In March, following the publication of the report, Gwent Police asked Avon and Somerset Police to look at the WAO findings.
Mr O’Sullivan was suspended on full pay with deputy Mr Barnett taking up the role on a temporary basis.
Pay rises of up to 30% for 21 senior council bosses were agreed by a secret committee of councillors in September 2012. The committee had approved the pay deal after being recommended to do so in a report penned by Mr O’Sullivan.
A spokesman for Caerphilly County Borough Council said: “We were informed this morning by Avon and Somerset Police that two senior council employees have been arrested and are being interviewed. We have been advised by the police it would be inappropriate to comment further at this stage, but we will continue to co-operate fully with the ongoing investigation.”
Avon and Somerset Police, in a statement, said: “Following a request to carry out a review by the Wales Audit Office two people have been arrested on suspicion of fraud and misconduct in public office.
“They currently remain in police custody where they are being questioned.
“It would be inappropriate to comment further at this stage.”