Will the forfeited share bonuses and dividends on shares received as a result of foreign employment be subject to salaries tax?

On July 22, 2022, the Court of Appeal ruled in favor of the taxpayer. The forfeitable share bonuses and related dividends received by the taxpayers as a result of their employment abroad are not subject to tax.

Background

Richard Paul Mark Aidan Forlee v Commissioner of Inland Revenue [2022]

Before June 30, 2014, the taxpayer was employed in the UK. On July 1 of the same year, the taxpayer commenced employment with a Hong Kong company. Both companies belong to the same group. When the taxpayer was employed in the UK, he was granted shares as an incentive for his performance. Under the UK company’s share award scheme, the shares granted to the taxpayer were divided into four tranches. Each tranche has four different release dates. At the same time, there is a “retention period” of six months from the release date of each tranche.

The shares are held by a Group nominee on behalf of the taxpayer from the date of issue. The taxpayer has the same rights as other shareholders under the UK companies’ share incentive schemes. That is, the taxpayer is entitled to dividends and shareholder voting rights from the date of award.

There are several restrictions on the shares granted to taxpayers under the scheme: – 1.

1. there is a restriction on the transfer of shares after the date of issue of the shares and during a “retention period” of six months thereafter. The shares continue to be held by a group nominee on behalf of the taxpayer. The taxpayer may not transfer; dispose of or sell the shares during the period of restriction

2. the shares granted may be forfeited if the taxpayer’s employment is terminated before the share release date

3. before the share release date, a UK company may reduce the number of shares granted to the taxpayer due to the state of the business or its performance at the time.

The Inland Revenue Department (IRD) is of the view that the above share bonuses were granted to the taxpayers while the taxpayers were employed in Hong Kong. Therefore, these share bonuses were in fact granted to the taxpayers as a result of the taxpayers’ employment in Hong Kong and were chargeable to salaries tax. For the same reason, the dividends from the above share bonuses were also derived from the taxpayer’s employment in Hong Kong, and the Inland Revenue Department (IRD) should charge salaries tax on this income.

The taxpayer’s appeal to the Board of Review was dismissed. The taxpayer further appealed to the Court of First Instance (CFI).

The Court of First Instance held that the taxpayer had received the relevant dividends under the UK company’s share incentive scheme and had exercised all the shareholders’ rights. The shares and dividends received by the taxpayer should be accrued to his employment in the UK. The Court of First Instance therefore ruled in favor of the taxpayer. Subsequently, the Inland Revenue appealed to the Court of Appeal.

The Court of Appeal’s decision

On July 22, 2022, the Court of Appeal handed down its judgment. The Court of Appeal dismissed IRD’s appeal and upheld the Court of First Instance’s ruling in favor of the taxpayers.

The Court of Appeal held that the shares were not income received by the taxpayer in the course of his employment in Hong Kong. Instead, the shares were acquired on the basis of the taxpayer’s performance during his employment in the UK.

The Court of Appeal also held that the shares granted to the taxpayer should have been included in the taxpayer’s income at the time of the grant of the shares, even though the shares might still be forfeited. In addition, dividends received from shares are exempt from salaries tax because they are essentially income from shares and not employment income.

Conclusion

The Court of Appeal’s decision confirms that employers have the flexibility to assist taxpayers in influencing the timing of charging salaries tax on share dividends, subject to the proper design and implementation of an equity incentive scheme. The decision also clarifies the principle of when income from share bonuses should be counted and subject to salaries tax. The decision reiterates the distinction between direct grants of forfeitable shares and conditional grants of shares subject to vesting conditions.

Employers should consider the tax principles set out in this case when designing new equity incentive plans or reviewing existing equity incentive plans. The terms of an Equity Incentive Plan may affect the timing of when tax obligations arise. If you have any questions, please consult a tax or legal professional.