In the event of termination of an employment contract, it is often financially important for the employee to know if payments made by the employer under the termination agreement such as accrued salary, payment in lieu of notice and annual leave pay etc would be subject to salaries tax. This is particularly so during the period of economic downturn, high inflation and COVID 19 pandemic. The question of whether the payment or benefit, or any gain from the exercise of any such benefit, so paid and conferred at termination of employment is chargeable to salaries tax is of great public importance and was carefully analyzed in the recent Court of Final Appeal case of Poon Cho-Ming, John v Commissioner of Inland Revenue FACV 1/2019  HKCFA 38.
The taxpayer, Mr Poon, was employed by a Hong Kong listed company as the Group Chief Financial Officer in 1999. In 2008, Mr Poon’s employment was terminated pursuant to a Separation Agreement, which provided for, among other things, a payment in lieu of discretionary bonus in the sum of Euro 500,000 (“Payment in lieu of Bonus”) and the acceleration of the vesting schedule of share options which Mr Poon had been granted and which Mr Poon then exercised and derived notional gain (“Share Option Gain”).
The Commissioner of Inland Revenue, the Board of Review and the Court of First Instance considered and ruled that the Payment in lieu of Bonus and Share Option Gain were derived from Mr Poon’s employment and were therefore chargeable to salaries tax under section 8(1) of the Inland Revenue Ordinance (“IRO”).
Section 8(1) of the IRO 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.”
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 wages, salary… bonus or allowance, 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.”
Mr Poon appealed the Court of First Instance’s decision to the Court of Appeal, which overturned the previous decision and decided in favour of Mr Poon in 2018 (i.e. the Payment in lieu of Bonus and Share Option Gain were not taxable). The Commissioner of Inland Revenue then appealed against the Court of Appeal’s decision to the Court of Final Appeal.
The Fuchs Test
To determine whether or not terminal payments are subject to salaries tax, the Court of Final Appeal referred to the following key principles laid down in the case Fuchs v Commissioner of Inland Revenue  14 HKCFAR 74 :-
(a) Income chargeable under section 8(1) of the IRO is not confined to income earned in the course of employment but also embrace payments made in return for acting as or being an employee, as a reward for past services or as an inducement to enter into employment and provide future services.
(b) 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, is found to be derived from a taxpayer’s employment in foregoing sense, then it is assessable.
(c) If the payment was for something else, then it is not taxable.
The True Nature of the Payment / Gain
After considering the substance of the Payment in lieu of Bonus and applying the Fuchs test, the Court of Final Appeal decided that the Payment in lieu of Bonus was not taxable. Although this payment was described as “ in lieu of a discretionary bonus” under the Separation Agreement, the payment was made in an arbitrary amount, which was of a wholly different nature from a discretionary bonus under the employment contract. Rather, the Payment in lieu of Bonus was paid to Mr Poon by the employer for him to go away quietly but not for inducing him to provide future services or as a reward for past services.
As for the Share Option Gain, the Court determined that the employer agreed to allow Mr Poon to exercise the share options immediately on the signing of the Separation Agreement as part of the terms of termination of his employment. Had the parties not entered into the Separation Agreement accelerating the vesting dates of the options, Mr Poon would never have received the Share Option Gain at all. The Court of Final Appeal held that the Share Option Gain was not taxable. It 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 and it was clear that the acceleration was not given to induce Mr Poon to provide future services.
It is important to note that the fact that a service was rendered after the formal end of the employment would not necessarily preclude a finding that the payment for that service was received “from” the employment. Frequently, there are obligations arising post-termination which the employer and / or the employee must comply. Further, it is not uncommon for an employer to request an ex-employee to return to perform some follow-up work. It is entirely possible for a sum to be paid pursuant to a termination or settlement agreement, and yet still be “from” the taxpayer’s employment and therefore taxable (see Zarin v Commissioner of Inland Revenue  4 HKC).
The only burden that the taxpayer faces is to identify that payment was not “from” his prior employment but “from something else”. It is not necessary for the taxpayer to identify or prove the “something else”.
Employers and employees should bear in mind that when a payment is given for a contemplation in the contract of employment, or a reward for past, present or future services in employment, it will be regarded as derived from employment and is therefore chargeable to salaries tax. It will be the substance and not form that will be examined.
If you have any questions about the above eNews or need advice regarding any employment issues in Hong Kong or China, including drafting of employment contract, termination and remuneration, workplace discrimination issues, employees’ handbook etc experienced lawyers in our Employment Department will be happy to assist you.