POON CHO-MING, JOHN v. COMMISSIONER OF INLAND REVENUE

HCIA 2/2015

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

INLAND REVENUE APPEAL NO. 2 OF 2015

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J U D G M E N T
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1.  This is an appeal by way of case stated in respect of a decision of the Inland Revenue Board of Review (“IRBR”).

Background

2.  The appellant (“Taxpayer”) was employed as an executive director, company secretary and deputy chairman of a Hong Kong listed company (“Company”) pursuant to a written employment contract dated 20 October 1999 (“Service Agreement”) until 20 July 2008 when he and the Company entered into a written agreement to terminate the employment with immediate effect (“Separation Agreement”).

3.  During the course of the Taxpayer’s employment, depending no doubt upon the Company’s assessment of his work performance over the previous year and in the discretion of the Company, the Taxpayer was eligible for consideration for the grant of a discretionary cash bonus.  From time to time, he was also granted share options by the Company under a share option scheme (“Scheme”) adopted by it.  Both the bonus and the share options were provided by the Company as incentives to its employees to achieving better performances. 

4.  Under the Scheme, at its discretion, the Company might offer an employee options to subscribe for shares in it (subject to the terms of the Scheme).  The options granted in one year would, if the employee remained employed by the Company, vest (in annual tranches) over the following 5 years.  In the event that the employee no longer remained with the Company, the unvested options might lapse depending upon the decision of the Company. 

5.  On 20 July 2008, apparently due to disagreements within the Company’s board of directors (“Board”), the Taxpayer’s employment and offices within the Company came to an abrupt end.  The termination of employment was preceded by negotiations between the Company and the Taxpayer (assisted by his solicitor), which resulted in the Separation Agreement. 

6.  Under the Separation Agreement, the Taxpayer was paid, in addition to payment in lieu of 6 months’ notice of termination and other statutory entitlements, under clause 4.1.4 of that document: “payment in lieu of a discretionary bonus for the Financial Year ending 30 June 2008 – €500,000” (“Sum D”).  Further, under clause 5, the vesting date in respect of 3 tranches of shares, the options of which had been granted to the Taxpayer, was accelerated to the date of termination of his employment, and the Taxpayer was allowed to exercise those options within 3 months from that date.  Those options were duly exercised by the Taxpayer resulting in gains.

7.  Following an unfavourable determination by the Deputy Commissioner of Inland Revenue, the Taxpayer appealed to the IRBR from the salaries tax assessment raised upon his 2008/09 year of assessment (“Assessment”).  The issues raised in that appeal were :

(a) Whether Sum D was taxable;

(b) Whether the notional gain derived from the share options conferred by the Company on the Taxpayer (“Share Option Gain”) was taxable;

(c) If the Share Options Gain was taxable, which was the relevant date for the computation of the notional gain (“Relevant Date”), ie, the date of the exercise of the share options (19 August 2008) or the date of allotment of the shares by the Company to the Taxpayer (20 August 2008).

8.  In its Decision (“Decision”), the IRBR held that :

(a) Sum D was taxable;

(b) The Share Option Gain was taxable;

(c) The relevant date for the computation of the Share Option Gain was 20 August 2008.

9.  The Taxpayer now appeals pursuant to s.69 of the Inland Revenue Ordinance, Cap. 112 (the “Ordinance”) by case stated upon the following question of law (“Question”) :

“Did the Board of Review err in law in failing to conclude, upon the true construction of the 20 July 2008 Separation Agreement and the 20 October 1999 Service Agreement, that all of the Sum D payment in lieu of a discretionary bonus plus the notional Share Option Gain, were in the nature of payments of compensation for the Employer’s abrogation of the Service Agreement and for the Taxpayer’s agreement to the additional covenants in the Separation Agreement and therefore they are not chargeable to salaries tax under Part 3 of the Inland Revenue Ordinance (Cap. 112)?”

10.  The facts which were agreed by the parties and found by the IRBR are set out in paras 8 to 22 of the Decision (a copy of the Decision is annexed to this judgment as Annex I).  The Taxpayer and his solicitor gave evidence, which the IRBR accepted as true.  However, the IRBR found that the evidence of the latter was of limited assistance (Decision, para 25).

11.  It is the Taxpayer’s case that the answer to the Question is that the IRBR did err in law because, under Part III of the Ordinance, neither Sum D nor the Share Option Gain was part of the Taxpayer’s 2008/09 net chargeable income and to that extent the Assessment was incorrect and/or excessive, and the Ordinance requires that it be reduced by the deletion of those 2 components. 

12.  The Decision is, with respect, a well-written document.  In it, the material facts had been set out and carefully analysed. The applicable principles of law and relevant authorities were identified and applied.  I see no flaw in the Decision and I agree with it. 

Applicable law

13.  The relevant charging provisions for salaries tax are to be found in ss.8(1) and 9(1) of the Ordinance (Decision, paras 26 and 27).

14.  In Murad & Ors v CIR [2009] 6 HKC 478, it was observed by Chung J that: “There have been numerous cases concerning the taxability of payments which an employee received upon the termination of his employment contract.”

15.  In Fuchs v CIR (2011) 14 HKCFAR 74, the highest court on this land (“CFA”) carried out a comprehensive review of the case law in this area and sought to simply the law (no doubt with the view to reducing the number of disputes between taxpayers and the Inland Revenue) by identifying the test to be applied in determining whether payments made to employees upon termination of their employments are or are not taxable. 

16.  The most important parts of the judgment of Fuchs are paras 17, 18 and 22, which can be found in para 28 of the Decision.  For the present purpose, I need only refer to, firstly, the test identified in para 22 of Fuchs :

“… the operative test must always be the test identified above, reflecting the statutory language: In light of the terms on which the taxpayer was employed and the circumstances of the termination, is the sum in substance ‘income from employment’?Was it paid in return for his acting as or being an employee? Was it an entitlement earned as a result of past services or an entitlement accorded to him as an inducement to enter into the employment? If the answer is ‘Yes’, the sum is taxable and it matters not that it might linguistically be acceptable also to refer to it as ‘compensation for loss of office’ or something similar. On the other hand, the amount is not taxable if on a proper analysis the answer is ‘No’. As the ‘abrogation’ examples referred to above show, such a conclusion may be reached where the payment is not made pursuant to any entitlement under the employment contract but is made in consideration of the employee agreeing to surrender or forgo his pre-existing contractual rights.”

[emphasis added]

17.  Secondly, Mr Wong SC, appearing for the respondent (“CIR”), has laid emphasis on the reference in para 19 of Fuchs to payments made to an employee by his employer who had terminated the employment contract in breach of it :

“As the decided cases show, a variety of payments may fall outside the test. Thus, it well-established that damages obtained in a suit for wrongful dismissal or a payment under a settlement agreement reached in such a suit are not regarded as income from employment. Such a sum is properly regarded as deriving from a cause of action arising after the contract has been discharged by breach. …”

18.  Although the applicable test has been clearly identified in simple terms, it was acknowledged by the CFA in Fuchs (para 22) that: “It may sometimes not be easy to decide whether [a submission that a payment was attributable to the abrogation of the taxpayer’s employment rights] should be accepted”. 

The Question

19.  In light of the test identified in para 22 of Fuchs, I believe that the Question is too narrowly framed, referring only to the true construction of the Service Agreement and the Separation Agreement.  Instead, it should refer to the former and the relevant circumstances of termination, which no doubt include the latter. 

20.  Mr Wong agreed with the above observation, whilst Mr Barlow SC, appearing for the Taxpayer, implicitly also agreed.  The arguments before this court proceeded on the basis of the Fuchs test.  I see no reason to send the stated case back for amendment (see s.69(4) of the Ordinance) and I shall deal with it on the wider basis suggested above.

Taxpayer’s arguments

21.  In his skeleton arguments, Mr Barlow submitted that both Sum D and the Share Option Gain constituted payments made to the Taxpayer for the abrogation of his rights under the Service Agreement.  In his oral arguments, there was a shift in emphasis.  It was submitted that both Sum D and the Share Option Gain were derived from the Separation Agreement.  Put another way, it was that agreement which conferred entitlement to Sum D and the Share Option Gain.

Sum D

22.  In my view, the answer here is fairly straightforward.  First of all, it should be said that it is common to find that incentive awards for employees are structured such that the awards are subject to the discretion of the employer.  However, where the employees have managed to meet their performance benchmarks, they are likely to have an expectation for receiving the awards.

23.  In this case, the evidence accepted by the IRBR in connection with bonus award was that at the end of a financial year (1 July to 30 June), the Company’s auditors would prepare the audited accounts.  The Company’s executives would examine the audited results and make suggestion to the remuneration committee in about August each year.  That committee would then make a recommendation to the Board.  For each year of his employment (1999 to 2007), the Taxpayer did receive a bonus from the Company (Decision, paras 48 and 49).

24.  The Taxpayer’s employment was terminated before the completion of the above exercise for 2008.  However, he had performed his duties as an employee of the Company for the year ended 30 June 2008.  The entitlement to the discretionary bonus can be traced to clause 4.3 of the Service Agreement (Decision, para 47). 

25.  Further, I accept, as did the IRBR, Mr Wong’s submission that Sum D, being a payment in lieu of bonus should be treated in the same way as the bonus normally paid to the Taxpayer.  In addition to Mairs v Haughey [1994] 1 AC 303 which was referred to in the Decision (para 55), Mr Wong relied upon London and Thames Haven Oil Wharves Ltd v Attwoll [1967] 1 Ch 772 at 815C-E, per Diplock LJ (as he then was) :

“… I see nothing in experience as embalmed in the authorities to convince me that this question of law, even though it is fiscal law, cannot be solved by logic, and that, with some temerity, is what I propose to try to do.

I start by formulating what I believe to be the relevant rule.  Where, pursuant to a legal right, a trader receives from another person compensation for the trader’s failure to receive a sum of money which, if it had been received, would have been credited to the amount of profits (if any) arising in any year from the trade carried on by him at the time when the compensation is so received, the compensation is to be treated for income tax purposes in the same way as that sum of money would have been treated if it had been received, instead of the compensation.”

26.  In the premises, I am unable to see any real argument that Sum D was an income from employment and is taxable. 

27.  In respect of the submission that Sum D was paid for the abrogation of the Taxpayer’s right(s) under the Service Agreement, like the IRBR I am unable to find any such right(s) when the Company was entitled to terminate the Service Agreement with 6 months’ notice (see Decision, paras 32 to 45). 

28.  In an attempt to answer Mr Wong’s criticism that the Taxpayer had failed to explain what rights of his that had been abrogated, Mr Barlow suggested that the Taxpayer had surrendered everything he was entitled to under the Service Agreement.  Mr Barlow also referred to 2 specific matters – the right to sue for wrongful dismissal and surrendering by the Taxpayer of all his directorships.

29.  With respect, these are illusory answers.  They can only serve to expose the fragility of the Taxpayer’s case.  I see no right to sue for wrongful dismissal when the Company’s entitlement to terminate the Service Agreement with 6 months’ notice is not disputed.  The resignation from all the directorships of the Company’s subsidiaries was provided for in the Service Agreement – the Taxpayer was obliged to resign from such directorships upon termination of his employment with the Company (Decision, paras 42 to 44). 

30.  I should add that this court has been read many of the provisions in the Separation Agreement.  However, I am unable to see how they affect the true nature of Sum D (and the Share Option Gain). 

31.  Mr Wong was at pains to point out that where, as here, the employer had a right to terminate the employment contract, the termination of contract pursuant to such right cannot give rise to an abrogation of the employee’s rights (assuming that the employee’s entitlements upon termination, eg, payment in lieu of notice, have been met).  Mr Wong relied upon para 19 of Fuchs (see para 17 above) and took the court to many authorities to make good the point.  I am inclined to agree with Mr Wong.  It is indeed very difficult to see what right of the employee can be abrogated when the contract of employment comes to an end lawfully.  In other words, in such cases the employee “surrenders no rights” : see Fuchs, paras 21(d) (referring to Dale v de Soissons [1950] 2 All ER 460) and 26. 

32.  For completeness, it should be mentioned that the Separation Agreement was clearly drafted by lawyers and, expectedly, it referred to various rights being surrendered by both sides.  It is unnecessary for the IRBR or this court to be bogged down with the formulations deployed in that document.  For the present purpose, the abrogation of rights is a matter of substance.  An employee would have no difficulty in identifying his right(s), if any, which has been abrogated. 

33.  As regards the submission that Sum D was derived from the Separation Agreement, it may technically be right because the Service Agreement provided no right to such payment.  However, I agree with Mr Wong that this is not the test prescribed by Fuchs.  Bonuses and gratuities paid to employees are, more often than not, discretionary payments (and therefore not entitled as of right), but they are clearly taxable under s.9(1)(a) of the Ordinance. 

34.  Finally, I should mention 2 further points raised by Mr Barlow.  Firstly, I agree with Mr Wong that s.11D of the Ordinance does not assist the Taxpayer because it is not about what is or is not chargeable to salaries tax, but the timing whereby income is to be assessed for such tax.  Secondly, I see no inconsistency between the IRBR’s analysis on whether the Taxpayer had surrendered any right under the Service Agreement (Decision, paras 32 to 45) and the “clean break” between the Taxpayer and the Company (Decision, paras 73 to 78).  The IRBR had clearly applied the correct legal test and found that Sum D (and the Share Option Gain) were income from employment (Decision, paras 76 to 78).  

35.  In the premises, I can see no escape from the conclusion that Sum D was in substance an income from the Taxpayer’s employment with the Company. 

Share Option Gain

36.  The acceleration of vesting date concerned 3 tranches of shares, namely, the last tranche of shares under share options granted to the Taxpayer in November 2003 with original vesting date of 26 November 2008; and the last 2 tranches of shares under share options granted to the Taxpayer in November 2004 with original vesting dates of 27 November 2008 and 27 November 2009 (Decision, paras 15, 19 and 61).

37.  Plainly, these options were granted back in 2003 and 2004 as incentives to the Taxpayer.  They were structured such that under each set of options there were 5 tranches of shares to be vested over 5 years.  It is clear that the purpose of doing so was, inter alia, to encourage the Taxpayer to continue to work for the Company.  There is no dispute that upon the termination of the Taxpayer’s employment, the unvested shares might, subject to the decision of the Company, lapse (Decision, paras 68 to 70). 

38.  There is no disagreement that had the Taxpayer’s employment with the Company continued and the shares in question became vested in the course of his employment, the notional gain from them (governed by  s.9(4)(a) of the Ordinance: Decision, para 79) must be chargeable to salaries tax. 

39.  Does the acceleration of vesting dates make any difference to the true nature of these shares (or the gain derived from them)?  

40.  I am unable to see why the question can be answered in the affirmative.  In my view, one may distinguish the 2 tranches of shares with original vesting dates in November 2008 and the one with original vesting date in November 2009.  In respect of the former, it may be said that the Taxpayer would have “earned” those shares had the Company not chosen to make the payment in lieu of notice.  In the absence of such payment, the Taxpayer would have worked until January 2009 and the shares would have been vested by then.  The court is not required to resolve the legal technicalities whether the Taxpayer was entitled to the shares in July 2008 when the Service Agreement was terminated with a payment in lieu of notice.  It is required to consider the true nature of the notional gain made from the shares.  I am in no doubt that such income came from the Taxpayer’s employment with the Company. 

41.  As regards the shares with the original vesting date in November 2009, one may say that the Taxpayer had not at the time of termination fully earned the shares.  However, it was part of the share option granted to him back in November 2004 as an incentive for continued service. The fact that the Taxpayer was able to obtain the benefit of it prior to the original vesting date simply shows that he had managed, probably after negotiations, to augment his lawful entitlements upon termination of his employment.  A parallel may be drawn with “Sum A” in the case of Fuchs (see headnotes and para 26).  Again, I see no reason to conclude that it was not an income from employment. 

42.  The analysis under Sum D above has sufficiently dealt with the Taxpayer’s arguments identified in para 21 and the additional points mentioned in para 34 above.  

Relevant Date

43.  There is a half-hearted attempt to challenge the IRBR’s decision on the Relevant Date (see para 21 of the Taxpayer’s skeleton arguments).  It is impermissible because it forms no part of the Question.  Like Mr Wong, I shall ignore it. 

Conclusions

44.  There is no error of law shown to have been committed by the IRBR.  This appeal is accordingly dismissed.  I make an order nisi that the costs of this appeal be paid by the Taxpayer, to be taxed if not agreed.

Annex I