Does the contractual provision provide that payments made to the employee on termination of employment should be subject to salaries tax?

On February 1, 2011, the Court of Final Appeal upheld the decision of the Court of Appeal and dismissed the taxpayer’s appeal. It also ruled that the contractual provisions stipulating that the payments made to the employee upon termination of employment should be subject to salaries tax.

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Background

Fuchs v Commissioner of Inland Revenue

The taxpayer was employed by a bank under a three-year employment contract. When the bank was acquired two years later, the taxpayer’s employment contract with the bank was terminated and the employer agreed to pay the taxpayer compensation for “loss of office”.

The compensation consisted of three payments:

The first amount was equivalent to the amount of wages paid to the taxpayer during the remaining period of the employment contract;

The second amount is equivalent to two years’ annual salary;

The third amount is the average of the taxpayer’s bonuses for the previous three years.

The taxpayer is entitled to receive the second and third payments when the employer terminates the contract early under the employment contract. The Inland Revenue Department (“IRD”) therefore levied salaries tax on the second and third payments received by the taxpayer under the employment contract, but not on the first payment. The taxpayer appealed to the Court of First Instance (“CFI”), claiming that the second and third payments were made to him as compensation for his removal from office and therefore should not be chargeable to salaries tax.

The Court of First Instance ruled that the third payment was an entitlement under the contract of employment and that the second payment was similar in nature to compensation for non-contractual redundancy, and therefore the third payment was chargeable to salaries tax but not the second payment.

The case was appealed to the Court of Appeal. The Court held that the second payment would not have been payable if the contract of employment had continued for the full three-year period, and therefore disagreed that the second payment was in the nature of a severance payment. The Court of Appeal therefore ruled that both the second and third payments, which were specifically provided for in the employment contract, were chargeable to salaries tax.

The taxpayer further appealed to the Court of Final Appeal.

Disputes

In the case of termination of employment, it is common for employees to claim that their entitlements have been extinguished and seek exemption from salaries tax on the compensation received on the ground that it is attributable to the extinguishment of entitlements.

However, in ruling on this, the Court will need to answer the following questions: Is the amount of compensation in essence “income from employment”, given the conditions under which the taxpayer was employed and the circumstances under which his employment was terminated? Is it compensation paid because he was or became an employee? Is it a right acquired as a result of past service, or is it a right given as an inducement to enter the employment?

The Court of Final Appeal (CFA) ruling

The Court of Final Appeal handed down its judgment in 2011.

The Court held that if the answer to the above question to be answered was “yes”, the compensation payment should be chargeable to salaries tax even though it could be linguistically described as “compensation for loss of office”. In this case, the compensation is clearly a right under the contract of employment (e.g. providing for payment on early termination).

However, if the answer is “no”, the compensation payment should not be chargeable to salaries tax either (e.g. where the payment takes into account the employee’s waiver or surrender of certain rights under the contract of employment).

In this case, the Court held that the taxpayer’s entitlement to the two payments was “not accidental in any material sense”. The second and third payments received by the taxpayer were assessed because they were received at the time he terminated his employment under the contract. Once the bank, as employer, exercised its right to terminate the taxpayer’s employment, the taxpayer’s right to remuneration under the contract arose, and the employer paid the second and third amounts in satisfaction of that right. The CFA further held that the right to compensation in the event of an unjustified early termination was an essential part of the contract and a self-evident inducement for the taxpayer to enter into the employment contract.

It was therefore clear that the two sums were monies received by the taxpayer from his employment and were chargeable to salaries tax.

Conclusion

According to the above CFA judgment, the wages in lieu of notice received by an employee should be chargeable to salaries tax. Employers will be required to report to the Inland Revenue Department (“IRD”) on payments made in lieu of notice to their former employees, and employees will be required to report any payments received by them in their personal tax returns for IRD’s assessment. However, different viewpoints and numerous precedents on the taxation of termination payments show that the application of these principles is often difficult and there are often nuances in whether the payments are taxable or not. If you are in any doubt, please consult a tax or legal professional.