Global Watch - Hong Kong: Court of Appeal's judgement in the CIR v Tsai Ge Wah case - gratuity or long service payment? 

 

The facts
 
The taxpayer in this case was employed on a series of contracts that were renewed periodically.  There is a clause in these contracts as well as the last renewal agreement ("the gratuity clause") which provides that the taxpayer would receive a gratuity upon completion of satisfactory services and that costs borne by the employer, such as severance pay and long service pay, will be deducted from the gratuity.  Gratuities were being paid to the taxpayer upon the renewal of the earlier contracts pursuant to this gratuity clause.  Salaries tax was paid on those gratuities as the taxpayer's employment had not been terminated at the end of each earlier contract so those amounts were not treated as long service payments.  Upon the completion of the last renewal agreement, the taxpayer's employment was terminated and he was again paid a lump sum in accordance with the gratuity clause.
     
Section 31Y of the Employment Ordinance ("EO") provides that if an employee has received a gratuity which exceeds the statutory long service payment, he is no longer entitled to any long service pay.  On the other hand, section 31YAA provides that any gratuity which an employee would otherwise be entitled will be reduced by the amount of long service payment received.  Similar treatments apply to severance payment and are stipulated in sections 31I and 31IA of the EO.  It is a declared policy and established practice of the Inland Revenue Department ("IRD") that long service and severance payments made in accordance with the EO are not subject to salaries tax.
   
The taxpayer's and the CIR's submissions
 
The taxpayer contended that as the gratuity clause of the renewal agreement stated that severance pay and long service pay would be deducted from the gratuity, the gratuity received by him upon completion of the last renewal agreement included the severance payment due to him.  As such, section 31IA of the EO was applicable (i.e. severance payment was made prior to gratuity payment) and part of the sum received should be exempt from salaries tax.  The CIR, however, argued that since the taxpayer was paid gratuities pursuant to his earlier contracts, the circumstance of the taxpayer came under section 31I or 31Y (i.e. gratuity payment was made prior to severance or long service payment) and the taxpayer's entitlement to a severance or long service payment would have been reduced to nil.  As such, the whole sum received upon completion of the last renewal agreement was gratuity.  The CIR also argued that there was no evidence to show that the taxpayer did receive any severance or long service payment as provided by the EO out of the gratuity received by him.
      
The Board's decision
 
The Board allowed the taxpayer's appeal in its decision (i.e. BOR Case No. D68/05).  Having considered the contracts of employment and the last renewal agreement, the Board found that the final gratuity received by the taxpayer upon completion of the last renewal agreement consisted of two natures, firstly a long service payment and secondly a gratuity.  The Board interpreted the gratuity clause as indicating that the employer intended to make the long service payment prior to or at least at the same time as the final gratuity payment.  In addition, based on the terms of the renewal agreement which were agreed between the parties, costs of the long service pay would be deducted from the gratuity.
      
The Courts' judgements
 
The CFI dismissed the CIR's appeal against the BOR's decision.  It held that the gratuity clause makes it clear that long service pay must be deemed to have been paid in advance of the gratuity payment.  It did not accept the CIR's submission that the gratuities previously received by the taxpayer upon the earlier renewals or extensions of his contract can be used to reduce to nil the long service pay to which the taxpayer only became entitled upon the completion the last renewal agreement.  As the previous gratuities have been subject to salaries tax, accepting the CIR's submission would lead to double taxation.  In its appeal to the CFI, the CIR also argued that the Board misapplied the burden of proof in its conclusion that the taxpayer was entitled to a long service payment as the taxpayer had not proven that he did not fall into any of those cases in section 31S of the EO in which such entitlement will be removed.  The CFI again disagreed with such contention and concluded that the burden of proof provision in the Inland Revenue Ordinance does not require the taxpayer to demonstrate that the circumstances in section 31S had in fact not happened in the absence of any realistic suggestion that one of those situations had occurred.
 
At the COA, the CIR's appeal was dismissed by one of the judges and allowed by the other two.  The majority of the COA held that section 31Y of the EO is intended to relate all gratuities received by an employee which are referable to the period in respect of which a long service payment would be payable.  As the gratuities in the present case were all paid during the taxpayer's employment with the same employer, they should be taken into account in determining whether any amount of long service payment would be payable upon completion of the last renewal agreement.  In the COA's view, the Board erred as it did not regard the previous gratuities as being relevant and failed to consider that section 31Y remains relevant even if the terms of the gratuity clause meant that any long service pay was to be paid prior to any element of gratuity.  In other words, the taxpayer was not entitled to receive any long service pay from his employer on the termination of his employment under section 31Y because the gratuities previously received by him would reduce such long service pay to nil.  Also, the question of double taxation did not arise as any tax payable on the final gratuity would relate to that gratuity and not the earlier ones.
      
Our comment
 
Interestingly, the major dispute in this case is not over a provision in the IRO but the applicability of sections 31Y and 31YAA of the EO.  As the Board and the COA pointed out in their decisions, the purpose of sections 31I /31IA and sections 31Y/31YAA of the EO is to prevent an employer from being obliged to pay twice for the same nature of payment but these sections, together with the lack of a precise legal basis and logic in the way the IRD's policy of exempting severance and long service payments is operated in practice, have created undesirable and unfair results to taxpayers.

Depending on the terms of an employment, an individual may receive a long service payment which is exempt from tax under the current policy and practice of the IRD while another individual may have to pay tax on a payment that represents a substitute for such long service payment.  For the IRD, this suggests that it may be worthwhile for it to consider whether the exemption should be extended to situations where section 31I or 31Y of the EO applies and provide clarification accordingly.  For taxpayers, the implication of the case is that their employments should be carefully structured and the terms of their employment contracts properly drafted so as to avoid falling into the situations under section 31I or 31Y of the EO.
 
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