Quite recently in Poon Cho-Ming, John vs Commissioner of Inland Revenue  HKCA 297, the Court of Appeal held that Mr. Poon’s (“the Taxpayer”) entitlement to the termination package was not “from his office or employment” and thus was not taxable. Previously, in Fuchs v CIR (2011) 14 HKCFAR 74 and Mrs. Murad and Others v CIR HCIA 1/2009, the courts held that the relevant taxpayers’ entitlements to the termination payments were “from [their] office or employment” and were consequently chargeable to salaries tax.
Despite of the differences in findings and outcomes, the courts when assessing the taxability of the termination payments had consistently adopted a “substance over form” approach in which they looked at the purpose and nature of the termination payments notwithstanding the labels of such payments.
A. The facts in the Poon Cho-Ming case
The Taxpayer served, among other important roles, as the Group CFO and executive director of a company (“the Employer”). On 18 July 2008, the chairman of the board informed the Taxpayer of his immediate termination of employment and wished both parties could come to terms to avoid adverse publicity. The chairman also mentioned that the Taxpayer would be given payment in lieu of notice and for accrued and unused annual leave upon his termination. As to the unvested share options held by the Taxpayer, the chairman might consider them but there was no mention of the discretionary bonus.
The Taxpayer was aggrieved by the Employer’s decision and, after seeking legal advice, informed the chairman that he would either take this matter to the hands of the shareholders to create negative shareholder reaction or file a claim to the court to attract unwarranted media’s attention (“the Two Actions”). The Taxpayer, however, at that time failed to consider that he was obliged under his service agreement to resign at the request of the Employer upon his termination of employment. Nonetheless, the Taxpayer’s intention to challenge the Employer in respect of his directorship with his Two Actions was not disputed.
Finally, on 20 July 2008, the Taxpayer and the Employer signed a separation agreement and the Taxpayer’s employment was terminated on the same date (“the Separation Agreement”). The Separation Agreement contained the following material provisions:
- The Taxpayer would receive severance payment which included the payment in lieu of discretionary bonus (“Discretionary Severance Payment”);
- The Taxpayer would be entitled to exercise the share options held by him, tranche A to C within three months from 20 July 2008 which was accelerated from the original vesting dates (“Share Option Gain”); and
- The Discretionary Severance Payment and Share Option Gain were part of the considerations paid in full and final settlement of all claims and rights of action taken by the Taxpayer against the Employer.
Various sums under the Separation Agreement were later chargeable to salaries tax which prompted the Taxpayer to challenge their taxability in the Inland Revenue Board of Review (“BOR”). By the time the case reached the Court of Appeal, only the taxability of the Discretionary Severance Payment and Share Option Gain remained to be an issue.
B. The relevant law and test for determining the taxability of termination payments
Section 8(1) of the Inland Revenue Ordinance (Cap. 112) provides that “income from office or employment” is chargeable to salaries tax and such income is defined in the following section 9 to include any salary, leave pay, bonus, gratuity and gain realized by the exercise of share options obtained by the taxpayer as an employee etc. Sections 8(1) and 9 apply to all payments including payments given on termination of employment.
Even though section 9 defines the types of payments that would fall under the meaning of “income from office or employment”, labelling the payments otherwise than types specified under section 9 would not render such payments non-taxable. The test as set out in Fuchs v CIR (2011) 14 HKCFAR 74 stipulated that the court should look at the substance of the bargain for the payments, inter alia, the nature and purpose of the payments before deciding on whether the payments were “income from office or employment”.
The Fuchs case further provided that (1) payments specified under the contract of employment and (2) payments in return of the person acting as or being an employee, or as a reward for his services past, present or future were both classified as “income from office or employment”.
C. Applying the Fuchs test to the Discretionary Severance Payment and Share Option Gain
The Court of Appeal held that both the Discretionary Severance Payment and Share Option Gain were not payments “from the employment”. It is because the Taxpayer was not entitled to such sum under his service agreement and the purpose of such payments was for the Taxpayer to agree to give up on taking the Two Actions and to resign from his office peacefully.
In relation to the Discretionary Severance Payment, the Taxpayer‘s right to discretionary bonus stemmed from his service agreement, however, the decision-making procedure which was required for the board to make decisions as to the bonus had not even commenced yet. As such, the Discretionary Severance Payment was an “entirely arbitrary amount”. The COA also considered that attention should be placed to the actual facts surrounding the Discretionary Severance Payment at that relevant time and it was irrelevant that the Taxpayer would have had to pay tax if he had received the discretionary bonus.
Separately, even though the board had a discretion under the Grant Letters of the share options to the Taxpayer to accelerate the vesting dates of share options that fell within the notice period, the vesting date of tranche C of the share option did not fall within the notice period at that time. The number of share options with accelerated vesting was therefore decided “arbitrarily”.
D. The main takeaway
Not until the judgement is overturned by the Court of Final Appeal (which in our view is quite unlikely), the following remarks still hold:
- Payments that were made in consideration of the employee agreeing to surrender his pre-existing rights under his employment contract and payments that were made as compensation for the loss of employment, given that none of them was made pursuant to any entitlement under the employment contract, were unlikely to be considered as “income from office or employment’ and thus were not taxable.
- A detailed analysis of the facts and evidence surrounding the termination payments would be made by the court and the BOR. As such, the employer and the taxpayer should be cautious at all stages starting from the drafting the employment contract to the drafting of the termination agreement, especially when answering any requisitions raised by the Inland Revenue Department (“IRD”).
Issues relating to the taxability of the termination payments are technical and merely relying on the labels of the termination payments is not going to achieve the intended purpose. OLN offers a range of related services to assist our clients, including drafting of the employment contract and the termination agreement, advising on the negotiation of the termination payments and handling any requisitions raised by the IRD. If you are interested in our services or have any issues regarding the above, please contact any member of our employment law and tax advisory team.