Tax treatment of terminal payments

In November, the Court of Final Appeal dismissed the Commissioner's appeal and reaffirmed the long-standing position that payments made in return for services of employment are taxable.  

Summary of Facts

Mr Poon was employed as an executive director and the Group Chief Financial Officer with a multinational company.  He was terminated by the company, and threatened to escalate the matter to the shareholders. To avoid an acrimonious and costly dispute, the company entered into a separation agreement with Mr Poon, under which he would receive a payment in lieu of any discretionary bonus ("Sum") and acceleration of the vesting schedule of certain option shares granted to him by the company ("Share Option Gain").

Decision

The key issue

The Court was asked to consider whether the Sum and Share Option Gain were chargeable to salaries tax.

Analysis

The Court relied on the landmark decision in Fuchs v Commissioner of Inland Revenue (2011) 14 HKCFAR 74, and distinguished between (i) payments made as a reward for past, present, or future services in employment, and (ii) payments made to discharge obligations other than pursuant to the terms of a contract of employment.  Payments, including terminal payments, made under ground (i) fall within the operation of the Inland Revenue Ordinance ("Ordinance") and are chargeable to salaries tax. In contrast, payments made under ground (ii) fall outside the operation of the Ordinance and are non-taxable.

When determining whether the Sum and Share Option Gain are chargeable to salaries tax, the Court found that Mr Poon had no existing contractual entitlement to either of these payments. Applying Fuchs, the Sum and Share Option Gain were not paid as a reward for the services of Mr Poon, but for him to go quietly.  Therefore, both the Sum and the Share Option Gain were not taxable.

Key Takeaways

• This landmark decision clarifies the tax treatment of terminal payments. The key is the purpose for which the money is paid – if the payment is made in accordance with the contract of employment, or to reward services of employment, then the payment is taxable.

• The definitive judgment is relevant in negotiations of terminal payments between the employer and the employee, and in the construction of separation agreements.