Two court cases concerning the taxability of payments received upon termination of an employment were handed down recently, namely, Fuchs, Walter Alfred Heinz v. CIR ("the Fuchs case") and the executors of the estate of the late Mr. Murad, Mike M. v CIR ("the Murad case"). The taxpayers lost in both cases. The two cases share considerable similarities in terms of the facts as well as the reasoning adopted by the courts in arriving at their judgments. Below are a summary of the two cases and an analysis of the court decisions.
The Fuchs case 
The facts The taxpayer was first employed by a German bank in 1976. He signed a three-year contract to work for the bank in Hong Kong in January 2004. In the contract, it was stated that in the event the bank terminates his employment, the bank would pay to him as agreed compensation or liquidated damages: (1) two annual salaries (referred to as "Sum B" in the judgment); and (2) an average amount of bonus paid in the three previous years of his employment with the bank (referred to as "Sum C" in the judgment).
The taxpayer's employment contract was terminated after about two years. The taxpayer entered into a termination agreement with the bank under which the bank paid him Sum B and Sum C as referred to in the employment contract plus a sum equivalent to his salary under the remaining period of contract (referred to as "Sum A" in the judgment).
The Inland Revenue Department ("IRD") assessed salaries tax on Sums B and C but not on Sum A on the basis that Sums B and C were made pursuant to the taxpayer's employment contract. The taxpayer contended that both Sum B and Sum C were compensation for the termination of his employment and not taxable. The taxpayer also argued that if Sum B and / or Sum C did constitute assessable income, the two sums should be apportioned so that only that portion of the sums derived from the period of his Hong Kong employment (about two years) as oppose to his entire career with the bank (about 29 years) should be taxed.
The taxpayer lodged an appeal directly to the Court of First Instance ("CFI") without a hearing at the Board of Review.
The CFI's decision The CFI concluded that Sum B was capital in nature based on a number of factors taken together and not taxable whereas Sum C was income from employment and taxable. Although the CFI described both sums as "borderline" and considered that some of the factors of Sum B also applied to Sum C, it arrived at opposite conclusions on the two sums by applying a "totality of facts" approach.
The CFI also held that Sum C cannot be apportioned by reference to the period of services rendered in Hong Kong over the entire period of employment with the bank because (1) the payment was made pursuant to the three-year contract with the Hong Kong branch; and (2) it was determined with reference to bonuses earned in Hong Kong. As Sum C relates to the taxpayer's Hong Kong employment, no question of apportionment can arise and the entire sum should be subject to Hong Kong salaries tax.
The taxpayer appealed to the Court of Appeal ("COA") against the CFI's judgment on Sum C while the Commissioner cross appealed against the CFI's judgment on Sum B.
The COA's decision In its judgment on 30 October 2009, the COA observed that questions as to the taxability of termination payments have often been described as "difficult, borderline and depending on narrow distinctions" and it is often difficult to decide on which side of the line (i.e. taxable or not taxable) a case falls. However, the COA considered that it is clear that there is a line derived from the language of the taxing provision. In this regard, based on the decisions in precedent cases, the following two propositions were referred to in the COA's judgment:
- Where a sum is paid under a contract of employment, it is taxable, even though it is received at or after the termination of the employment.
- Where a sum is paid as consideration for the abrogation of a contract of employment, or as damages for the breach of it, that sum is not taxable.
Taking into account the above distinction and after performing a detailed analysis of the numerous authorities in this area, the COA came to the conclusion that both Sum B and Sum C are taxable because:
- The determination of whether the sums are taxable is essentially a matter of applying the statutory language to the facts, the language used to label the payments is not the determining factor the true nature of the payments;
- Both sums are payable under the terms of the taxpayer's employment contract so they are emolument from the employment;
- Neither of the two sums represents compensation for abandonment / waive of any contractual rights or damages for breach of the employment contract. On the contrary, the sums were paid in accordance with the employment contract to honour the taxpayer's contractual entitlement so no rights were surrendered by the taxpayer; and
- Neither Sum B nor Sum C is in the nature of a redundancy payment or severance pay (which is specifically exempt from salaries tax if certain conditions are met).
The COA also agreed with the CFI's analysis on the question of apportionment and held that no apportionment on the two sums is available.
Taxpayer has applied for leave to appeal to Court of Final Appeal.
The Murad case
The facts The taxpayer entered into a service agreement with a bank in Hong Kong in April 1999 The clauses of the service agreement stipulated that the taxpayer would be entitled to a number of payments upon early termination of his employment by the employer, including the total basic annual salary, fixed bonus payment, removal and shipping expenses and cost of airfare (collectively "the taxed sums"), etc. The taxpayer's employment was terminated due to corporate acquisition and restructuring and a separation agreement was entered into in July 2004. The separation agreement specifically referred to the service agreement with respect to the taxpayer's entitlement of the taxed sums.
The IRD determined that the taxed sums are assessable income from employment as the taxpayer's entitlement to those sums arose out of the service agreement and the sums stemmed from the terms of the employment. The taxpayer's case is that the taxed sums were compensation for loss of office and thus not taxable. The taxpayer appealed directly to the CFI against the IRD's determination.
The CFI's decision The judge of this case is also one of the judges of the Fuchs case. Unsurprisingly, the judge in the present case followed the COA's analysis in the Fuchs case and adopted the same legal principles in coming up with the conclusion that the taxed sums are subject to tax because they were paid to the taxpayer under the terms of his employment contract and in return for his acting as or being, or for becoming, an employee.
The taxpayer has filed an appeal to Court of Appeal. Date of hearing not yet fixed.
PwC's commentary The gist of the court decisions in these two cases is that there is a critical distinction between a termination payment that is made in pursuance of a provision of an employment contract and one that is not covered by an employment contract but is paid as consideration for abandonment of the contractual rights under the employment contract.
The table below compares the features of termination payments that are likely to be regarded as taxable with those that can arguably be regarded as non-taxable (subject to IRD's review of the fact pattern of each case).
| Termination payments that are likely to be regarded as taxable |
Termination payments that can arguably be regarded as non-taxable |
| Provided for in the terms of an employment contract |
Not provided for in the terms of an employment contract |
| Agreed at the outset of an employment |
Agreed at the time of terminating an employment |
| An inducement to enter into an employment contract |
An inducement to terminate an employment contract |
| Made pursuant to the terms of an employment contract i.e. fulfilling an obligation under the employment contract |
Made pursuant to the terms of a termination agreement as compensation for abandonment or release of obligations under an employment contract / damages for breach of an employment contract |
| Payment for upholding a contractual right |
Payment for buying out a contractual right |
| In return for becoming / being an employee |
In return for abrogation of an employment contract |
| Emolument from an employment |
Compensation for surrender of contractual rights in respect of an employment |
As illustrated in these two cases, the presence of a termination agreement that is subsequently concluded between the employer and the employee upon termination of employment would not be helpful in cases where the sum payable under the termination agreement is provided for under the terms of the original employment contract. In such cases, the taxpayer is entitled to receive the sum pursuant to the provisions of the employment contract at the outset of the employment and therefore, the sum is likely to be regarded by the IRD as an emolument from the employment or from becoming or being an employee and taxable.
The court decisions once again reconfirm the assertion that the "label" of a payment is not a conclusive factor in determining its taxability. Rather, it is the nature of the payment that is determinative.
In light of the above, employers and employees should take into consideration the tax consequence of any intended termination payments as early as in the stage when the original employment contract is drafted rather than at the time when a termination agreement is prepared. Proper review of the terms of the employment contract should be conducted upfront before execution.
