Tax Guidance on Termination Payments

by Barbara Forrest, Lloyd Deverall, Ayesha Macpherson and Darren Bowdern, KPMG , 18 January 2010

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topics:
Accounting and Regulations Tax

tags:
Court of Appeal Court of First Instance Inland Revenue Department taxation termination payments

The Hong Kong Court of Appeal recently handed down its decision in the case of Fuchs, Walter Alfred Heinz v Commissioner of Inland Revenue. In it, the Court of Appeals overturned in part the decision of the Court of First Instance in 2008, ruled in favour of the Commissioner, and dismissed the taxpayer’s appeal.

The decision provides insight into the approach used by the courts to determine the taxation of termination payments. In general, a payment will be chargeable to Salaries Tax if it is paid to an employee in return for acting as or being an employee. On the other hand, a payment will not be chargeable to tax if it is paid as consideration for the abrogation of a contract or as damages.

Accordingly, care should be taken when drafting contracts of employment which include a termination clause. A review of the employment contract is critical to determining the true nature of a termination payment.

Background

The taxpayer was employed by a bank. On 1 January 2004, his employment was transferred from Singapore to the bank’s Hong Kong Branch for an initial fixed term of three years. Under his contract of employment, the taxpayer was entitled to an annual salary and a discretionary variable bonus. In addition, the contract provided that if the taxpayer’s employment was terminated prior to the expiry of the initial term, he would be paid an agreed compensation or liquidated damages of (i) two annual salaries; and (ii) an average amount of the bonuses paid in the three previous years of his employment with the Hong Kong Branch.

The taxpayer’s employment was terminated after approximately two years and under a termination agreement he received a single compensatory payment. The payment consisted of the following components:

Sum A — a sum equivalent to his salary for the remaining period of his contract (12 months);

Sum B — an amount equivalent to two annual salaries; and

Sum C — an amount equivalent to the average of his three previous annual bonuses.

The Inland Revenue Department levied Salaries Tax on Sums B and C on the basis that they were paid pursuant to his contract of employment. Sum A was regarded as “compensatory in nature” and was not charged to tax.

By consent, the taxpayer’s appeal to the Hong Kong Board of Review was transferred to the Court of First Instance, which ruled that Sum C, but not Sum B, was chargeable to tax.

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