Calculating holiday pay: commission can no longer be discounted

Author: Darren Newman

Consultant editor Darren Newman explains the potentially costly implications of a recent ruling on calculating holiday pay where workers receive commission, and forecasts that a similar principle will shortly be applied to overtime payments.

When an employee takes annual leave, how much should he or she be paid? You might think that this would be a straightforward question, but it is proving to be one of the most contentious and difficult issues in UK employment law. The latest development is the ruling of the European Court of Justice (ECJ) in Lock v British Gas Trading Ltd [2014] IRLR 648 ECJ that an employee who was paid commission each month should be credited with a notional amount of commission in respect of weeks when he took annual leave, so that his future wages would not suffer.

The ECJ is involved because the right to paid annual leave under the Working Time Regulations 1998 (SI 1998/1833) is derived from the Working Time Directive (now 2003/88/EC) and must be interpreted in line with its provisions. However, the Directive itself contains no definition of what is meant by paid leave and the Regulations simply adopt the long-standing definition of a "week's pay" set out in ss.220 to 229 of the Employment Rights Act 1996. It has now become clear that this definition is not fit for purpose and can no longer be relied on.

The Employment Rights Act definition seeks to divide workers into those who have "normal working hours" and those who do not - and those whose pay varies with the amount of work done and those whose pay is fixed. For those who receive a fixed amount for working their contracted hours, a week's pay is that amount. For those whose pay varies - either because there are no normal working hours or because their pay varies with the amount of work done - the amount of a week's pay is averaged over a 12-week reference period.

Lock concerns commission payments made to an employee in respect of successful sales. The Court of Appeal previously ruled in Evans v Malley Organisation Ltd t/a First Business Support [2003] IRLR 156 CA that, where commission was paid based on the success of the employee's endeavours rather than the amount of work the employee had actually done, holiday pay had to be calculated on the basis of the basic pay for working a normal week without the inclusion of any element of commission.

The ECJ has now held that the approach in Evans is wrong. The Court regarded it as well established that normal pay has to be maintained during an employee's annual leave and found that it was a breach of that requirement for an employee to lose out on the commission that he would have earned during the leave period - even though the payment in respect of the lost commission was deferred until some weeks or even months after his return. When this ruling is taken with the earlier ECJ decision in Williams and others v British Airways plc [2011] IRLR 948 ECJ, which held that pilots were entitled to have various allowances included in their holiday pay, a clear principle emerges. Paid annual leave is regarded by the ECJ as a particularly important social right and employees must not be deterred from taking their full entitlement. To ensure this, its view is that employees should not be financially worse off as a result of taking annual leave.

Employers will now have to give some thought as to how commission schemes can build in some sort of averaging provision that makes appropriate allowance for periods of annual leave. But commission is not the only issue; overtime will also need to be considered.

The UK provisions on a week's pay exclude overtime unless it is a minimum requirement of the contract to work a set number of hours of overtime each week. This means that even employees whose patterns of overtime are regular and predictable are not entitled to have any element of overtime reflected in their holiday pay. That position is now being challenged in two cases due to be heard by the Employment Appeal Tribunal. In both Neal v Freightliner Ltd and Fulton v Bear Scotland Ltd, the employer is appealing against a tribunal finding that overtime payments had to be included in the calculation of holiday pay.

Usually I am very cautious about predicting the outcome of litigation, but on this issue it does seem that only one result is possible. Employees who earn overtime must surely be entitled to have their holiday pay averaged over a reference period so that it reflects their actual earnings rather than just one component of them. In the light of Lock I cannot see how any other conclusion is possible. If this is right, the impact will be huge.

The reason for this is not just the increased future cost of annual leave, but also the possibility of substantial claims for back-pay. Failure to pay the correct amount of holiday pay has been held by the House of Lords to be an unlawful deduction from wages under part II of the Employment Rights Act (HM Revenue and Customs v Stringer and others sub nom Commissioners of Inland Revenue v Ainsworth and others [2009] IRLR 677 HL). Where there is a series of unlawful deductions, the employee can claim in respect of all the deductions in the series, provided that he or she brings a claim within three months of the last one. A consistent failure over the years to pay the correct amount of holiday pay would certainly seem to be a series of unlawful deductions, so there is a danger that employees with the presence of mind to bring a claim within three months of receiving an inadequate payment will be able to bring claims stretching as far back as the implementation of the Working Time Regulations in 1998.

Once again we are left in the unsatisfactory position that, if you want to understand what the law actually means, the last place you should look is the Regulations themselves. A redraft is essential. The ECJ case law is now sufficiently clear to allow for a new definition of a week's pay to be drafted making it clear that an employee is entitled to be paid the same amount in respect of holiday that he or she would have received for a normal week's work. Where that varies - for any reason - holiday pay should be averaged over a representative reference period.