual (8%)). Think of it this way, the employee could have taken the entitlement as leave, but you cannot be on annual leave on a public holiday, so that is why the employee gets any public holidays in the period. The value of public holidays taken will also go into the 8% for leave and is taxed as extra pay and is included in the gross for KiwiSaver.

Alternative holiday paid-out holidays

An alternative holiday is earned when an employee works on a public holiday that is an otherwise working day. On termination, if the employee has unused alternative holidays, it is based on the value of the employee’s final day of employment paid at RDP or if the day cannot be determined, ADP. This is part of the 8% on termination, taxed as extra pay and is included in the gross for KiwiSaver.

Personal grievance payment under Section 123 of the Employment Relations Act

If a personal grievance has been settled that involves a termination payment, payroll may be involved in paying a range of payments depending on what has been settled, including final wages and salary, notice, any leave entitlement not used and the 8%. The other common payment is a tax-free compensation payment under Section 123(1)(c) of the Employment Relations Act 2000. As this payment is tax-free, it is not part of the 8% or KiwiSaver. I regularly hear from payroll that they are not allowed to see the settlement agreement and are told what to pay, but what has been stated does not seem correct. There is nothing confidential in a settlement agreement that payroll should not see (as with all the confidential information we see daily in payroll!). It is also a document to put on file as IRD can investigate any tax-free payments made to an employee, including those made under Section 123(1)(c).

Payment made to the employee after they have been terminated

Once a termination pay has been made and the employee has left, there are occasions when an additional payment may need to be made to the now ex-employee, such as commission and bonus payments. If this payment is made, it is taxed as extra pay, and it will still incur the 8% for leave and be part of the gross for KiwiSaver. Payroll should contact the employee to get an ir330 (not revert to the one used while employed). As the extra pay could be based on four weeks of zero, the employee can provide written confirmation if they want the extra pay to be taxed at a higher rate than the present rate that would be based on what threshold the payment was in to be taxed as an extra pay.

Using your payroll system to best effect when doing a termination pay

I have talked about what needs to be done for a range of situations regarding termination pay, but what all ties it together is, of course, the payroll system being used. So, it is important that payroll fully understands what their payroll system can and cannot do when a termination pay is made. Now, you may think every payroll system should be able to do everything required for termination pay, but that is far from the truth. Our unregulated payroll industry can see any software provider create their view of what a payroll system should be, and they decide what is included or not. Just to give you one example, throughout this article, I have mentioned what payments are taxed as extra pay. Now some payroll systems don't even have the ability to do the extra pay tax calculation (so payroll must do manual calculations).

One other thing I want to mention here is that I get numerous questions on final pay from payroll practitioners because they do not trust what their payroll system is doing. One of the big issues is the lack of transparency, where it cannot be seen how calculations have been undertaken and what has been included or excluded in the payroll system software. It may mean payroll has to create manual calculations and worksheets to confirm that what the system is doing is correct. Payroll may even use manual workarounds instead of using what the payroll system provides. I know of several payrolls that have all termination pays done manually because of the known issues with the payroll system. If the payroll system does not provide the tools to complete a compliant termination pay, you should clearly voice your concerns to the payroll provider.

In conclusion, payroll needs to do some work on ensuring that all elements of a termination pay are clearly understood (by payroll) and transparent to all parties (especially the employee when they receive their final pay). As termination pay is a critical payroll activity, it should be documented, not over the top with a ten-volume set of policies and procedures (that took ten years to create but are never used) but a set of plain language operational procedures in an easy-to-use format that is updated when needed. By setting procedures in place and following the requirements by law and agreement, payroll can minimise any risk of getting a termination pay wrong while ensuring the employee gets paid correctly.

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