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Jul 2008
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In Brief:
In June 2008, the Court of First Instance held down a case in respect of tax implications on termination payments from a Hong Kong salaries tax perspective. The Taxpayer was entitled to termination payments according to his employment contract. The Court is of the opinion that although the starting point to determine whether a payment is taxable is to look at the employment contract, one should consider the "true nature" of the payments - whether the payment represents income derived from services rendered under the contract. Thus, the Court ruled that a payment made with reference to two annual salaries, which is capital in nature, is not taxable while another payment made with reference to the average of three previous annual bonuses is taxable on the basis that it was intended as a substitute for the bonus the Taxpayer would have received, i.e. income derived from services rendered. |
Background
The Taxpayer was first employed by a German bank in 1976. He was transferred within the bank to Singapore in 2000 and in January 2004 he signed a three-year contract to work for the bank in Hong Kong. In the contract, it is stated that in the event the bank terminates him, the bank would pay to him as agreed compensation or liquidated damages in terms of (a) two annual salaries; and (b) an average amount of bonus paid in the three previous years of his employment with the bank.
The Taxpayer's contract was terminated and the bank paid him the following:
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Sum A - $3,120,000 being a sum equivalent to his salary under the remaining period of contract;
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Sum B - $6,240,000 being "two annual salaries" referred to the employment contract; and
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Sum C - $8,916,667 being "the average of his three previous annual bonuses" also referred to the employment contract.
The Inland Revenue Department ("IRD") assessed salaries tax on Sums B and C but not on Sum A on the basis that Sums B and C were made pursuant to the Taxpayer's contract of employment.
The Court's decision
The Court concluded that Sum B is capital in nature, i.e. not subject to Hong Kong salaries tax, based on the following factors ("taken together"):
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It is akin to a non-contractual redundancy payment because it is calculated with reference to an annual salary;
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The employer referred it as "agreed compensation";
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All future rights and obligations were terminated when the contract came to an end;
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It is not referred to any services performed (but by virtue of his seniority);
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It is not calculated by reference to services performed;
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It would not have been paid if the contract had gone its full terms of three years; and
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It may be regarded as an arbitrary amount, payable in the event of early termination, designed to soften the blow of premature unemployment.
On the other hand, Sum C is taxable. The Court concluded that the payment was intended as a substitute for the bonus the Taxpayer would have received had employment continued. The quantum of the bonus carried a significant weight of the Taxpayer's remuneration. The payment was an inducement for the Taxpayer to enter into the contract and therefore it was a contractual entitlement representing income derived from services rendered during the contract. Hence, income arising from employment should be taxable for Hong Kong salaries tax purposes.
The Court also ruled that Sum C cannot be apportioned by reference to the period of services rendered in Hong Kong over the entire period of employment with the bank (about 29 years) because (a) the payment was made pursuant to the three-year contract with the Hong Kong entity; and (b) it was also determined with reference to bonuses earned in Hong Kong. Thus, the entire sum should be subject to Hong Kong salaries tax.
PwC's commentary
One of the key observations in this case is the Court's view on contractual provisions. While the IRD is of the view that payments made pursuant to an employment contract should all be subject to tax, the Court's decision once again reconfirms the assertion that the "label" of a payment is not a conclusive factor in determining its taxability. Rather, it is the nature of the payment. Income arising from employment (i.e. services rendered) is subject to Hong Kong salaries tax.
In addition, the Court challenged why the "agreed compensation" were broken into 3 separate payments and this would imply that these three payments were of different natures. The Court is of the opinion that if the payment was made purely for compensation for loss of office, there would have been one single sum only.
It is interesting to note that the Court admits some of the factors of Sum B also apply to Sum C. As such, it has applied a "totality of facts" approach on both sums and arrived at opposite decisions.
In light of the above, if an employer is about to offer a compensatory payment for loss of office to an employee, proper review on the original employment contract and proposed separation agreement should be conducted upfront before execution. Clauses in the proposed separation agreement should be carefully drafted such that they will not contradict the intention as well as the nature of the payment.
We are however aware that both the taxpayer and the IRD have lodged an appeal to the Court of Appeal. We will provide an update of the Court's decision once available.
Note: This bulletin is designed for the information of readers. Whilst every effort has been made to ensure accuracy, information contained in this bulletin may not be comprehensive or may not yet be passed into law. Recipients should not act upon it without seeking professional advice. |
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