Severance payments made in consideration of post-employment restrictive covenants are generally not subject to salaries tax. However, where details of the payment are contained in the letter of employment, the issue becomes less clear. The recent Court of First Instance decision in the case of The Commissioner of Inland Revenue v Yung Tse Kwong  considered whether a severance payment made in these circumstances is taxable.
Mr Yung's letter of employment provided that, "as an insurance policy for peace-of-mind if you should be terminated from your assignment as President of ACNielsen Media International for other than 'cause', we will reassign you to another ACNielsen opportunity or offer you severance pay for 12 months equal to your base salary at the time in accordance with our Career Transition Plan."
Mr Yung's employment was terminated. He was not offered reassignment, but was offered 12 months' severance pay ("Sum A") in return for signing a "Severance Agreement and Release" (the "Severance Agreement"). This contained a post-employment restrictive covenant preventing Mr Yung from soliciting customers from his former employer or entering into direct competition for 12 months from the date of termination.
The Board of Review considered whether Sum A was taxable under section 8(1A) of the Inland Revenue Ordinance ("IRO") which provides that tax is payable on "income derived from services rendered in Hong Kong". The Commissioner argued that Sum A was taxable because it was used to induce Mr Yung into employment to provide future services. Mr Yung's point of view was that Sum A was not taxable because it was paid only as consideration for the restrictive covenant. The Board agreed with Mr Yung and found that tax was not payable on Sum A.
Subsequently, the case came before Justice Tang in the Court of First Instance. He said that, if the Severance Agreement required services to be performed in Hong Kong in return for Sum A, section 8(1A) would render such payment taxable. In that regard, if Sum A was paid as an inducement to enter into employment, then it would be taxable because it would be paid for services rendered in Hong Kong.
He found that: the real issue was whether Sum A was paid solely or partly as an inducement to enter into employment, or was it solely or partly for signing the restrictive covenant the Board had failed to ask itself whether any part of Sum A was paid as an inducement to enter into employment to the extent that Sum A was paid partly as an inducement to enter into employment, that part would be subject to salaries tax under section 8(1A), and it was necessary to look at all the facts and circumstances to determine whether Sum A was paid as an inducement to enter into employment or to enter the Severance Agreement (containing the restrictive covenant).
Justice Tang found that it was the complete offer (of reassignment or Sum A) that induced Mr Yung into employment and not just Sum A. Therefore, he found that what was taxable was that part of the entire offer (i.e. both the possibility of reassignment and Sum A, and not Sum A alone) that induced Mr Yung into accepting the job. He assessed the value of the offer (which was taxable) at 10 percent of Sum A, but also acknowledged that this approach was not entirely scientific or logical.
|Q & A on when severance payments are liable to salaries tax |
|Q1 ||When will an employee be liable to pay tax on a severance payment?|
|A1 ||Section 8(1A) of the IRO provides that tax is payable on "income derived from services rendered in Hong Kong". The courts have said that salaries tax will be payable on a severance payment in a situation where the payment induced the employee into commencing employment with the employer. |
|Q2 ||How can an employer maximise the benefit to employees of any severance payment from a tax perspective?|
|A2 ||If the terms of a severance payment are to be included in the contract of employment, both employer and employee must study carefully the purpose for which such severance payment is to be made. If the payment is partly "income derived from services rendered in Hong Kong" (which is taxable) and partly for some other purpose (which is not taxable), then the payment will be taxed proportionately |
|Q3 ||What facts and circumstances need to be considered in determining whether a severance payment was paid as an inducement to enter into employment (which is taxable) or paid in return for signing a restrictive covenant (which is not taxable)?|
|A3 ||In Mr Yung's case, Justice Tang said that the value of the offer was difficult to calculate and depended on many variables. These included the length of employment and the likelihood of the employee refusing to enter into the restrictive covenant. In apportioning 10 percent of Sum A as the inducement to enter into employment, Justice Tang took account of the nature of the employer's business, the Severance Agreement, Mr Yung's position in the business and his length of service. |