Many employers will have been concerned about the recent media coverage of an Employment Appeals Tribunal decision regarding overtime and holiday pay. Not many employment law cases feature in the national news, and this is a very important case that all employers need to be aware of. As always, the devil is in the detail, and complex legal decisions do not lend themselves to the soundbites of journalism. We set out below a detailed note of what the case means, what it does not mean, what we still do not know and what steps employers can take.

The key issue is whether payments in addition to basic salary should be included in holiday pay. Although the recent EAT case related to overtime, employers whose pay structures include commission or any other regular payments on top of basic salary, also need to be aware that the legal landscape on holiday pay has changed significantly.

The Old System

For many years there has been an established calculation for holiday pay. It was rarely challenged legally, and it was applied by almost all employers.

The right to holiday pay was introduced by the Working Time Regulations in 1998 (WTR). This enacted the European Working Time Directive (WTD) into domestic law. The European WTD required that employees be given a minimum of four weeks’ paid annual leave. The domestic WTR are actually more generous and give UK employees 5.6 weeks’ paid leave. That is 28 days per year for someone working Monday to Friday.

Although both the European WTD and the domestic WTR specify that holiday must be paid, neither contains a calculation setting out how much should be paid. In the UK, this has been dealt with by using an existing piece of legislation, the Employment Rights Act 1996 (ERA). The ERA includes a method for calculating weekly pay. It was an existing method, so legal and HR practitioners were already familiar with it. It could be a complicated calculation, especially for employees without regular hours, but the calculation method itself was rarely in dispute. Broadly speaking, the amount of holiday pay per week is calculated as a normal week’s basic salary, or, if an employee does not have a fixed weekly salary because they are a piece worker, shift worker or on a zero hours contract for example, then a normal week’s pay is calculated based on an average salary over the 12 weeks preceding the holiday.

The key point in this calculation was that holiday pay would be related to basic salary only. Even if an employee regularly worked overtime, their holiday pay would not normally reflect this. Even if they earned considerable commission on top of a basic salary, their holiday pay would reflect basic salary only. There were Employment Tribunal cases challenging both these points, but the case law always confirmed the position that holiday pay should reflect basic salary only, not overtime or commission.

Until recently, this was settled law and virtually all employers applied these rules when calculating holiday pay.

The Recent Challenge under European Law

The first case that came to people’s attention as a possible challenge to the status quo was the European Court of Justice’s decision in British Airways plc v Williams.

This case related to the holiday pay for civil aviation workers. It therefore did not directly deal with the WTR, as civil aviation has its own specific rules on working time. It also did not deal specifically with either overtime or commission. However, in this case the ECJ had to consider the concept of what “paid” leave should mean, and the rationale they established in the case left the door open for other claims to challenge the existing method for calculating holiday pay.

In this case, the employees were entitled to additional payments on top of their basic salary for time spent actually flying, or for time spent away from home. It had always been the case that their holiday pay was based on basic salary only, excluding these supplements, because when they were on holiday they would neither be flying nor spending time away from home on company business. However the ECJ held that this was the incorrect approach. The principle underlying this decision was that holiday pay should properly reflect an employee’s normal earnings, even if this was made up of elements additional to basic pay. The employee should not lose out financially by taking their annual leave, otherwise they might be discouraged from taking it. The purpose of the laws requiring paid holiday is that it is good for employees’ health and well-being to take a break from work. Therefore there should be nothing that acts as a disincentive to them taking annual leave. If they earn less on a week’s holiday than they would have earned in a week at work; that is a potential disincentive.

Following the British Airways case, there were further cases that used the principle established by the ECJ to challenge the WTR directly. Earlier this year the case of Lock v British Gas dealt with the issue of whether commission should be taken into account in holiday pay. The ECJ followed the same line as in the British Airways case; that holiday pay should put an employee in the same financial position as if they had been at work. Therefore it established the principle that commission should be included in holiday pay, although there was no clear guidance about how this should work in practice.

The Recent EAT Decision

With the change of approach in Europe, several employees in the UK saw their opportunity to challenge other aspects of holiday pay. There were a number of cases on the issue of whether overtime should be included in the calculation. The Employment Tribunals hearing these cases all came to slightly different decisions. They were then grouped together so that the Employment Appeals Tribunal could consider the issue. This is the decision in the case of Bear Scotland v Fulton (and conjoined cases) that was delivered by Mr Justice Langstaff on 4 November and that was so widely reported in the press.

Key Issues

  • Does European law require that overtime, and other payments additional to basic salary, be included in the calculation for holiday pay?

Employers listening to the press coverage of this judgment could be forgiven for thinking that it applies to all kinds of overtime. However, this judgment is limited to the specific types of additional payment that were involved in the particular cases it was considering. Therefore the judgment is actually limited to two relatively narrow types of payment:

  1. Overtime which is not guaranteed by the employer, but which the employee is required to work if requested to do so, and which they do in fact regularly work (non-guaranteed, non-voluntary overtime); and
  2. Travel allowances that recompense the employee for their time spent travelling (rather than being a direct repayment of expenses incurred in travelling, e.g. train fares etc), and which are therefore deemed taxable by HMRC (travel time allowances).

The test to be applied to additional payments is whether they amount to part of the employees' “normal” remuneration. This test potentially has much wider application beyond non-guaranteed, non-voluntary overtime and travel time allowances, so it is very possible that other types of payment could in the future be found to be part of normal remuneration, but currently the decision only applies directly to these two payments.

  • Is it possible to read the domestic law, the WTR, to give effect to this requirement of European law?

Yes. This was to be expected, because judges are used to applying a creative interpretation to UK legislation when they want it to comply with EU law. That means that employees can sue their employers for underpayments.

  • How should overtime and other payments be included in a calculation for holiday pay? For example what reference period should be used to calculate average earnings if they vary from week to week?

The EAT judgment did not really give any guidance on this point. The judgment makes the point that the exact nature of the calculation to be carried out is a matter for national legislation so there is no prescribed formula from the EU.

Employers are used to using a reference period of 12 weeks before the holiday in other situations, but there is no reason why this could not be changed by case law or legislation in the future.

  • Should a requirement to include overtime and other payments in holiday pay apply only to the 4 weeks' holiday provided by European law, or the full 5.6 weeks given under domestic law?

The decision was that this should apply only to the 4 weeks. Employers may continue to pay basic salary only in relation to the other 1.6 weeks.

This may work out to be slightly cheaper for employers in terms of the absolute amount of holiday pay due, but it will make the calculations more complicated as there will be a two-tier approach to holiday calculations. Many employers might decide to pay the higher rate for the full 5.6 weeks purely for simplicity.

  • How far back will employers' liability for historic underpayments of holiday extend?

A claim for underpayment of holiday under the Working Time Regulations must be brought within three months of the underpayment. However, such a claim can also be framed as an unlawful deduction from wages claim. In this case, then the claim must still be brought within three months of an underpayment, but it can then be brought in relation to all deductions from wages, of which the latest holiday underpayment would be the last in a long line. So a claim could potentially be brought in relation to historic underpayment of holiday going back for years. It is not even clear whether the usual civil claims limitation period of six years would apply, and potentially claims could go back as far as the introduction of the Working Time Regulations in 1998.

This was the aspect of the decision that was causing the most anxiety for many employers. Many employers felt that they could change their holiday pay calculations going forward if they must, but the prospect of being hit with a bill for underpayments going back 16 years was daunting to say the least.

Mr Justice Langstaff’s solution is a novel introduction to UK law, and while it offers some comfort to employers concerned about back-payments, it does raise further complications. His decision is that holiday pay claims can be brought as unlawful deductions from wages claims, and therefore an employee can treat several deductions as a “series” and bring a claim for that entire series. However an interval of more than three months between deductions, will break the chain of the series and therefore limit the amount the employee can claim.

Although employers will find this solution preferable to having liability go back to 1998, it is not a simple three-month limitation period. It will depend on each employee’s pattern of annual leave and therefore it is not straight forward to say how far back liability will extend without scrutinising each individual case.

It also makes the distinction between the 4 weeks' EU holiday and the 1.6 weeks' extra holiday very significant. Previously there was no real difference between the two types of holiday so employers would not have addressed their minds to whether any particular day’s holiday was part of the employee’s 4 weeks (under European law) or the 1.6 weeks (under domestic) law). However, in relation to breaking a series of deductions it could be crucial to identify which was which. If an employee was taking part of their 1.6 weeks, then they would have been paid correctly. There was therefore no deduction from their wages in that period and that can count towards a three-month gap which would break the series of deductions.

Watch this Space

  • Mr Justice Langstaff has given permission for both parties to appeal his decision to the Court of Appeal, so all of the points established above are not set in stone. He particularly indicated in his judgment that his decision about the three-month gap breaking a series of deductions could be open to challenge.
  • These overtime cases, and the commission case of Lock and British Gas, will now be sent back to the original Employment Tribunals to apply the high-level decision and make a ruling on the facts. This will mean that the Tribunals will actually have to make a decision of how much historic holiday pay to award. This will involve them deciding the basis for the calculation to be performed, which should give us some guidance on how the calculation should work.
  • We can expect further cases dealing with all sorts of other payments apart from non-guaranteed, non-voluntary overtime and travel time allowances.
  • The same day that the judgment came out, Vince Cable announced a government task force to look into the issue. So there may be new legislation in due course to deal with the point.

Key Questions for Employers

1. Can you change your holiday pay system?

There is still a lot of uncertainty around this issue, and only a very limited number of employers will now have the information they need to properly revise their holiday policies. If the only payments you pay in addition to basic salary are non-guaranteed, non-voluntary overtime and / or taxable travel allowance, and if those payments are so regular that it is clear what normal earnings are, without the need to calculate average earnings over a period, then you are probably safe to go ahead and amend your holiday pay systems now.

However, most employers will have other payments in addition to holiday pay, or they will have more complicated calculations to perform. Those employers still do not have the information they need to be sure that they are calculating holiday pay correctly. It may well be extremely complex and expensive to introduce a new holiday pay system, especially since it may be the case that a unique calculation will need to be performed for every occasion when an employee wants to take holiday. Our advice to those employers is to wait and see what the further developments indicated above will bring.

2. Should you review your employment contracts?

Employers may want to consider amending their employment contracts to make it clear when an employee is using the 4 weeks' holiday they are entitled to under European legislation, and when they are using the extra 1.6 weeks they get under domestic law, for example by directing that an employee will be deemed to use their 4 weeks' holiday first in any holiday year, and then their 1.6 weeks when that is exhausted. This will give clarity to what category any particular day’s holiday falls into, and this may help with demonstrating a three-month break in underpayments.

3. Can you calculate your potential liability?

If the number of employees is relatively small, or if the system of holiday records is sophisticated enough to allow you to perform the calculation easily, then employers may want to consider making a rough calculation of their potential liability.

A good place to start will be reviewing your holiday records to see how far back you need to go to find a three month interval when an employee did not receive holiday pay. Remember that bank holidays may form part of an employee’s 4 weeks’ holiday. The sticky issue of distinguishing between the 4 weeks and the 1.6 weeks may make this difficult, but for some employees it may be clear cut.

Then you will need to work out roughly what you think the underpayments were. Although we only have a definitive decision on those two particular types of additional payments, for a “worst case scenario” calculation, we would suggest that you assume that any regular additional payments may end up being included in holiday pay.

For the purposes of a rough calculation, we would advise that you apply a calculation based on average earnings over the established 12 week period preceding the holiday.

4. How should you deal with claims?

Whether you are facing enquiries from employees, approaches from ACAS under the early conciliation scheme or actual employment claims, you need to think about your response.

Unless the employee’s case falls within the narrow band indicated above, then their entitlement is still unclear. We are advising clients in this situation to respond to such claims by stating that you are of course aware of the recent case law, but the legal position is not finalised through judicial process in relation to the particular circumstances relevant to that employee. You can reassure the employee that when the issue is resolved, either by further case law or new legislation, then your organisation will of course fully comply with its legal obligations.

Should you receive a Tribunal claim, our view is that the Tribunals are likely to stay them pending final judicial authority. Therefore should you receive a claim we recommending writing to the Tribunal requesting that the claim is stayed pending these decisions. We can of course assist you with such application letter should you so require.

5. What should you tell staff?

An employer must also consider their relations with the workforce. The issue of holiday pay was all over the news and it may well come to employees’ attention, especially if they are members of a union.

Some employers may decide that they prefer to be seen as pro-active and address the holiday pay issue promptly, either by making changes to their holiday pay systems (if possible) or by making an announcement to staff that they will do so once the law is clear.

Other employers may believe that by doing so they risk alerting their employees to the fact that they may have been underpaid in the past, and it is better not to raise the issue until there is legal certainty.