Contractually agreed sums paid to an employee on termination of employment are assessable to salaries tax

Background to the Court of Final Appeal ("CFA") case, Fuchs v Commissioner of Inland Revenue [2011] 2 HKC

The appellant ("Mr. Fuchs") was employed under an employment contract for a term of three years (the "Contract"). The Contract was terminated after two years whereby the Employer agreed to pay Mr. Fuchs a sum in compensation "for the loss of his position". The sum comprised of an amount equal to Mr. Fuchs' salary for the remaining term of the Contract ("Sum A"), "two annual salaries" ("Sum B") and "the average of his three previous annual bonuses" ("Sum C"). Mr. Fuchs was entitled to receive Sum B and Sum C on premature termination by the Employer under the Contract. The Inland Revenue Department ("IRD") levied salaries tax on Sum B and Sum C (but not on Sum A) on the basis that they were paid to Mr. Fuchs under the Contract. Mr. Fuchs appealed to the Court of First Instance ("CFI") contending that Sum B and Sum C were not chargeable as they were paid to him as compensation for abrogation of office.

The CFI held that Sum C was chargeable but Sum B was not as Sum C was an entitlement under the Contract while Sum B was, in nature, similar to a non-contractual redundancy payment.

The case was appealed to the Court of Appeal ("CA") where the CA held that Sum B and Sum C, which were expressly provided for in the Contract, were both chargeable. In particular, the CA disagreed that Sum B was in the nature of a redundancy payment as it would not have been paid if the Contract had continued for the full term.

Mr. Fuchs further appealed.

Ruling of the CFA

The CFA held that in cases of termination of employment, employees will often claim that their rights have been abrogated and seek a tax exemption on the payments they receive on the basis that the payments were attributable to such abrogation.

However, whether payments received by an employee on termination of employment were chargeable turned on the construction of section 8(1) of the Inland Revenue Ordinance (i.e. whether the payments were income from any office or employment of profit). The test to be applied involves asking the following questions:

"In light of the terms on which the taxpayer was employed and the circumstances of the termination, is the sum in substance 'income from employment'? Was it paid in return for his acting as or being an employee? Was it an entitlement earned as a result of past services or an entitlement accorded to him as an inducement to enter into the employment?"

If the answer is 'Yes', the payments would be chargeable even though it might be linguistically acceptable to also refer to the payments as "compensation for loss of office or something similar". This is the case where the payment is clearly an entitlement under the employment contract (such as, an amount stated to be payable on early termination or paid according to a clause which entitles the employer to make payment in lieu of notice of termination).

However, if the answer is 'No', the payments would not be chargeable (such as where a payment was made in consideration of the employee forgoing or surrendering certain rights under the employment contract).

In the present case, Mr. Fuchs' right to Sum B and C "were not contingent in any material sense". Mr. Fuchs was assessed on Sum B and Sum C because he had received them on termination of his employment under the Contract. As soon as the Employer exercised its right to terminate Mr. Fuchs' employment, Mr. Fuchs accrued an enforceable right to be paid under the Contract, and Sum B and C were paid in satisfaction of that right.

The CFA further considered that the right to be given compensation on early termination without cause was an important part of the contractual consideration and self-evidently an inducement for Mr. Fuchs to sign the Contract.

Therefore, Sum B and Sum C were clearly amounts derived from Mr. Fuchs employment and were chargeable. Mr. Fuchs was not paid the sums in consideration of the abrogation of his rights under the Contract, and indeed, he surrendered no rights.

Implications for Employers and Employees

Previously, payments in lieu of notice paid to and received by an employee were not required to be reported to the IRD and were not chargeable to salaries tax.

However, in light of the CFA's ruling above, from 1 April 2012 onwards, payments in lieu of notice accrued to an employee (whether under an express term in the employment contract or in accordance with the Employment Ordinance) will be chargeable.

This means that from the 2012/13 year of assessment onwards, employers will be required to report payments in lieu of notice made to their departing employees to the IRD on the "Notification by an employer of an employee who is about to cease to be employed" or "Notification by an employer of an employee who is about to depart from Hong Kong".

Employees will also be required to report any payments in lieu of notice received by them on their "Tax Return – Individuals".

Key Contacts

Cynthia Chung

Partner | Corporate Commercial | Employment and Pensions

Email or call +852 2825 9297