8 July 2021
When an employment relationship comes to an end, it is not uncommon for the parties to enter into a termination agreement setting out the departing employee’s rights and obligations. A question naturally arises as to whether, and to what extent, these benefits are chargeable to salaries tax. In the recent case of Heath Brian Zarin v CIR [2021] HKCFI 1846, the Court of First Instance considered this question in the context of bonus shares vested and paid pursuant to a termination agreement, and ruled that the income concerned did not constitute income “from” employment and fell outside of the salaries tax regime.
Deacons acted for Mr. Zarin both as solicitors and as advocates throughout these proceedings.
Background
The taxpayer, Mr. Zarin, was employed by a bank (“Company”) and was accorded the right to participate in the bank’s discretionary bonus scheme. In 2012, Mr. Zarin was granted a restricted share award under the scheme, on which terms the shares would vest in three tranches in 2013, 2014 and 2015 respectively. The share plan (“Plan”) provided, among others, that:
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The rules of the Plan did not form part of Mr. Zarin’s employment contract.
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The award shares would vest on the dates specified in the Plan, provided that Mr. Zarin remained continuously employed within the group or left the group as a good leaver (including being terminated on redundancy).
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If Mr. Zarin left the group as a good leaver and had entered into a termination agreement, any unvested award shares would not vest until he had complied with, or was released from his obligations under, that termination agreement.
The Company terminated Mr. Zarin’s employment in January 2013 on the ground of redundancy. After series of negotiation on the termination package, the parties entered into an agreement in June 2013 setting out the terms and conditions regarding Mr. Zarin’s termination of employment (“Termination Agreement”). The terms of the Termination Agreement included that:
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Mr. Zarin would be treated as a good leaver for the purpose of the Plan and the remaining shares would vest on the dates specified in the Plan subject to the terms of the Termination Agreement.
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Mr. Zarin agreed to comply with various post-termination obligations (including, among others, to provide reasonable assistance in a litigation in which the Company was involved (“Litigation”), to withdraw an outstanding data access request and to provide the usual release and discharge of claims).
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Any release of the award shares would be conditional on Mr. Zarin having not committed any breach of any terms of the Termination Agreement.
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In case Mr. Zarin did commit any breach under the Termination Agreement, any unvested award shares would be forfeited.
Having complied with the terms of the Termination Agreement, Mr. Zarin received two sums in 2014 and 2015 representing the final two tranches of the award shares. The Inland Revenue Department assessed the payment to salaries tax, and Mr. Zarin appealed. The Board of Review dismissed his appeal, and he appealed to the CFI.
CFI Decision
The key issue was whether payment of the sums constituted income “from” employment chargeable to salaries tax under s.8(1) of the Inland Revenue Ordinance (Cap. 112). The Court answered the question in negative and allowed the appeal.
As a prior matter, one must distinguish between the grant of a share subject to vesting, at which time the participating employee gets nothing of value unless and until he complies with all of the applicable vesting conditions, and the actual vesting of the same, when a transfer of value does, indeed, take place. Referring to authorities including Fuchs v CIR (2011) 14 HKCFAR 74 and CIR v Poon Cho Ming [2019] HKCFA 38, the Court confirmed that in ascertaining whether a sum is from employment for salaries tax purposes, one needs to ascertain the substance of the bargain for the payment and the purpose of payment. If the payment in question were in substance a reward or inducement for past, present or future services rendered as employee, it would be income “from” employment chargeable to salaries tax. If the payment were made for some other reason, it would not qualify as a taxable income. In the context of termination, it is not conclusive simply to show that the taxpayer agrees to surrender or forego some pre-existing contractual rights by receiving the payment in question. The ultimate question remains one of the purpose of payment.
Applying the above principles, the Court found that the main purpose for releasing the award shares to Mr. Zarin was to procure that he provide potentially long-term assistance in the Litigation (instead of rewarding him for services provided in the course of his employment with the Company). The Court placed much weight on the provision in the Plan stating that in case a good leaver entered into a termination agreement pursuant to the cessation of his employment, the award shares would not have vested unless and until the awardee’s obligations under such agreement have been complied with or waived. It was on this basis that the Court considered that the Plan envisaged a situation whereby an awardee might have to provide some fresh consideration (in this case, among other things, the agreement to provide continuing support in the Litigation) unrelated to employment in order to become entitled to vesting.
The Court was also aware that in its previous decision (see [2020] 2 HKLRD 229), another sum paid by the Company to Mr. Zarin under the Termination Agreement was held to be consideration for the latter’s assistance in the Litigation, based on which CIR argued that the release of award shares could not possibly be consideration for the same assistance. Considering the circumstances of the two payments, the Court drew a fundamental distinction between the previous sum (which was consideration for time and expenses actually incurred in assisting in the Litigation) and the payment of the award shares (which was consideration to secure Mr. Zarin’s cooperation in principle) and so rejected CIR’s argument.
How we can help
As observed by the Court, matters concerning the taxability of income received in connection with employment are highly fact sensitive and may involve difficult issues decided on narrow distinctions. We have extensive experience advising clients in both non-contentious and contentious employment tax matters, and representing them before the Board of Review and higher courts in salaries tax disputes and stand ready to assist.
For further information, please contact:
Stefano Mariani, Partner, Deacons
stefano.mariani@deacons.com.hk
