Hong Kong Court of Final Appeal affirms terminal payments not taxable

The Court of Final Appeal in Poon Cho-Ming, John v Commissioner of Inland Revenue FACV 1/2019 [2019] HKCFA 38 has found for the taxpayer and affirmed the decision of the Court of Appeal below, which was the subject of a separate client alert we issued on 4 July 2018 (accessible here). This judgment affirms the longstanding distinction at Hong Kong law between payments made by an employer, or former employer, to an employee, or former employee, in accordance with the terms of a contract of employment, and payments that are made otherwise than as a reward for past, present or future services in employment. Only in the former case will the payment be chargeable to salaries tax. 

Facts

The facts bear some recapitulation. Mr Poon was a highly paid executive, employed by a renowned multinational clothing company. He fell out with his employer’s management, which dismissed him. Mr Poon instructed solicitors and sought to bring the matter to the attention of his former employer’s shareholders. With a view to avoiding a protracted and acrimonious dispute, his former employer agreed to enter into a separation agreement with him, which provided for, among other things, a payment in lieu of discretionary bonus (Sum D) and the acceleration of the vesting schedule of certain shares which Mr Poon had been granted, but which had not yet vested (Share Option Gain). 

Analysis

In categorising terminal payments for tax purposes, the Court of Final Appeal drew an important distinction between payments that are made pursuant to the terms of a contract of employment and payments that are made to discharge some other obligation. The former kind of payments, albeit terminal payments, are paid because the employee was entitled to them under and by virtue of his contract of employment. In other words, they were reward for past, present, or future services in employment and, on that footing, from employment within the meaning of section 8(1) of the Inland Revenue Ordinance. In contrast, however, a payment that is made not in satisfaction of an existing contractual right of the employee, but for some other reason, will not be chargeable to salaries tax, even if it is paid by an employer or former employer. In Mr Poon’s case, it was imperative from the perspective of his former employer that he go quietly. In order to achieve that objective, his former employer agreed to pay him both Sum D and the Share Option Gain, to which he was not entitled at the time of the cessation of his employment. In other words, Mr Poon had no vested contractual right to either payment, nor could either payment be regarded as a reward for his past services in employment; on the contrary, his former employer had been dissatisfied with his performance in employment. As the Court of Appeal below rather pithily put it, Sum D and the Share Option Gain were the “antithesis to a reward for past services”. Further, the bare fact that Sum D and the Share Option Gain were computed by reference to mechanisms governing the former employer’s employee incentive scheme did not have any bearing on the source of those payments: correlation does not imply causation.

Counsel for the Commissioner of Inland Revenue ingeniously sought to argue that, as regarded Sum D, it was a sum paid in substitutionof a discretionary bonus. It is axiomatic at revenue law that a sum paid in substitution of another acquires the fiscal nature of the sum so substituted. An example of this is the payment of a sum to compensate a trader for loss of trading profits, which is thereby chargeable to profits tax. By the same logic, a sum paid in substitution of a discretionary bonus should, likewise, be chargeable to salaries tax. The Court declined to apply the principle of substitution to Mr Poon’s case, finding instead that Mr Poon was simply not entitled to receive either Sum D (or any other discretionary bonus) or the Share Option Gain as at the date of his departure. There was, therefore, nothing to be substituted.

Takeaways

Poon’s case is now an authoritative and definitive statement of the law on terminal payments in Hong Kong. Employers and employees should bear in mind that the critical question is what a given payment was for: if it was contemplated in the contract of employment, or otherwise a reward for past, present or future services in employment, it is to be regarded as derived from employment and is, on that footing, taxable. If, however, it was paid for some other reason, then it should escape the charge to salaries tax. Put simply, in Mr Poon’s case the bargain from the perspective of his former employer went like this: “do this thing which you are not obliged to do under your contract of employment (i.e., go quietly) and we shall pay you these sums to which you are not entitled, and which we are therefore not otherwise obliged to pay you (i.e., Sum D and the Share Option Gain)”.