Introduction

It is not uncommon for the employment contracts of senior executives or employees to provide that they be paid a considerable amount of terminal payments upon the termination of their employment. The fundamental test on whether or not such terminal payments are subject to salaries tax is thoroughly analysed and affirmed recently by the highest appellate court of Hong Kong, the Court of Final Appeal (“CFA”), in its judgment of a hotly contested appeal case of Commissioner of Inland Revenue v Poon Cho Ming John [2019] HKCFA 38.

Background

By an employment contract, a Hong Kong listed company (“Employer”) employed Mr Poon, the taxpayer employee (“Employee”), as an executive director and the Group Chief Financial Officer (“Group CFO”) in December 1999. By a separation agreement (“Separation Agreement”), the Employer terminated the Employee’s employment contract in July 2008. Under the Separation Agreement, the Employer paid the Employee certain sums and benefits including (1) a sum of €500,000 “in lieu of a discretionary bonus” (“Payment in lieu of Bonus”) and (2) share options, under which the Employee had exercised such options and derived notional gain (“Share Option Gain”).

Relevant statutory provisions

The question of whether or not the Payment in lieu of Bonus and the Share Option Gain are chargeable to salaries tax is governed by section 8 (Charge of salaries tax) of the Inland Revenue Ordinance (Cap. 112) (“IRO”). Section 8(1) provides that:

“Salaries tax shall… be charged for each year of assessment on every person in respect of his income arising in or derived from Hong Kong from the following sources –

(a)        any office or employment of profit; and

(b)        any pension. ” (emphasis added)

Section 9 (Definition of income from employment) of the IRO sets out the kinds of payment covered by “income from any office or employment”, where under section 9(1) includes, among others:

“(a)  any … bonus… whether derived from the employer or others …

(d)   any gain realized by the exercise of … a right to acquire shares or stock in a corporation obtained by a person as the holder of an office in or an employee of that or any other corporation. ”

Procedural history

1.     Inland Revenue Department (“IRD”)

In the 2008/2009 year of assessment, the IRD assessed both the Payment in lieu of Bonus and the Share Option Gain as taxable under section 8(1) of the IRO.

2.     Board of Review (“BoR”)

The Employee appealed the IRD’s decision to the BoR, but the BoR came to the same conclusion. The BoR considered that:

1.         the purpose of the Payment in lieu of Bonus was “to buy from the [Employee] the opportunity to be considered for a discretionary bonus, and since the opportunity stemmed from the [employment contract], [the Payment in lieu of Bonus] was also a sum which stemmed from the [employment contract]” and hence, taxable; and

2.         in respect of the Share Option Gain, “the options ‘stemmed from the Share Option Scheme’ which right was obtained by the [Employee] as an employee…” and hence, taxable.

3.     Court of First Instance (“CFI”)

The Employee then appealed the BoR’s decision to the CFI. For essentially the same reasons given by the BoR, the CFI dismissed the Employee’s appeal and handed down its judgment in 2016. The CFI considered that:

1.         the Payment in lieu of Bonus “should be treated in the same way as the bonus normally paid”; and

2.         the Share Option Gain is part of the share options granted during the Employee’s employment as an incentive for him to continue service.

4.     Court of Appeal (“CA”)

The Employee further appealed the CFI’s decision to the CA. The CA handed down its judgment in 2018 and allowed the Employee’s appeal to the effect that both payments were not taxable. The CA held that in light of the facts found by the BoR, both the Payment in lieu of Bonus and the Share Option Gain were payments the Employee obtained from the challenges he posed to the Employer and for him to drop his proposed course of action, thus not for past, present or future services but for something else.

5.     CFA

The Commissioner of Inland Revenue (“CIR”) appealed against the CA’s decision to the CFA.

The Fuchs Test

The fundamental test regarding whether or not terminal payments are subject to salaries tax was confirmed by the CFA in its decision in Fuchs Walter Alfred Heinz v Commissioner of Inland Revenue (2011) 14 HKCFAR 74, [2011] 2 HKC 422.

In Fuchs, Mr Fuchs was employed as the managing director and the CEO Asia of a German bank. The bank was later taken over by another group and Mr Fuchs’s employment was going to be terminated. Mr Fuchs negotiated with the management over the terms of termination and the bank agreed to pay him a one-time compensation for the loss of his position including (1) two annual salaries for the duration of service with the bank and (2) an average amount of the bonuses paid to him in the previous 3 years. However, the two said payments were also covered by Mr Fuchs’s primary employment contract as agreed compensation or liquidated damages upon termination, i.e. something Mr Fuchs could have sued under his primary employment contract.

The CFA in Fuchs took the view that whether a payment received by an employee on termination of his employment was taxable turned on the construction of section 8(1) of the IRO, i.e. whether or not such payment was an “income from any office or employment of profit”. Income chargeable under section 8(1) was not confined to income earned in the course of employment but embraced payments made in return for acting as or being an employee, or as a reward for past services or as an inducement to enter into employment and provide future services. If a payment, viewed as a matter of substance and not merely of form and without being blinded by some formulae which the parties may have used, was found to be derived from a taxpayer’s employment in foregoing sense, then it was assessable.

Applying the Fuchs test, which is a fact-sensitive test, the CFA in Fuchs decided that since the “compensation” paid on termination was expressly specified in the primary employment contract, it was paid in satisfaction of the rights which had accrued to the leaving employee under his employment contract, i.e. derived from his employment, and therefore chargeable to salaries tax.

Application in present case

Payment in lieu of Bonus

The Employee’s employment contract provided that he would be eligible to participate in an annual bonus scheme on such terms and at such level as the Employer’s board of directors may from time to time determine with reference made to the remuneration committee’s recommendation based on the Employer’s audited results. Since the Employer had yet paid any bonus to the Employee for the financial year ended 30 June 2008 and would like to eliminate any claim for unpaid bonus brought by the Employee, the Employer and the Employee then entered into the Separation Agreement, among which, an entirely arbitrary amount of Payment in lieu of Bonus was mutually agreed by the parties.

After considering the substance of the Payment in lieu of Bonus and applying the Fuchs test, the CFA decided that the Payment in lieu of Bonus was not taxable. Although the payment was labelled as “in lieu of bonus”, the payment was made in an arbitrary amount, which was of a wholly different nature from any discretionary bonus under the employment contract. The Employer only paid the Payment in lieu of Bonus to the Employee for him to go away quietly but not for inducing him to provide future services or as a return for past services.

Share Option Gain

The Employer had offered various rounds of share option scheme to the Employee upon, inter alia, a term stated in the relevant grant letters that the option would only be granted to the Employee in his capacity as the Group CFO and may lapse if he ceased to be in the position. According to the grant letters, the Employer’s board of directors may also in its absolute discretion accelerate the vesting period of the options by allowing the Employee to exercise part or all of any unvested option if his employment was terminated and salary was paid in lieu of notice. The Employee had accepted various offers at different points of time before his termination. When it came to the termination of employment, the Employer agreed to allow the Employee to exercise the share options immediately on the signing of the Separation Agreement as part of the terms of the cessation of his employment. The number of share options with accelerated vesting was also an entirely arbitrary number, and the Employer aimed to settle all outstanding matters upon cessation of the Employee’s employment by allowing such acceleration of vesting of share options.

The CFA held that the Share Option Gain was not taxable. The CFA considered that the real issue in respect of the taxability of the Share Option Gain was whether the acceleration was given for reward for past services or for something else, as it was clear that the acceleration was not given to induce the Employee to provide future services.

The CFA considered the Fuchs test and distinguished the facts of the present case from that of the Fuchs case. The CFA took the view that the Share Option Gain was not a sum for which the Employee could have sued under his employment contract. Had the Employer declined to accelerate the vesting schedule, the unvested shares in question would simply have lapsed. Moreover, on the evidence and the facts found by the BoR, it was plain that the acceleration was given for something else, i.e. being part of what was given to make the Employee go away quietly. Therefore, the Share Option Gain was also not taxable.

Takeaways

The CFA’s judgment in Commissioner of Inland Revenue v Poon Cho Ming John affirms the Fuchs test that only payment received by an employee from his employment, including reward for past services or as an inducement for future services, could be taxable. Taxpayers have to examine the facts carefully, and consider all the relevant documentation and their interpretation in determining whether or not a payment agreed between an employer and an employee regarding the termination of employment is in substance derived from a taxpayer’s employment – if it is, it is taxable, and if not, it is not taxable.