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Legal Update: Tax Treatment of Payments on Termination of Employment

By Jade Tang

 

In its recent decision in Commissioner of Inland Revenue v Poon Cho Ming, John [2019] HKCFA 38, the Court of Final Appeal revisited the issue of tax implications on terminal or severance payments. It reaffirms the orthodox position in Fuchs v Commissioner of Inland Revenue (2011) 14 HKCFAR 74 that a payment made in return for acting or being an employee is taxable.

 

Background

Immediately prior to July 2008, the Claimant was employed as an executive director and the Group Chief Financial Officer with a company in Hong Kong. On 18 July 2008, he was informed of the company’s decision to terminate his employment but refused to go quietly. He threatened to bring the matter in front of shareholders and to take his claims to court, which would likely attract media attention and trigger market reaction.        

To avoid acrimonious disputes, the company entered into a Separation Agreement with the Claimant, promising to pay, inter alia, a payment in lieu of any discretionary bonus (the “Sum”) and acceleration of the vesting of certain option shares of the company previously granted to him so that he could exercise those share options (“Share Option Gain”).

 

Judgment

The test laid down in the Court of Final Appeal’s landmark decision in Fuchs is that a payment has to be paid as a reward for past, present or future services in employment to be classified as income earned in the course of employment, which is chargeable to salaries tax. Everything else is outside the operation of the statute and non-taxable.  

As a matter of substance, the Sum, which was in an arbitrary amount, was of a “wholly different nature” from any discretionary bonus under the employment agreement between the Claimant and his employer. It was decided that the Sum was not a payment to induce the Claimant to provide future services or to reward him for past services. Rather, it was paid with a view to eliminating any possible claim the Claimant might advance against the company. The Court applied the Fuchs test and found that the Sum is not chargeable to tax.

With reference to the Share Option Gain, it was paid under the Separation Agreement, which abrogated any rights that Mr Poon might have under his employment contract. It has been held that sums paid to employees as consideration to or compensation for the total abrogation of contract (Henley v Murray [1950] 31 TC 351 and Comptroller-General of Inland Revenue v Knight [1973] AC 428) are not given to reward past services, and hence non-taxable. In the same vein and consistent with Fuchs, the Share Option Gain was not taxable as it was not paid as a reward for past services.

 

Implications

This decision clarifies the tax treatment of sums paid in scenarios where an employer terminates the employment of staff and wishes to placate them with payments. Essentially, one must look at the reason for which the money is paid and consider whether it arises out of arrangements in the employment contract. The determination of the nature of such payment becomes a question of fact.

One of the arguments advanced by the Commissioner in the present case was that the “substitution test” from Mairs v Haughey [1994] 1 AC 303 should be applied so that the Sum, made in lieu of bonus, would be considered to take on the nature of a bonus which means the Sum would be regarded as recognition of the Claimant’s past employment services. However, looking at the substance of the Sum, the Court found that the Sum was paid to silence the Claimant and the amount was determined arbitrarily.

The reaffirmed principle in relation to terminal payments is helpful to both employers and employees when they have to negotiate for and structure the drafting of a separation agreement.  It is also essential for the employers and employees to maintain documentary evidence relating to the terminal payments.  

If you have any questions in relation to the above, please contact any member of Employment and Tax Teams or the writer at [email protected].

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