Hong Kong: Salaries tax implications of employment termination and restricted shares (court decision)

The Court of Appeal issued a judgement in a case, holding that remuneration paid for assistance in litigation and restricted shares released pursuant to a termination agreement are not subject to salaries tax.

The Court of Appeal’s decision affirmed previous judgements of the Court of First Instance.

The case is: Heath Brian Zarin v. Commissioner of Inland Revenue [2022] HKCA 412 

The decision is useful precedence because it illustrates how the principle of whether a payment is “in return for acting as or being an employee” (which is subject to salaries tax) or “for something else” (which is not subject to salaries tax). Even though restricted shares may have been awarded during employment as a reward for past services, the vesting or release of the shares may be attributable to “something else”—in this case, fresh consideration under the termination agreement. 

The individual taxpayer was employed by a bank pursuant to an employment letter, which afforded him participation in the bank’s discretionary bonus scheme in the form of restricted share awards.

In 2013, the bank terminated the taxpayer’s employment on the grounds of redundancy. Following a series of negotiations, six months after the termination, the parties came to agreed terms (and entered into the “termination agreement”) that included five sums—“Sum A,” “Sum B1,” “Sum B2,” “Sum C,” and “Sum D”—which were paid to the taxpayer.

• Sum A and Sum B1 represented the 2011 restricted shares awards (“2011 shares”) that would continue to vest per the original award terms.
• Sum B2 and Sum C represented the 2012 restricted shares awards (“2012 shares”) that would be conditional on the taxpayer not having committed a breach of the termination agreement and providing post-termination support in respect of the bank’s on-going litigation.
• Sum D represented the compensation that would be paid to the taxpayer on a daily basis for time spent in assisting certain litigation matters of the bank for the next five years (“litigation compensation”).

The case before the Court of Appeal concerned the Commissioner’s appeal in respect of Sums B2 and C (the 2021 shares) and Sum D (the litigation compensation). Prior to this, all five sums were determined by the Board of Review to be taxable.

The Court of First Instance initially granted the taxpayer leave to appeal in respect of the litigation compensation, with the Court of Appeal subsequently granting leave to appeal in respect of the 2012 shares. The Court of First Instance upon re-examination allowed the taxpayer’s appeal in respect of the 2012 shares. 

The Court of Appeal dismissed the Commissioner’s appeal ruling in favour of the taxpayer. The litigation compensation and 2012 shares were found to stem from the termination agreement, for which the parties had agreed to new obligations.

In respect of the 2012 shares, the Commissioner argued that the lower court ought not to have disturbed the Board’s conclusion, highlighting that the judge had commented that the 2012 shares were “a borderline case.” The Commissioner further argued that (1) the 2012 shares were awarded in return for the taxpayer acting as or being an employee, or as a reward for his past services; and (2) the Court of First Instance had failed to determine what constitutes the dominant purpose or substantial cause of the payment of the 2012 shares. Emphasis was placed on the fact that the 2012 shares constituted a significant part of the taxpayer’s remuneration package and that they were awarded during employment as a reward for services.

The Court of Appeal refuted the argument of the Commissioner, finding that (1) the taxpayer had taken up new obligations under the termination agreement, over and above his obligations under the employment letter and (2) the employment cannot be regarded as a substantial cause for the payment of the 2012 shares. The Court of Appeal upheld that the lower court had applied correct tests on both litigation compensation and the 2012 shares.

Tax professionals believe that the taxation of termination payments will continue to be a contentious matter in Hong Kong.
 

For more information contact a KPMG tax professional:

David Ling | +1 609 874 4381 | davidxling@kpmg.com