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Oct 2006
CACV 286/2006, Date of Judgment: 17 Oct 2006
This was an appeal by the Commissioner of the Inland Revenue ("the Commissioner") against the decisions of the Court of First Instance (HCIA 12/2005) and the Board of Review (D87/04) concerning the apportionment of compensation payment for the termination of employment into taxable and non-taxable amounts.
Background facts
The taxpayer was a co-founder of a company which was acquired by a US company. Following the acquisition, the taxpayer was offered the position of MD and CEO for a term of five years and received an award of 5,000,000 Incentive Compensation Plan Units ("Existing Units"), plus a right to further grants of additional units contingent on business performance ("Future Units"). The Units entitled the taxpayer to annual payments based on a percentage of net income of the company. The taxpayer's employment was terminated less than six months into his new apportionment and USD11mil was paid to him as compensation for cancellation of the Units.
Matters on appeal
The Commissioner agreed with the decisions by the Court of First Instance and the Board of Review that the USD11mil was a payment in exchange for the taxpayer's Units, which comprised of Existing and Future Units. The Commissioner also agreed that part of the USD11mil represented compensation for cancellation of Future Units, which was a payment for abrogation of rights and that this was not taxable following Henley v. Murray (1950) 31 TC 351. However, the Board's decision in applying a "rough and ready" method of apportioning only 50% of the USD11mil as being taxable was disputed by the Commissioner. The taxpayer also countered that none of the USD11mil should be subject to tax as it was wholly for abrogation of rights under the Incentive Compensation Plan ("ICP").
The decision
The crux of the issue identified by the Judge in the hearing the appeal was: should the taxpayer be liable to any tax at all? This necessitated an assessment of what rights were conferred onto the taxpayer when he was granted the Units and, whether as a direct result of the termination of employment that those rights became extinguished.
The Judge found that under the terms of the ICP, the Units represented a right to receive annual payments of profit share; the taxpayer also had a one-off right to elect for termination of the ICP in return for a lump sum payment in lieu of annual payments. The Commissioner contended that based on this, the taxpayer would have been entitled to receive annual payments from the Units irrespective of whether or not the employment had ended and that the USD11mil was just a substitution of taxable income. The taxpayer claimed that the annual payments were contingent on continued employment and as his employment was prematurely terminated, the USD11mil represented compensation for loss of right to future payouts.
The Judge found that both the Board and the Court of First Instance's decision were flawed on the premise that the annual payments would nevertheless continue notwithstanding termination of employment. Furthermore, the Judge did not agree that the Existing Units represented an inducement to employment and found that the taxpayer was not able to exercise the election to cash out the Units before the end of five years. The Judge decided that the taxpayer had a "whole bundle of rights" under the ICP, which were curtailed as direct result of the termination of employment. Furthermore, it was impractical to isolate the value of the consideration for buying out the Future Units.
It was held the whole of the USD11mil was compensation for loss of rights under ICP and wholly not subject to tax.
Our comment
The Hong Kong Inland Revenue Department ("IRD") generally accepts UK case law that payments for buying out a contractual right should not be subject to tax. However, as demonstrated in this case, there is a very fine line between what constitutes "payment for buying out a contractual right" (non-taxable) and "payments for upholding a contractual right" (taxable). There is an element of bargain in the former, in that the parties would arrive at a sum to be paid as consideration for the buy-out. The taxpayer in this case was able to demonstrate through clauses in the Termination Agreement that there was an element of bargain being struck. The terms of the ICP were also structured such that the annual profit share were only made if the taxpayer remained as an employee. Hence, the taxpayer was able to establish he had rights curtailed as a direct result of termination of employment and that the USD11mil was to compensate for that loss.
A point also worth noting is that the Hong Kong IRD tends to favour the "apportionment" approach, whereby they will agree for a portion of compensation for loss of employment to be non-taxable. However, the Judge in this case stated that any attempt at apportionment is fraught with difficulties and they do not agree that one should just adopt an arbitrary approach to apportionment. It will be interesting to see if this will change the current position of the IRD. |
