MRS. MURAD AND OTHERS v. COMMISSIONER OF INLAND REVENUE

HCIA 1/2009

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

INLAND REVENUE APPEAL NO. 1 OF 2009

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BETWEEN

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J U D G M E N T

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Introduction

1.  There have been numerous cases concerning the taxability of payments which an employee received upon the termination of his employment contract. This is one of them.

2.  This is the taxpayer’s appeal brought against the determination dated 4 February 2009 (“the determination”) of the Deputy Commissioner of Inland Revenue (“the commissioner”) pursuant to s. 67, Inland Revenue Ordinance (Cap. 112). S. 67(4) provides:-

“An appeal in respect of which notice of appeal is transmitted to the Court of First Instance under subsection (3) shall be heard and determined by the Court of First Instance as in all respects an appeal to the Court of First Instance against the determination to which the notice of appeal relates”.

Grounds of Appeal

3.  There are two grounds of appeal.

4.  The first is the determination erroneously concluded that the severance payments described therein as Sums A, B, D and E (and more particularly described in para. 3 of the separation agreement) (collectively “the taxed sums”) did not arise from breach of the service agreement, but from the terms of the service agreement. Specifically, the errors were:-

(a)  sums A and B arose out of the terms of the employment as sums provided for in case of termination of the service agreement;

(b)  sums D and E were relocation expenses likewise originating from the terms of the service agreement.

The terms “service agreement” and “separation agreement” are set out in more detail in para. 6(1) and 7 to 9 and 6(2) and 10 to 15 respectively below.  The taxed sums are set out in more detail in para. 16 below.

5.  The second is that the commissioner arrived at the conclusions in the determination in relation to the taxed sums through incorrect analysis and application of the relevant statute and case law.

Background Facts

6.  The taxpayer was employed by a bank in Hong Kong from the late 1980’s to 20 July 2004. The agreements concerning his employment which are relevant to this appeal are:-

(1)  the service agreement dated 20 April 1999 (as subsequently amended in writing on 20 November 2000);

(2)  the separation agreement dated 19 July 2004.

7.  Clause 3.1 of the service agreement stipulated:-

“The term of employment under [the service agreement] … shall from the date of [the service agreement] continue until 30 September 2004 unless terminated by either party giving to the other not less than 3 months’ notice in writing”.

8.  Clause 3.2 of the service agreement stipulated:-

“If the Company requests [the taxpayer] to resign …, then the Company undertakes without condition to honour in full the terms and conditions of [the service agreement] (for the avoidance of doubt this shall be limited to basic annual salary, fixed bonus payment and housing allowance) up to and including [30 September 2006] and in this regard the Company shall make an immediate lump sum payment to [the taxpayer] on the date of his departure from employment, being an amount equal to the total basic annual salary, fixed bonus payment and housing allowance which [the taxpayer] should have received if he continued without interruption in the employment of the Company until [30 September 2006] … ” (emphasis supplied).

9.  Clause 12 of the service agreement stipulated:-

“The Company shall (in the event that the Company shall request [the taxpayer] to resign …) reimburse to [the taxpayer]:-

12.7  all removal and shipping expenses directly or reasonably incurred by [the taxpayer] by reason of having to re-locate from Hong Kong to Miami, Florida, USA … ; and

12.8  the cost of one first-class airfare from Hong Kong to Miami, Florida, USA … ” (emphasis supplied).

10.  Because of corporate acquisition and restructuring, by the separation agreement, the bank requested the taxpayer to resign with effect from 20 July 2004, which he did. The following terms in the separation agreement are relevant.

11.  Recital C thereof stated:-

“[The separation agreement] contains the agreement reached between the parties and operates inter alia as an amendment of certain provisions of [the service agreement] relating to termination of the Employment, the financial consequences of termination and certain pre- and post-termination obligations of [the taxpayer] as more fully described below” (emphasis supplied).

12.  Clause 2.1 thereof stated:-

“[The bank] and [the taxpayer] agree that [the taxpayer] will be asked to resign … the resignation will be treated as a resignation at the request of [the bank] for the purposes of Clause 3.2 of the Service Agreement”.

13.  Clause 3.1 thereof stated:-

“Payments pursuant to Clause 3.2 of the Service Agreement

3.1.1  [The bank] will make a payment of US$1,946,057.62 which represents an amount equal to total basic annual salary [the taxpayer] would have received had he continued without interruption in the Employment …

3.1.2  [The bank] will make a payment of US$1,347,270.66 which represents an amount equal to total fixed bonus payments [the taxpayer] would have received had he continued without interruption in the Employment … ” (emphasis supplied).

14.  Clause 3.5 thereof stated:-

“[The bank] will make a payment of US$30,000 to [the taxpayer] in respect of all removal and shipping expenses in respect of his entitlement under Clause 12.7 of the Service Agreement” (emphasis supplied).

15.  Clause 3.6 thereof stated:-

“[The bank] will make a payment of US$5,720 being an amount equivalent to the cost of one single first class airfare from Hong Kong to Miami, Florida, USA … ” (emphasis supplied).

16.  In the determination:-

(a)  US$1,946,057.62 was referred to as Sum A;

(b)  US$973,028.81 (being part of US$1,347,270.66) was referred to as Sum B;

(c)  US$30,000 was referred to as Sum D;

(d)  US$5,720 was referred to as Sum E.

The Commissioner’s Analysis and Conclusion

17.  The Commissioner determined that the taxed sums are assessable pursuant to s. 8, Cap. 112. The gist of the analysis was set out in the determination as follows:-

(1)  s. 8(1), Cap. 112 provides that salaries tax shall be charged in respect of income arising in or derived from Hong Kong from any office or employment of profit;

(2)  “income from any office or employment” is defined by s. 9(1)(a), Cap. 112 as “[including] any wages, salary, … bonus, gratuity, perquisite or allowance”;

(3)  the taxpayer’s entitlement to the taxed sums arose out of the service agreement;

(4)  Sums A and B stemmed from the terms of the employment and were part and parcel of his remuneration package (clause 3.2, service agreement);

(5)  Sums D and E were payments in lieu of the relocation expenses which were provided for in clauses 12.7 and 12.8, service agreement;

(6)  support for the above can be found in Dale v. de Soissons (1950) 32 TC 118.  Henley v. Murray (1950) 31 TC 351; [1950] 1 All ER 908, relied on by the taxpayer, is distinguishable.

Legal Principles

18.  There is a vast body of authorities with regard to the legal principles concerning the above dispute.

19.  A recent re-statement of those principles can be found in Fuchs v. Commissioner of Inland Revenue CACV 196/2008 (30 October 2009).

20.  The test for differentiating cases where the sum(s) paid to the employee should be assessable, as opposed to cases where the sum(s) paid should not be assessable, has been worded in different ways.

21.  Payments held to be assessable have been variously described in the authorities as:-

“… a case in which the contract persists.  Though the right of one party to call upon the other for performance of its terms may be modified, or indeed wholly given up, still the corresponding right to acquire payment … is preserved and is still payable under the contract” (Henley v. Murray (1950) 31 TC 351, 363);

“… it was something to which he became entitled as part of the terms upon which he promised to serve, something which he was entitled to receive in the particular event specified … In the present case [the taxpayer] surrendered no rights.  He got exactly what he was entitled to get under his contract of employment” (Dale v. de Soissons (1950) 32 TC 118, 127 and 128);

“… the payment, if it is to be the subject of assessment, must arise ‘from’ the office or employment.  In the past several explanations have been offered by judges of eminence … It has been said that the payment must have been made to the employee ‘as such’.  It has been said that it must have been made to him ‘in his capacity of employee.’ … For my part, … while it is not sufficient to render a payment assessable that an employee would not have received it unless he had been an employee, it is assessable if it has been paid to him in return for acting as or being an employee” (Hochstrasser v. Mayes [1960] AC 376, 391-2);

“… where a sum of money is paid under a contract of employment, it is taxable, even though it is received at or after the termination of the employment” (Comptroller-General of Inland Revenue v. Knight [1973] AC 428, 433;

“… a sum payable under a contract [of employment], even though it is and is expressed as compensation for loss of future earnings under the contract” (Williams v. Simmonds (1981) 55 TC 17, 20);

“I prefer the simpler view that an emolument arises from employment if it is provided as a reward or inducement for the employee to remain or become an employee and not for something else” (Shilton v. Wilmshurst [1991] 1 AC 684, 693);

“… whether a payment in lieu of notice made in pursuance of a contractual provision, agreed at the outset of the employment, which enables the employer to terminate the employment on making that payment is properly to be regarded as an emolument from that employment.  In the absence of authority which compels a contrary conclusion, I would have no doubt that that question must be answered in the affirmative” (EMI v. Coldicott [1999] STC 803, 810 (and 819));

“…a payment on termination which is made pursuant to an obligation entered into at the commencement of the employment … ” (EMI v. Coldicott, at p. 812)(emphasis supplied).

22.  On the other hand, payments held to be not assessable have been described as:-

“the contract itself goes altogether and some sum becomes payable for the consideration of the total abandonment of all the contractual rights … [in other words] … consideration payable … for the total abrogation imposed upon [the taxpayer] of his contract of employment; so that … no contract existed under which [any sum(s)] could be paid” (Henley v. Murray, at p. 363);

“… where a sum of money is paid as consideration for the abrogation of a contract of employment, or as damages for the breach of it, that sum is not taxable” (Comptroller-General v. Knight, at p. 433);

“The critical distinction was the continued existence or otherwise of the contract of employment.  As Jenkins LJ remarked (at p. 367) [in Henley v. Murray], ‘the question in each case is whether, on the facts of the case, the lump sum paid is in the nature of remuneration of profits in respect of the office or is in the nature of the sum paid in consideration of the surrender by the recipient of his rights in respect of the office.’  In the present case, the Agreement unquestionably came to an end” (CIR v. Elliott [2007] 1 HKLRD 297, 307);

“… a payment on termination which is made pursuant to an agreement to waive or release an existing obligation entered into at the commencement of the employment” (EMI v. Coldicott, at p. 812) (emphasis supplied).

23.  Although the test has been variously worded, its meaning is reasonably clear. It therefore serves no useful purpose for me to attempt to add yet another linguistic formulation and I shall not do so.

24.  Applying the test to the facts is, however, another matter. As observed in the Fuchs case above:-

“it is often difficult to decide whether the facts fall within the statutory language” (para. 13 thereof).

That observation was shared by some of the earlier authorities:-

“Questions as to the taxability of payment received by employed persons at the end of their employment have … often been described as difficult, borderline and depending on narrow distinctions”: Knight above, p. 433, quoted in the Fuchs case, para. 14;

“… this is an area in which there is an abundance of authority.  It is not always easy to reconcile these authorities since as is to be expected they are frequently concerned with situations close to the borderline between payments which fall within and payments that fall without the statutory provision”: Mairs v. Haughey [1993] STC 569, 578, quoted in the Fuchs case, para. 35.

25.  There are recognized exceptions to the above passages, such as pension and redundancy payment: the Fuchs case, para. 38, 47 to 48 and 66 to 68.

Deciding this Appeal

26.  The main plank of the taxpayer’s case in this appeal is that the taxed sums were “compensation for loss of office”.

27.  I agree with the commissioner that this is not the true test for deciding if a sum paid on earlier termination of an employment contract should be taxed.

28.  First, disputes of this kind always involve a “loss of office”. Sum(s) paid on such an occasion is/are often described as “compensation” as a matter of common language. Thus, so understood, the phrase “compensation for loss of office” is apt for all such cases irrespective of whether the sum(s) should or should not be taxable.

29.  Further, as can be seen from the passages in the judgments quoted above (see para. 21 and 22 (especially para. 22) above), this is not the test propounded by the authorities. The test was worded as whether the payment was for the “total abandonment of … contractual rights”, “total abrogation … of … contract of employment”, “damages for the breach of it”, “consideration [for] the surrender … of … rights in respect of the office” or “[waiving] or [releasing] an existing obligation”. Hence, the emphasis is consistently on the abandonment or abrogation of contractual rights.

30.  In the factual context of this appeal, I agree with the commissioner:-

(a)  the taxed sums were paid pursuant to the sums agreed in the service agreement.  Those sums were part of the taxpayer’s assured entitlements under his terms of employment;

(b)  clauses 3.1 and 3.5 of the separation agreement expressly acknowledged the above;

(c)  the taxed sums were not payment for damages for the breach of the service agreement, nor were they paid in abrogation of the service agreement;

(d)  to put it in another way, the taxed sums were paid to the taxpayer in return for acting as or being, or for becoming, an employee.

31.  I also agree with the commissioner the following contentions of the taxpayer are irrelevant:-

(1)  whether he had “reasonable expectations that his contract would continue to the end of the term” because of his past employment period.  The taxability of the taxed sums is dependent on their true nature which in turn is dependent on the relevant facts, which do not include his reasonable expectations;

(2)  prior notice of termination was required under clause 3.1, service agreement.  This is because, as a matter of fact, the bank relied on clause 3.2 to request for the taxpayer’s resignation instead;

(3)  the taxpayer’s employment was brought to an end (by his resignation), and that the separation agreement provided for the “full and final settlement of all Claims” which the taxpayer had or might have against the bank (clause 6.3, separation agreement).

32.  Equally, that the parties entered into a subsequent agreement, upon the termination of employment, which provides for the payment of the same sum, is irrelevant: the Fuchs case, para. 43; Richardson v. Delaney [2001] STC 1328, 1341-2. Nor is the label given to the payment by the parties conclusive: the Fuchs case, para. 13; Coldicott, at p. 808.

Conclusion

33.  In relation to the first ground of appeal, the commissioner has not erred in concluding the taxed sums were taxable income.

34.  In relation to the second ground of appeal, the commissioner’s analysis and application of the relevant statute and case law was correct.

35.  Accordingly, this appeal is dismissed.

Other Matters

36.  Certain “anomalies” have been mentioned in some of the authorities.

37.  Four categories of payment made at the termination of employment (referred to as “payment in lieu of notice”) have been set out in Delaney v. Staples [1992] 1 AC 687:-

“… (1) an employer gives proper notice of termination to his employee, tells the employee that he need not work until the termination date and gives him the wages attributable to the notice period in a lump sum.  In this case (commonly called ‘garden leave’) there is no breach of contract by the employer. … the lump sum payment is simply advance payment of wages. (2) The contract of employment provides expressly that the employment may be terminated either by notice or, on payment of a sum in lieu of notice, summarily.  In such a case if the employer summarily dismisses the employee he is not in breach … provided he makes the payment in lieu.  But the payment in lieu is not a payment of wages in the ordinary sense … (3) At the end of the employment, the employer and the employee agree that the employment is to terminate forthwith on payment of a sum in lieu of notice.  Again, the employer is not in breach of contract by dismissing summarily and the payment in lieu is not strictly wages … (4) Without the agreement of the employee, the employer summarily dismisses the employee and tenders a payment in lieu of proper notice” (emphasis supplied) (at p. 692).

38.  The English court of appeal opined in EMI v. Coldicott that the first category payment is taxable (at p. 809). It would appear the court regarded the second category payment as equally taxable (see para. 21 above, and EMI v. Coldicott, pp. 809-810 and 819).

39.  However, it is unclear if the court in EMI v. Coldicott would regard the third and fourth category payment as taxable. In Henley v. Murray, the court appears to opine otherwise as regards the fourth category:-

“In the course of the argument an extreme case was put to [counsel] of an employer who breaks wrongfully a contract of service and discharges a servant wholly therefrom and the servant then sues for damages for wrongful dismissal.  Although of course it is true to say that the sum awarded as damages arises from the contract in the sense that if there had never been a contract the sum of damages could never have been awarded, still … in a case of that sort it would be impossible to suggest … that the sum awarded to him for damages was taxable … ” (emphasis supplied) (p. 363).

Later, the court said:-

“If in the case of dismissal where the employee says ‘I am wrongfully dismissed’ and sues for damages he is admittedly outside [s. 8(1)] and untaxable, it seems … to follow from that, if one goes by stages, that if you take a case where equally the employer dismisses his employee and the damages are agreed without litigation, the fact they are agreed instead of being awarded by a judge or jury cannot affect their legal position in regard to the Income Tax Code” (emphasis supplied) (p. 367).

But the taxability of the third category payment was left open:-

“What would be the position if there were a mutual agreement between the employer and the employed that the service should be ended abruptly and a sum paid is a matter which can be dealt with when it arises” (p. 367).

40.  Another “anomaly” was referred to in Williams v. Simmonds:-

“… [the taxpayer] accepted that … his employment had been terminated and elected to accept compensation under the terms of his service agreement instead of serving notice under [the contract].  The result is unfortunate, in that, if [the taxpayer] had served notice under [the contract] and, like the director in Henley v. Murray, had subsequently bowed to the pressure which was being exerted on him and had resigned his employment and had then agreed to accept, as compensation for the abrogation of his rights under the service agreement, a sum equal to the compensation which would have been payable under [the contract] if he had not served notice, the sum so payable might well not have attracted tax … ” (p. 22-3).

The “anomaly” appears to flow from what can sometimes be an artificial distinction between a sum accepted as “compensation under the terms of [contract]” and one accepted as “compensation for the abrogation of [contract]”.

41.  The “anomalies” mentioned above are, however, irrelevant to this appeal and are summarized above purely for the sake of comprehensiveness.

Costs Order

42.  The parties agree the usual rule that costs should follow the event is applicable. There will accordingly be a costs order that the costs of this appeal be paid by the taxpayer to the commissioner to be taxed if not agreed.