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The Importance of Structuring Employee Termination Payments

  • Hong Kong
  • Employment law - HR E-Brief

16-01-2020

A recent decision of the Court of Final Appeal has illustrated that properly structuring termination payments in an employee settlement agreement may significantly reduce the employee’s Salaries Tax liability and save the employer the hassle of responding to queries from the IRD long after separation.

In the case of Commissioner of Inland Revenue v. Poon Cho Ming John [2019] HKCFA 38, the employee was the Group Chief Financial Officer and an executive director of a listed company in Hong Kong. On 20 July 2008, he entered into a separation agreement with his employer (“Separation Agreement”), pursuant to the terms of which he was entitled to receive certain sums and benefits from his employer.

Among the payments and benefits, the taxpayer was entitled to receive a sum of €500,000 stated to be “in lieu of a discretionary bonus” (“Sum D”) and was granted certain stock options for shares in the employer company, which he subsequently exercised at a price lower than the market price of the shares, making a notional gain of HK$43,250,400 (the “Share Option Gain”).

Procedural History

The Commissioner Inland Revenue assessed both Sum D and the Share Option Gain as taxable, which was disputed by the employee taxpayer. The Board of Review agreed with the Commissioner and dismissed the taxpayer’s appeal, who further appealed to the Court of Appeal, where he succeeded. The Court of Appeal found that Sum D and the Share Option Gain were both non-taxable. The Commissioner then appealed to the Court of Final Appeal.

The law

Under section 8(1) of the Inland Revenue Ordinance, Salaries Tax shall be charged on every person in respect of his income arising in or derived from Hong Kong from any office of employment of profit and any pension. The Court of Final Appeal has in Fuchs v Commissioner of Inland Revenue (2011) 14 HKCFAR 74 held that this is not limited to income earned in the course of employment but also includes payments made in return for acting as or being an employee. It includes rewards for past service and payments made by way of inducement to enter into employment and provide future services. A payment found to be derived from a taxpayer’s employment in the analysis above would be chargeable to salaries tax; if the payment were for something else, it would not be chargeable to salaries tax.

The facts

The employee had expected to succeed the then Chairman of the employer’s board of directors when instead the Chairman informed him that the employer was preparing to terminate his employment immediately. He was surprised by the termination and refused to go quietly. He planned to bring the matter before the shareholders and challenge the board’s decision to remove him. The employee was prepared to take the case to court to attract media and stock market reaction. It is against this background that the employee and the employer negotiated for the separation. These negotiations took place over the weekend and involved lawyers on both sides before the Separation Agreement was signed two days later.

Upon enquiries made by the Commissioner, the employer confirmed that Sum D was an “entirely arbitrary amount mutually agreed” between the employee and the Chairman of the employer and that it was paid to eliminate any claim for unpaid bonus. There was no evidence that Sum D was determined on the basis of the financial performance of the employer, the employee’s individual performance, or on the basis of any bonus metrics that could otherwise be awarded to him. The court found that Sum D was paid as an arbitrary amount to make the taxpayer go away quietly. As a result, it was held not to be a reward for past service and not taxable.

With regard to the Share Option Gain, under the original terms of the share options scheme, the share options would vest in the employee taxpayer only in a few years provided that he was still in the employment of the employer. Under the Separation Agreement, the employer agreed to grant and immediately vest 1,080,000 share options which originally would have vested on a later date. In other words, the taxpayer would not have be entitled to receive any share options but for the provisions of the Separation Agreement. The employer confirmed to the Commissioner that the number of share options that they agreed would be vested was determined arbitrarily and with a view to settle all outstanding matters upon the cessation of the employee’s employment. The Court of Final Appeal found that the share options were granted to the employee taxpayer under the Separation Agreement to make him go quietly rather than as reward for past service, and thus the Share Option Gain was also not taxable.

Conclusion

The decision reaffirms the principle established in the case of Commissioner of Inland Revenue v Elliott [2007] 1 HKLRD 297 that a payment received by an employee in satisfaction of his rights under his contract of service is taxable, while a payment received by an employee in abrogation of his rights under his contract of service is not taxable.

The decision serves as a reminder that when negotiating separation agreements, there is a benefit to both the individual and the employer if the nature of each payment is carefully considered to ascertain potential Salaries Tax exposure. The tax savings benefit to the employee under a well-structured agreement is a factor that employers can take into account during their negotiations.

Ideally, any separation agreement should record the nature and purpose of each payment to avoid lengthy litigation with the Inland Revenue Department on the tax treatment of the termination payments as we have seen in Commissioner of Inland Revenue v. Poon Cho Ming John.