In 2023, the Court of Appeal upheld the Court of First Instance’s decision that damages paid by a former employer to an employee for loss of statutory and contractual holidays were not taxable income for salaries tax purposes.
Dr. The Honourable Leung Ka-Lau v The Commissioner of Inland Revenue
From June 1995 to November 2011, the Hospital Authority employed taxpayers as professional physicians. During the period of employment, doctors were required to be present in the hospital area; or to be on call within 30 minutes of the hospital after normal working hours. Doctors are required to be on duty under the same conditions even on Sundays or public holidays.
Taxpayers and other doctors who are also employed by the Hospital Authority have sought assistance from the judiciary to enforce their statutory and contractual rights to rest days and holidays deprived by the on-call system. In October 2009, the Court of Final Appeal ruled in favor of the physicians, who were entitled to damages from the Hospital Authority. The damages were assessed in an amount equal to a full day’s labor for each day of rest or leave that the physician was deprived of. The taxpayers in this case were also awarded damages equal to the number of days of rest lost between March 1996 and October 2005.
Subsequently, the IRS attempted to assess salaries tax on the amount of the compensation on the basis that it constituted earned income. The taxpayer appealed, but the Board of Tax Appeals upheld the Commissioner’s decision and dismissed the appeal. The taxpayer filed a further appeal to the Court of First Instance and won. The IRD appealed the decision to the Court of Appeal.
The main issue in this litigation was whether the employer’s compensation for the loss of rest days and statutory holidays was employment income within the scope of section 8(1) of the IRO.
The Court of Appeal’s decision
On February 22, 2023, three judges of the Court of Appeal handed down a judgment dismissing the IRD’s appeal by two to one and affirming the judgment; the IRD was also required to pay the taxpayer’s costs.
In analyzing this tax case, the Court of Appeal relied on the principles enunciated in Fuchs, Walter Alfred Heinz v CIR (2011) to determine whether compensation is substantially employment income within the scope of section 8(1) of the IRS.
The appellate court cited several principles for its decision:
1. that the monetary amount of compensation was an equivalent compensation paid as a result of the on-call system, which abrogated the taxpayer’s leave entitlement under the Employment Ordinance and the employment contract;
2. The compensation is not provided for in the employment contract between the taxpayer and the Hospital Authority. For statutory holidays, the Employment Ordinance prohibits the payment of wages in lieu of leave. Therefore, the compensation paid to compensate the taxpayer for the retroactive deprivation of statutory holidays is based on the EO;
3. There is no consensus or agreement between the taxpayer and the Hospital Authority regarding the on-call arrangement for holidays or rest days. Therefore, the amount of compensation paid to compensate the taxpayer for the deprivation of statutory holidays is not determined by the mechanism in the employment contract. The compensation is not a return to the taxpayer for being an employee;
4. The amount of compensation is payable as a result of the Court of Final Appeal’s determination that the Hospital Authority has violated the Employment Ordinance and the employment contract. The amount of compensation was based on a daily manual calculation of the “incidental” connection, not the direct cause.
For the foregoing reasons, the Court of Appeal affirmed and dismissed the IRD’s appeal.
It is important to note that the Court of Appeals’ decision was a majority, not a unanimous decision. One of the three judges dissented and held that the compensation at issue in this case should be taxable income for payroll tax purposes.
The Court of Appeal also noted that the distinction between an amount paid under the terms of a contract of employment or an equivalent payment as a cancellation of contractual rights is necessary in similar disputes. This remains a controversial issue.
It remains to be seen whether the IRD will apply for leave to appeal to the CFA.
There is still a lot of uncertainty in this tax case. Therefore, employers or employees should seek professional advice on tax issues and related legal implications if they have any questions.