The recent Court of Appeal decision in Poon Cho Ming, John v Commissioner of Inland Revenue CACV 94/2016  HKCA 297 affirmed the orthodox position in Hong Kong that terminal or severance payments are not taxable if they were paid wholly for the abrogation of the employee’s rights under his contract of employment. The Court of Appeal allowed the taxpayer’s appeal and overturned the decisions of the Board of Review and of the Court of First Instance, which had both found for the Commissioner of Inland Revenue (Commissioner). The judgment is of particular interest because it addressed two common classes of remuneration: cash bonuses and shares.
The facts of the case were typical of a terminal payment scenario: Mr Poon was a highly paid executive, employed by a renowned multinational clothing company. It was common ground that he had been highly successful in his role and had been appointed to numerous positions of prominence within his employer’s group. Nevertheless, he eventually fell out with his employer’s management, which elected to dismiss him. Mr Poon decided not to go quietly. He instructed solicitors and sought to bring the matter to the attention of his employer’s shareholders. With a view to avoiding a protracted and acrimonious dispute, his 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). Under Mr Poon’s contract of employment, a discretionary bonus could only be paid after a three-stage internal approval process, and, whereas the share option scheme provided that the vesting schedule of shares could be accelerated, such acceleration was entirely at the employer’s discretion. When Mr Poon was paid Sum D, the first of the three steps for determining whether an annual discretionary bonus should be paid had not been commenced by the employer, and the shares with respect to which he received the Share Option Gain had not yet vested.
Mr Poon argued that both Sum D and the Share Option Gain were not income from employment, in the sense that they were not reward for past, present or future services in employment; instead, they were payments for the abrogation of his contractual rights under his contract of employment and for his agreement to leave the employer quietly and on generally good terms. Conversely, the Commissioner argued that the payments, deriving from contractual rights, were inherent to Mr Poon’s conditions of employment and were in substance taxable emoluments from employment because they arose from his employment contract. Whereas the Board of Review and the Court of First Instance found for the Commissioner, and identified the causal nexus of both payments in Mr Poon’s contract of employment, the Court of Appeal found no basis to support those conclusions.
The starting point for the Court of Appeal’s decision was the landmark decision of the Court of Final Appeal in Fuchs v Commissioner of Inland Revenue (2011) HKCFAR 74, which laid out the fundamental test that in order to determine whether a payment is chargeable to salaries tax, one must first ask what it was paid for– if it was paid as a reward for past, present, or future services in employment, it will as a general rule be taxable, but if it was paid for some other reason, such as the abrogation of existing rights under an employment contract that was terminated at the instance of the employer, then it will usually not be taxable. In Mr Poon’s case, the Court of Appeal held that it was clear that he had no contractual entitlement at the time of his dismissal either to Sum D or the Share Option Gain. Both payments were clearly not paid on the terms of the contract of employment, but were paid as consideration for the separation agreement under which Mr Poon agreed to forbear from pursuing specific actions, such as bringing legal proceedings, that his employer considered inimical to its interests.
As regards Sum D, although he did indeed have an existing contractual right to be considered for a discretionary bonus, the process for determining whether such a bonus should be paid to him at all in the tax year in which his employment ceased had not even commenced. Logically, Sum D did not, therefore, flow from the contract of employment. It was paid by the employer specifically to placate Mr Poon and prevent any action he might otherwise have taken under his contract of employment. Had Mr Poon ceased employment absent the separation agreement, he would have gotten nothing at all.
Similarly, the share options Mr Poon had acquired were subject to a strict vesting schedule, which meant that unless the shares had vested at the time he left employment, they would be forfeited. The Commissioner sought to argue that because Mr Poon’s employer had agreed to accelerate the vesting schedule under the separation agreement, the Share Option Gain should be treated as a taxable employment related security, since the acceleration mechanism was expressly provided for in the terms of the share option scheme, which formed part of Mr Poon’s contract of employment. The Court of Appeal, however, disagreed and reasoned rather subtly that the decision of the employer to accelerate the vesting schedule was made not as a reward for past, present or future services rendered by Mr Poon, but was itself consideration to induce him to enter into the separation agreement and, therefore, to leave his employment as quietly as possible. Had Mr Poon’s employer declined to accelerate the vesting schedule, Mr Poon would not have received any part of the Share Option Gain, and the unvested shares in question would simply have lapsed. As with Sum D, the mere fact that Mr Poon got what he could have gotten under his contract of employment under the separation agreement did not mean that the payments in question arose from the contract of employment itself, or were otherwise paid for his services. Correlation does not equal causation.
The judgment in Poon Cho Ming is important because it restores clarity to the tax treatment of terminal payments. Put briefly, if a terminal payment is itself contained in the contract of employment it will be taxable when triggered. That is because the payment is part and parcel of the contract of employment: the promise of a guaranteed terminal payment is plainly an attractive condition in a contract of employment, and thus operates to induce an employee to enter into the contract, such that it is, in effect, a reward for services in employment. Conversely, where the terminal payment, irrespective of how it is computed or its actual amount, is made wholly for some reason other than a reward for services, it will in the ordinary course not be chargeable to salaries tax. Employers and employees should now have greater certainty that terminal payments paid for the abrogation of contractual rights under a contract of employment will not in the ordinary course be taxable. In turn, this facilitates the structuring of termination agreements both for in-house functions and their legal advisors.
The Court of Appeal’s decision is also an important reaffirmation of the principle that the salaries tax analysis must follow from a clear and legally accurate understanding of all of the underlying contractual documentation. Arguably, the Board of Review and the Court of First Instance adopted an unduly narrow focus by concentrating their analysis on the contract of employment alone, and therefore omitting the equally important discussion of whether the severance agreement might, itself, have an independent vitality by way of the exchange of fresh consideration between employer and employee.