28 April, 2016
Salaries tax is charged on income from employment, and emoluments from employment that are deemed by the Inland Revenue Ordinance to be income from employment. That is because those payments are from employment, constituting consideration for past, present, or future services of the taxpayer as an employee. Conversely, severance payments paid for the abrogation of contractual rights arising from the termination of a service contract are not usually taxable in Hong Kong. Such payments are not from employment; they are compensation for the breach of contract flowing from the termination of a service contract, or otherwise the voluntary surrender by an employee of his rights under that contract.
The distinction between the two classes of payment can sometimes be blurred. In Poon Cho-ming v CIR HCIA 2/2015, the appellant taxpayer entered into a severance agreement with his former employer, which provided for the payment of €500,000 in lieu of his discretionary bonus (designated in the judgment as “Sum D”), together with the acceleration of the vesting date of certain shares that had been conditionally issued to him. The issues before Court of First Instance in substance turned on whether Sum D and the shares vesting by virtue of the severance agreement were income from employment and thus chargeable to salaries tax. The taxpayer argued that his entitlement to both Sum D and the shares arose by virtue of the severance contract and so were consideration for the abrogation of his contractual rights as an employee, such that neither sum could properly be regarded as consideration for past, present, or future services as an employee and should therefore escape the charge to salaries tax. Conversely, the Revenue’s position was that both Sum D and the shares were plainly referable to consideration for the appellant’s past services as an employee. In dismissing the taxpayer’s appeal, Chan J set out in very lucid terms that the relevant test was whether Sum D and the shares were, in substance, remuneration for services whilst the appellant was an employee. On the facts, the appellant was simply being paid performance-related incentive payments which had accrued whilst he was in employment: the reason for him being entitled to Sum D and the shares was in the first instance his services as employee of the company. Whereas the appellant had argued that both Sum D and the shares were consideration for the abrogation of his rights under the now terminated contract of service, the contract in question had been lawfully terminated by his employer, such that it was not possible to identify any specific contractual rights which had been abrogated, and from which any consideration could be said to flow. The severance agreement was mere machinery for the taxpayer to collect emoluments from his employment that had accrued in the course of his service.
Parenthetically, it is interesting to note that the appellant’s got as far as it did, with Chan J tersely noting the transparent ‘fragility’ of the taxpayer’s case. Both taxpayers and practitioners should in this respect bear in mind the recent reform to the Board of Review appeals process, which requires leave to be obtained from a higher Court for the appeal to be heard on a ‘reasonable prospect of success’ basis. Had the new procedural rules applied, leave to appeal would more likely than not have been denied.
Turning to the United Kingdom, the recent decision of the Supreme Court in UBS AG and DB Group Services (UK) v HMRC [2016] UKSC 13 is a salutary reminder of how tax avoidance schemes in the context of employee remuneration can fall foul of the principle of the purposive construction of taxing statutes first comprehensively articulated in the seminal House of Lords decision in WT Ramsay Ltd V IRC [1982] AC 300 and thereafter known as the ‘Ramsay principle’. The facts in the UBS and DB case were complex. In summary, Deutsche Bank and UBS had in place similar employee incentive schemes whereby discretionary bonuses were not paid in cash but instead were rolled over into redeemable shares in offshore vehicle companies, with such shares being subject to notional restrictions under circumstances that had no commercial relevance and were in practice highly unlikely to arise. The objective of this scheme was broadly speaking to bring the shares in question within the preferential tax regime for restricted securities, such that employees could receive their discretionary bonus by redeeming the restricted shares free from income tax. Accordingly, the issue turned on whether the employee incentive arrangements fell within the terms of the statutory restricted securities regime, thereby largely escaping the charge to income tax, or whether they were taxable on the basis that proceeds from the redemption of the shares were in substance cash bonuses rewarding employee performance and so taxable as income from employment. In allowing the Revenue’s appeal, the Supreme Court found that upon a purposive construction of the taxing statute, the incentive schemes did not fall within the scope of the preferential restricted securities regime. Ultimately, the question was whether the relevant statutory provisions, construed purposively, were intended to apply to the transaction, viewed realistically. In the instant case the notional restrictions placed on the shares in order to bring them within the preferential taxing regime were not real, commercially relevant restrictions; they were elements which had been inserted into the arrangements without any business purpose and, for that reason, those arrangements were incapable of bringing the arrangements within the relevant provisions of the restricted securities regime when those provisions were construed purposively.
It is important to understand in this context that the Ramsay principle is not a general anti-avoidance provision, though it does evidently have the effect of targeting and preventing artificial tax avoidance; instead it is a principle of statutory construction which focuses on the purpose of a given statutory provision, rather than its literal reading. The Ramsay principle has met with approval in the Hong Kong courts, most notably in the stamp duty avoidance case Collector of Stamp Revenue v Arrowtown Assets Ltd [2003] HKCU 1347 decided by the Court of Final Appeal. Courts, whether in Hong Kong or in other common law jurisdictions, are hostile to artificial and aggressive tax avoidance and the judgment in UBS and DB shows how far the construction of taxing statutes has moved away from the historically prevalent literalist model. Practitioners and in-house legal functions should respond by focussing on prudent and sophisticated tax planning in structuring employee incentive arrangements and be prepared to consider all contingencies should those arrangements ever be challenged by the Revenue.
For further information, please contact:
Stefano Mariani, Deacons
stefano.mariani@deacons.com.hk
