Worldwide: Termination Payments - How To Determine Its Taxability And Reporting Requirements

Many legal disputes have arisen over whether specific termination payments made to an employee are attributable to salaries tax. It is important for employers when considering making termination payments to consider how to structure the payments so as to maximise the tax saving benefits for their employees and to know what their reporting requirements are.

What constitutes a termination payment?

Termination payments are payments made to an employee on the termination of their employment.

Termination payments which are chargeable to salaries tax

Section 8 of the Inland Revenue Ordinance (Cap112) provides that any income received by an employee on the termination of their employment is chargeable to salaries tax if it was attributable to any office or employment. A payment is chargeable to salaries tax if it is paid to an employee in return for them acting as or being an employee. Termination payments which are chargeable to tax include:

  • Final salary payment
  • Payments in lieu of notice accrued on or after 1 April 2012
  • Payments in lieu of any untaken annual leave

A payment received on the premature termination by the employer of an office or employment or in consideration of a variation of the terms of employment is not taxable. This is because the payment arises from the breach of contract and not from the employment itself. Non-taxable termination payments include:

  • Payments in lieu of notice accrued after 1 April 2012
  • Severance payments
  • Long service payments

Court decisions on termination payments

It is not always clear cut whether a payment received by an employee is chargeable to salaries tax or not. The cases mentioned below are examples of disputed termination payments which were ultimately decided by the Hong Kong Courts.

Fuchs, Walter Alfred Heinz v Commissioner of Inland Revenue 14 HKCFAR 74

The Court of Final Appeal considered whether compensation payable to an employee, on the early termination of his employment was taxable. The relevant clause in his contract provided:

"In the event that the Bank terminates or purports to terminate this agreement... the Bank shall pay to you as agreed compensation or liquidated damages

-  2 annual salaries
-  an average amount of the bonuses paid in the 3 previous years of your employment with the Bank"

The court considered that taxable income was not confined to income earned during the course of employment. It would also include payments made to a person in return for acting as or being an employee, or as a reward for past services, or as an inducement to enter into employment and provide future services. The contractual right to substantial compensation in the event of early termination without cause was part of the contractual consideration and an inducement to the employee to sign the employment contract. The sums were clearly derived from employment and were not paid in consideration of the abrogation of his rights under the employment contract. Therefore the payments were chargeable as income from his employment.

Murad v Commissioner of Inland Revenue [2010] 1 HKLRD C6

The employee had a contractual right to receive certain sums in the event that his employment continued until the end of the term specified in his contract. The employer requested the employee to resign, which he did. The parties entered into a separation agreement which provided for the payment of the same sums which he would have received if he had worked out his contract. The employee argued that the payments were not taxable since they were compensation for loss of office. The court considered that to be non-taxable, the sum must be paid for the abandonment or abrogation of contractual rights. As the payments were paid pursuant to sums agreed in the employment contract and were not damages for breach or abrogation of the contract they were chargeable to salaries tax.

Commissioner of Inland Revenue v Elliott [2007] 1 HKLRD 297

The Court of Appeal considered whether a payment of US$11,000,000 made to an employee in respect of existing stock units was chargeable to salaries tax. It considered that under the employment contract as the contingent right to income on the units ceased for any period after employment of the employee had terminated and the employee could not require the employer to 'cash out' the units until after the end of his five year fixed term contract, there was no contractual basis for the buy-out. The court ruled that the entire compensation was consideration for the total abandonment of a bundle of the employee's rights in relation to the stock units, including the contingent right to a share of income. No part of the compensation was paid in return for the taxpayer acting as an employee and therefore the entire sum was tax-free compensation for the loss of the units.

Commissioner of Inland Revenue v Yung Tse Kwong [2004] 3 HKLRD 192

A taxpayer's contract of employment contained a clause whereby upon termination other than for cause, and as "an insurance policy for peace-of-mind", the employee would be reassigned to another group company or offered severance pay for 12 months equal to his base salary in accordance with the employer's career transition plan. Following the termination of his employment, the employee was paid in accordance with the clause. Under the career transition plan, and as a condition for receiving the monies, the employee signed a severance agreement and release under which he agreed to certain restrictive covenants not to compete with the employer for a period of 12 months. The IRD considered the payment was taxable. 

The High Court considered it was a question of fact whether the payment was attributable to the employee giving the restrictive covenants or if the payment was security which induced him to enter into employment. The court considered that the offer of reassignment was the inducement element in the contract and not the payment of the severance sum. On this basis the amount liable to salaries tax would be the value of the offer as an inducement. The court valued the offer at 10% and therefore it was only to this extent that the employee had to pay salaries tax on the payment he received.

Implications for employers

Not all termination payments written into a contract of employment will be regarded as inducements to the employee to contract with the employer. In the event that HR Professionals choose to write termination payments into their employment contracts to ensure it will be non-taxable it should be for a lump sum and made in consideration of the employee entering into post termination restrictive covenants.

Where Separation Agreements are used to set out details of payments to be made to employees the employer must be clear as to what the termination payments made to employees represent. In the event that there is any ambiguity, the onus of proving that an amount is non taxable is on the employee. Where the nature of the termination payment is not specified the IRD may consider that it represents a non contractual gratuity for past services and therefore taxable.

Reporting requirements of the employer

Employers are under an obligation to notify the IRD one month before the date of termination of employment by filing form IR 56F. The IRD may accept shorter notice where reasonable such as in cases of summary dismissal or where the employee had a notice period of less than one month and gave notice.

Where the employee whose employment is to be terminated intends to leave Hong Kong for a period exceeding one month, the employer must file 2 copies of form IR 56G with the IRD at least one month before the expected date of departure and take the following steps:

  • To ascertain when the employee is expecting to leave the territory; and
  • Not to make any further payments due to the employee for a period of one month from the date on which notice is given unless a letter of release is issued by the IRD confirming that the employee has settled his outstanding tax liability.

Tips for employers

It is clear from the above that when considering whether a termination payment is chargeable to salaries tax the IRD will carefully consider the nature of the payments. In order to be non-taxable the employee must be able to show that the payment was received as compensation for a variation of their contract, loss of their office or in return for entering into post restrictive covenants. In the event that payment for an early termination is considered to be related to any past present or future services the payment will be chargeable to salaries tax. It is clear from Fuchs that the court looks beyond the form of the payment. In that case despite the payment being described as "agreed compensation or liquidated damages". The court will look into the substance of the payment and consider if it truly represents a payment flowing from the breach of the contract by the employer/the employee giving up his entitlements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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