What is a Discretionary Payment and why are they so controversial?

This is a regular topic of conversation between us and our clients so this may help in deciding if a payment is truly discretionary. It is controversial as 'true' Discretionary Payments do not add to Holiday Pay calculations, which can greatly increase their value.

If an employer is bound under the employment agreement to make a payment, then it is not a discretionary payment. Discretionary payments are ex-gratia payments that an employer doesn’t have to pay the employee under the employment agreement.

‘Employment agreement’ should be considered widely, ie to include variations of employment agreements, letters of offer, rules of commission schemes, bonus scheme rules, policies etc, especially if the employment agreement can be said to incorporate the entitlement to participate.
If the terms of a payment scheme are intended to be binding on the employer and employees, it is unlikely to be a discretionary payment.
If an employment agreement states that a payment is a discretionary payment for the purposes of the Holidays Act 2003, this in itself doesn’t make it a discretionary payment. Whether the employer is bound under the employment agreement to make the payment is what determines whether or not it is discretionary.
If an employer is bound by the employment agreement to make a payment to the employee even if the amount is discretionary (and could be zero), it is not a discretionary payment.
If the payment is dependent on the employee and/or the organisation meeting any type of targets, quotas, performance criteria or indicators, this does not make it a discretionary payment.
If payments are made on a regular and consistent basis, for example, annually if criteria are met, it is unlikely to be a discretionary payment.
If employees have a reasonable expectation of payment based on past practice, to the extent that the payment forms part of the employment agreement, it is unlikely to be a discretionary payment.

As it is rare for payments to be excluded it is recommended that employers seek advice before determining that a payment is discretionary, or else err on the side of caution and include the payment (in Holiday Pay calculations).

Examples of payments that are unlikely to be discretionary payments for the purposes of the Holidays Act 2003.

An employee’s remuneration statement includes a bonus amount at 100%. The bonus is covered by bonus rules that state that payment of and amount of the bonus is dependent on company and employee performance.
An employee’s employment agreement has an amount for on-target earnings (OTE) for commission. The actual amount of commission earned by the employee will depend on how many sales they make.
Each year the company decides who will be participating in the bonus scheme. Letters are sent out to employees who will be participating telling them that they are eligible to participate this year. The letters state that the amount they receive depends on their performance and could be zero.
A company gives all employees a Christmas bonus each year. This helps them recruit and keep good staff and employees are told about it by their employer when they start work with the company.

Examples of payments that are likely to be discretionary payments for the purposes of the Holidays Act 2003.

A business has had a really good year and the owner decides to give everyone a one-off bonus to reward their hard work. They do not do this regularly.
A company gives all employees a Christmas bonus from time to time.
A company decides that one employee has had an outstanding year and will be given an ex-gratia lump sum payment of 10% of their wages for the last 12 months.

What Does NOT Make a Payment Discretionary

The following factors do not make a payment discretionary:

Variability in the payment amount
Conditional nature (tied to performance targets)
Employer deciding who participates in the scheme
Requirements for employee effort tied to KPIs or targets

We work on the following basis:

If there is an expectation by the employee (in writing or verbally) that they will get a Bonus Payment, this is NOT DISCRETIONARY.
If historically employees receive a regular bonus payment, then this is NOT DISCRETIONARY.
If the Employee Contract has a clause mentioning ‘at the Director’s discretion, all Bonus Payments etc are discretionary’ then by definition they are NOT DISCRETIONARY.

Our Tests for ‘discretionary’ are:

Unexpected – the employee has no expectation of payment.
Random – there is no history of regular prior payments.
No pre-conditions – nothing can be written down regarding ‘x will happen if y occurs’.
Non-Contractual – there should be NO mention of a possible payment in the employee contracts, or verbally as any mention in ‘advance’ means the payment CANNOT be discretionary as you have pre-considered it.
"is the employer contractually bound to make a payment?"

Discretionary bonuses must be included in holiday pay calculations

June 23, 2020 Employment law

A full court of the Employment Court has taken a narrow approach to the meaning of “discretionary payments” in the Holidays Act 2003. As a result of the Employment Court’s interpretation, almost all incentive schemes will now have to be included in holiday pay calculations.

Background

Metropolitan Glass & Glazing Limited (MG) offered its employees a bonus scheme (scheme). The terms and conditions of the scheme provided for incentive payments (payments). The scheme was set out from time to time in letters to employees. These letters made clear that the scheme was not a term and condition of the employees’ employment agreement.

The scheme provided for payments when certain criteria were met. Even if these criteria were met, the scheme made it clear that any payments were totally at the discretion of MG’s Board of Directors. No payment could be made until the Board of Directors had approved the bonus payment and MG had the sole discretion to make payment, amend the scheme or discontinue it. The scheme also stated that payments did not come within the meaning of “gross earnings” for the calculation of holiday pay under the Holidays Act 2003 as they were “discretionary payments”.

An employee’s holiday pay under the Holidays Act 2003 is, in part, determined by their “gross earnings”. Discretionary payments are excluded from “gross earnings”. A discretionary payment is defined by the Holidays Act 2003 as a payment that the employer is not bound, by the employee’s employment agreement, to pay the employee. Discretionary payments do not include payments that the employer is bound to pay even though the amount is not specified or only if certain conditions are met.

Decision

The Employment Court found that while the scheme was set out in a separate letter, employment agreements may be composed of more than one part; policies or schemes may be incorporated by reference or inference into an employment agreement. The Court inferred that the scheme was intended to have contractual force (i.e. form part of the employment agreement) because it was designed to incentivise and remunerate employees to put in more effort to meet targets. The Court also relied on the fact that MG had previously offered participation in the scheme in exchange for employee’s agreeing to restraints of trade.

MG argued that the payments were discretionary payments as MG was not bound to pay them even when all targets were met. The Court found that this argument ran counter to the purpose of the gross earnings definition in the Holidays Act 2003 which is “to capture all remuneration for an employee’s job.”

It further found that the intent of the various definitions is that where productivity or incentive based payments are made, they are part of gross earnings. The Court held that the scheme’s payments were to provide an incentive and remuneration for performance and were tied to productivity – therefore, the payments were gross earnings. The Court neatly summarised its position: “Neither the variability of the amount of the payment, nor the conditional nature of it, makes the payment a discretionary payment for the purposes of the Act.” While that might be the Court’s view, it does seem to run counter to the clear words of the Holidays Act 2003.

The Court stated that “truly discretionary payments” (like a Christmas bonus paid at the employer’s initiative) will not be captured by gross earnings.

The Court went on to say that MG cannot contract out of the Holidays Act 2003. Statements that the scheme’s payments will not come within the meaning of gross earnings carry no legal weight, and responsibility cannot be avoided simply by labeling the scheme as “discretionary.”

On Appeal

Original Employment Court Decision

The Employment Court initially ruled that because the parties intended that the scheme had contractual force, the bonus payments were not discretionary and should be included in calculations for gross earnings. The Employment Court concluded that the payments received under the schemes were "remuneration for effort put in by the employee" and that productivity and incentive payments were captured regardless of whether they arose from employment agreements or policy documents.

Court of Appeal's Key Findings

The Court of Appeal overturned this decision based on the following specific conditions that were met:

1. Genuine Contractual Discretion

The employer did not just label the scheme discretionary but included an express term that the payment could be withheld even if targets were met. The scheme specifically stated that Metropolitan Glass had "the sole discretion not to make any payment", even where the criteria were met.

2. No Guarantee Clause

The scheme included explicit wording that there was "no guarantee of payment" and that "any payments made under this Scheme are totally at the discretion of Metro's Board of Directors and there is no guarantee of any payment even if the DIFOT, Retrofit & EBIT performance targets are achieved."

3. Retained Ultimate Authority

The Court found that Metropolitan retained the discretion to not pay the bonus even if the targets had been met, which took the scheme outside the scope of 'gross earnings' and into the territory of a discretionary payment.

4. Legal Test Applied

The Court of Appeal applied the legal test that "the hallmark of a discretionary payment and what distinguishes it from gross earnings is that it is a payment the employer is not contractually bound to make."

Court of Appeal's Reasoning for Overturning

The Court of Appeal found that the Employment Court had erred by not considering whether a residual discretion not to make any payment, even if all conditions were met, took the scheme outside the scope of 'gross earnings' and into the territory of a discretionary payment.

The Court emphasized that the payments were "not guaranteed or conditional" and were therefore discretionary payments for the purposes of the Holidays Act.

Key Distinction Made

The Court clarified that "if the employer was contractually bound to make the payment, then subject to a limited number of specified exceptions, it is gross earnings. The source of the employer's contractual obligation is irrelevant." However, in this case, Metropolitan was not contractually bound due to the retained discretion.

Important Note

The Court noted that employers are still required to exercise their discretion "fairly and reasonably," and a failure to do so could be grounds for a personal grievance, but this doesn't change the discretionary character of the payment for Holidays Act purposes.

The decision was significant because it potentially saved New Zealand employers hundreds of millions of dollars in backpay obligations that could have resulted if the Employment Court's decision had been upheld.

Essential Legal Requirements

1. Express Reservation of Ultimate Discretion

The payment terms must include an express term that even if all conditions are met, the employer retains the discretion not to make any payment. This goes beyond simply labeling something as "discretionary."

2. "No Guarantee" Clause

The scheme must explicitly state there is "no guarantee of any payment even if performance targets are achieved" or similar wording that makes clear payment is not assured.

3. "Sole Discretion" Language

Terms must state that the employer has "the sole discretion not to make any payment", even where criteria are met.

Specific Wording Examples from Metropolitan Glass Case

The Court of Appeal upheld the following specific language as establishing genuine discretionary payments:

Core Discretionary Language:

"Any payments made under this Scheme are totally at the discretion of Metro's Board of Directors and there is no guarantee of any payment even if the DIFOT, Retrofit & EBIT performance targets are achieved"

Additional Supporting Terms:

"[Metropolitan Glass] has the sole discretion not to make any payment even where the criteria in this Scheme are met"
"This Scheme is not a term and condition of your employment agreement"
"[The STI Scheme] is completely discretionary and [Metropolitan Glass] can at its sole discretion decide not [to] make any payment under this scheme, or amend, revoke or discontinue this Scheme at any time"

What Must Be Avoided

Terms That Do NOT Create Discretionary Payments:

The following factors do not make a payment discretionary:

Simply labeling the payment "discretionary"
Employer deciding who participates in the scheme
Employer determining the amount of payment
Payments only being made if certain conditions are met
Variable payment amounts
Conditional nature tied to performance targets alone

The "Effort Test" to Avoid:

If an employee has to put in effort and their effort is tied to a target/KPI to receive the bonus, then the payment is not discretionary "no matter how it is structured or worded"

Contractual Binding Test

The Court of Appeal established that the overriding factor is: "is the employer contractually bound to make a payment?" The payment must be one that "the employer is not contractually bound to make".

Drafting Requirements for True Discretion

Essential Elements:

Clear statement of no guarantee even when targets met
Express reservation of sole discretion not to pay
Right to withhold payment regardless of performance
Right to amend, revoke or discontinue the scheme at any time
Statement that scheme is not part of employment agreement (though this alone is insufficient)

Example Compliant Wording Framework:

Based on the successful Metropolitan Glass terms, a discretionary payment clause should include:

"Any payments under this scheme are entirely at the sole discretion of [Company]. There is no guarantee of payment even if all performance targets are met. [Company] retains the absolute discretion to withhold payment regardless of whether conditions are satisfied. This scheme may be amended, revoked or discontinued at any time at [Company's] sole discretion."

Critical Limitations

Fair Exercise Required:

Employers must still exercise discretion "fairly and reasonably," and failure to do so could be grounds for personal grievance, but this doesn't change the discretionary character for Holidays Act purposes.

Substance Over Form:

It is not sufficient to simply label a payment "discretionary" - the employer must retain actual discretion not to make any payment at all. The 'reality' of contractual employment arrangements matters more than particular wording.

Recommended Approach

Employers should include appropriate wording in employment agreements or bonus scheme terms that clearly expresses bonuses are awarded at the sole discretion of the employer, ensuring the terms genuinely reserve the right to withhold payment even when performance conditions are met.

This detailed framework ensures compliance with the Court of Appeal's interpretation while protecting the employer's position regarding holiday pay calculations.

We strongly recommend you seek your own Legal Advice on this matter.