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Jul 2005
The Board of Review ("BOR") has handed down a decision (Case No. D87/04) which provides taxpayers insight on the BOR's stance about the taxability of termination payment for Hong Kong salaries tax purposes. The BOR also referred to the judgment of the previous High Court case, CIR v. Yung Tse Kwong, when making its decision.
Background
The taxpayer was a co-founder of Company A, a company listed on the Hong Kong Stock Exchange. Company B (a third party of Company A) acquired the control of Company A on 29 January 1997. In this regard, the taxpayer entered into an employment agreement with Company A for a period of five years effective on 29 January 1997.
Among other terms and conditions, it was specified in the employment agreement that the taxpayer was entitled to participate in an Incentive Compensation Plan ("ICP"). Under the ICP, the taxpayer was awarded 5 million "ICP units" following the commencement of his employment with Company A ("5M Units"). In addition, he may be awarded up to 3 million additional ICP units in the future ("Future Units").
The taxpayer would be entitled to an annual payment which is linked up to the financial performance of Company A in future years, with reference to the number of ICP units he holds by then. In addition, he may opt to receive a lump sum payment in exchange of his ICP units following the fifth anniversary of his employment with Company A.
Company A subsequently terminated taxpayer's employment on 12 June 1997. Both parties entered into a termination agreement that, inter alias, the taxpayer would receive a termination payment of US$11 million for the cancellation of his ICP units. The taxpayer also agreed to abide to certain restrictive covenants in order to receive such payment.
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The Arguments
The taxpayer believed that the termination payment of US$11 million should not be assessed to salaries tax as it was paid "to extinguish his rights to substantial damages in respect of a breach of the Employment Agreement by Company A and/or Company B."
On the other hand, the Commissioner of the Inland Revenue ("CIR") argued that the termination payment should be regarded as employment income as it represents "compensation for the non-receipt of certain payments which might otherwise have to be made under the Employment Agreement", and imposed salaries tax on the payment accordingly.
Therefore, the taxpayer appealed to the BOR.
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The Board's Decision
The BOR referred to a number of precedent UK cases as well as the Yung case mentioned above to make the decision. The crux of its decision is that a distinction should be drawn between the 5M Units and Future Units.
In respect of the Future Units, since they were not awarded to the taxpayers during the short tenure of his employment with Company A, the BOR indicated that the portion of the termination payment attributable to these units was for the abrogation of the taxpayer's future rights on such units. Such amount was not for rewarding any past, present or future services of the taxpayer. As such, it should be non-taxable for Hong Kong salaries tax purposes, which is in line with the decisions of various precedent Court cases on this topic.
On the other hand, the BOR noted that the 5M units had already been awarded to the taxpayer soon after his commencement of employment with Company A, which is in accordance with the terms of his employment agreement. The portion of the termination payment relevant to the 5M units should therefore be regarded as an "inducement payment" for the taxpayer's entering into the employment agreement with Company A and, as such, should be taxable.
After segregating the termination payment into 2 portions and determining the taxability of each portion, the BOR went further to allocate the taxable element of the termination payment.
By referring to the decision in the Yung case, the BOR attempted to adopt an apportionment mechanism so as to fairly allocate the assessable income of the taxpayer (i.e. the portion arising from the 5M units). The BOR admitted that there was no "scientific or entirely logical" approach to make the apportionment. As such, it decided to apportion 50% of the payment, i.e. US$5.5 million, to be the taxable amount on an "equity is equality" basis.
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Comments
Once again, a taxpayer's claim that the termination payment should not be chargeable to salaries tax has not been fully accepted by the BOR. If any element of the termination payment is mentioned in the employment contract, it is difficult for taxpayers to justify that the whole payment is compensatory in nature as opposed to an inducement for the rendering of services for his employer.
We are aware that both the taxpayer and the IRD are not satisfied with the BOR's decision and have further appealed to the Court of First Instance. We will provide an update of the Court's decision in due course.
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