Under an employment agreement with Consolidated Electric Power Asia Ltd dated 30 October 1996, the remuneration package for a certain Mr Elliott included entitlement to five million Incentive Compensation Plan (ICP) units. These allowed the holder a percentage of the company's net income, and Mr Elliott was also entitled to additional units based on the performance of the company's commercial operations.
On 12 June 1997, he resigned and entered into a termination arrangement whereby he agreed, among other things, to forgo his entitlement to the ICP units for a payment of US$11 million.
Subsequently, the Deputy Commissioner of Inland Revenue determined that this amount was income from employment and, therefore, chargeable to salaries tax. Notified of this, Mr Elliott appealed to the Board of Review. It was decided that the portion of the US$11m attributable to the five million units was taxable and apportioned 50 per cent of the US$11m to these units by using a "rough and ready" method.
Not satisfied with this, Mr Elliott appealed to the Court of First Instance, arguing that the US$11m in its entirety was not taxable. Alternatively, he contended that the method used for the 50 per cent apportionment was not correct.
The Court of First Instance found that, to the extent that the US$11m represented the five million units, it was taxable. The issue of apportionment was then remitted to the Board for reconsideration.
In due course, the Commissioner of the Inland Revenue took the case to the Court of Appeal on the question of whether the 50 per cent apportionment was reasonable. Mr Elliott continued to maintain his original position that no income tax at all should be payable and, if that was not accepted, that the apportionment was incorrect.
The general principle is that a payment made as an inducement to enter into an employment contract is taxable. It does not matter whether it is paid before, during, or on termination of the period of employment. However, a payment made as consideration for the abrogation of a contract of employment or as damages for breach is not taxable.
In this case, the Court of Appeal found that the Board and the judge in the Court of First Instance had erred in law in interpreting the contract of employment, when they concluded that the five million units constituted an inducement for Mr Elliott to enter into the contract.
Their conclusion had been based on the view that part of the US$11m was taxable as "an accrued quantified entitlement". The Court of Appeal found that Mr Elliott had no right to "cash out" the five million units before the fifth anniversary of the "effective date" (which had not yet been reached). It also found that he only had a contingent right to a pro rata share of the relevant net income derived from the units.
The Court of Appeal said that it was important to distinguish between two scenarios. The first is where the employers remain liable for remuneration they have contracted to pay because the "contract persists", even if they have given up their right to ask the employee to work. The second is where the contract terminates altogether, in which case the sum payable is consideration of the total abandonment of all contractual rights. In the former situation, the contract continues, while in the latter, the contract is at an end.
The Court of Appeal found that Mr Elliott's contract had come to an end on termination of his employment. After looking at the matter from all sides, it held that the entire sum of US$11m constituted compensation for the abrogation of all of Mr Elliott's rights in relation to the ICP units. This covered the existing five million units, as well as future additional units, including the contingent right to a share of the income that may have been derived from them.
This contingent right was part of the "whole bundle of rights" which was extinguished through the cancellation of the ICP units.
The Court of Appeal found that none of the US$11m was paid to Mr Elliott "in return for acting as or being an employee" and that the whole sum was to compensate him for his loss of the ICP units. Therefore no part of the US$11m was taxable.
|Q & A on which payments are taxable|
|Q1 ||Are all payments made on termination of employment taxable?|
|A1 ||No, there are some types of payment which are not taxable. You need to look at the nature of the payment itself. This means looking at the terms upon which the payment is made, and whether it is spelled out in the employment contract or a separation agreement. |
|Q2 ||What types of payment made on termination of employment are taxable?|
|A2 ||If the payment represents an inducement to enter into employment then, regardless of when it is paid, whether before, during or on termination of the employment, it will be taxable. |