On 16 March 2006, the European Court of Justice (ECJ) ruled that “rolled-up” holiday pay is incompatible with the Working Time Directive (93/104/EC) (the Directive) (Robinson-Steele v PD Retail Services, Clarke v Frank Staddon Ltd, Caulfield & others v Hanson Clay Products Ltd (formerly Marshalls Clay Products Ltd), joined cases C-131/04 and C-257/04).

The immediate financial exposure for employers resulting from the decision is likely to be limited provided their system for rolling up holiday pay is “transparent and comprehensible”. This is because they will be able to set off rolled-up holiday payments against the holiday pay that would have been due in respect of specific periods of annual leave.

However, the ECJ also reminded EU member states that they are required to take measures appropriate to ensure that practices that are incompatible with the Directive are not continued.

Whether or not there is a change in the law, James Cox, a partner at Ashurst, expects the decision to have a significant impact going forward for employers who roll up holiday pay. Philip Titchmarsh, the senior associate at Pinsent Masons who advised the employers in Caulfield, agrees: “What the ruling means in practical terms is that the practice of paying rolled-up holiday pay will have to stop.”

The practice of rolling up holiday pay is common in the UK in the entertainment, construction and manufacturing sectors, where workers are employed on short-term, temporary or casual contracts or work irregular shifts.

Instead of paying the worker for annual leave at the time when a specific period of annual leave is taken, the employer pays the worker an hourly rate for any work done that incorporates an element in respect of their annual leave. This means that the worker receives their holiday pay in the form of part payments staggered over the year and paid together with remuneration for work done.

As well as simplifying administration for the employer, this should in theory enable the worker to save and plan for holidays in advance.

In practice, however, the fact that the worker is not paid for a specific period of annual leave can act as a disincentive to taking annual leave. Workers under rolled-up holiday pay arrangements often fail to take their annual leave and, in effect, end up receiving an allowance in lieu of taking it.

Under the Directive, member states are required to take the measures necessary to ensure that workers are entitled to at least four weeks’ paid annual leave. The Directive does not specify when payment in respect of annual leave should be made. However, it does provide that paying workers an allowance in lieu of annual leave is lawful only where the employment relationship is terminated (Article 7, the Directive).

The Directive was implemented in the UK by the Working Time Regulations 1998 (SI 1998/1833) (the Regulations).

The Regulations permit any remuneration paid in respect of annual leave to go towards discharging the employer’s obligation to pay remuneration in respect of a specific period of annual leave (regulation 16(5)). On the face of it, this would appear to permit the payment of rolled-up holiday pay.

However, in MPB Structures Limited v Munro, the Scottish Court of Session concluded that rolled-up holiday pay arrangements were unlawful because they put economic pressure on workers to forgo their holiday ([2003] IRLR 360).

The Employment Appeals Tribunal (EAT) (www.practicallaw.com/9-102-4661) and the Court of Appeal reached the opposite conclusion in Caulfield and it was partly this divergence of views that led to the ECJ references.

In a rare instance of the ECJ choosing not to follow the Advocate General’s opinion (www.practicallaw.com/0-201-6589), the ECJ held that Article 7 of the Directive:

The cases will now be returned to the national courts for decision.

The practical implications for employers are likely to be:

Mitigating effect of set-off. The fact that employers can set off amounts of rolled-up holiday pay against a worker’s entitlement to holiday pay for a specific period of annual leave may mitigate the immediate financial impact of the decision.

However, employers will need to consider whether their rolled-up holiday pay arrangements are transparent and comprehensible.

The ECJ decision does not give employers any guidance on this point but the EAT in Caulfield said obiter that in order for arrangements to be transparent:

Changing practices. The mitigating effect of set-off means that the decision has provided little financial incentive to employers who operate transparent and comprehensible systems to change their practices going forward.

Simon Jeffreys, a partner at CMS Cameron McKenna LLP, would go further: “Arguably, the government should amend the Working Time Regulations but what set-off means is that employers can carry on as they were, unless and until the government decides to do so.”

However, according to Titchmarsh, the position is not that simple for two reasons:

“What this means,” concludes Titchmarsh, “is that the only practical advice for employers who do not want to run the risk of a claim is that they will need to move to a system where workers are paid in respect of specific periods of leave.”

Cox agrees that employers will be looking at alternative arrangements such as holiday “stamp” or savings schemes and considering whether hybrid rolling-up arrangements are possible. “The challenge for practitioners,” says Cox, “is finding an alternative system that isn’t open to abuse by employees that arrange holidays so that they receive a disproportionately high amount of holiday pay. The challenge for employers will be persuading their workers to accept less take home pay.”