Noting that the case was “borderline”, the Court of First Instance (CFI) held that company shares that formed part of an employee’s “discretionary bonus scheme” were not taxable as it was not income derived from employment.
While it is common practice for employers and employees to enter into a termination agreement setting out the departing employee’s benefits, the question arises as to whether, and to what extent, these benefits are chargeable to salaries tax.
A recent High Court decision in Heath Brian Zarin v The Commissioner of Inland Revenue  HKCFI 1846 HCIA 4/2019, Inland Revenue Appeal NO. 4 OF 2019 involved an appeal by the appellant (Heath) from the decision D11/19 (Decision) of the Inland Revenue Board of Review (Board) dated 23 August 2019. The appeal was sought in relation to various constituent elements, which were defined at an earlier hearing. The Court considered the taxability of the value of shares that were awarded to Heath under a discretionary bonus scheme while he was employed, but only vested after the termination of his employment.
Under sections 8(1)(a) and (9)(1)(a) of the Inland Revenue Ordinance (Cap.112), salaries tax will be charged on income arising in or derived from any office or employment of profit, which includes any wages, salary, fee, commission and bonus. The applicable principles for determining the issue were those set out by the Court of Final Appeal in Fuchs v Commissioner of Inland Revenue.
Heath was employed by a bank (company) under a countersigned employment letter (Employment Contract). Under the Employment Contract, among other things, he was provided with participation in a “discretionary bonus scheme”, which vested evenly over a three-year period. Under the relevant rules of the share award plan, the grant of shares did not entitle the employee to a transfer of those shares, so that the grantee received nothing of value unless and until the shares are vested in accordance with the rules.
Following a series of negotiations, in June 2013, the employer and employee (the parties) agreed on the terms for Heath's termination (Termination Agreement) on the grounds of redundancy in January 2013. About five months later, the parties entered into a termination agreement providing for the terms and conditions regarding the employee’s termination of employment.
Under the termination agreement, the continued vesting of the shares was expressly stated to be in consideration for the contractual obligations agreed under the termination agreement, which contained covenants and undertakings from the employee as to various matters, including providing active assistance in the employer’s litigation for up to five years. Heath was treated as a “good leaver”, which permitted all remaining restricted shares previously awarded to him to be vested on the same terms.
In coming to its conclusion, the Court considered the “substance of the bargain” made between the employer and employee for the payments in question. The terms of the Termination Agreement identified that the purpose for releasing the shares was, among other things, to procure Heath to provide potentially long-term assistance in respect of the company’s on-going litigation.
The Court took into account a series of considerations: What was the substance of the bargain for the payments in question? What was the purpose of the payment? Was it a reward for services past, present or future (in which case it was from his employment or office), or was it “for some other reason” (in which case it was not). Further, the Court looked at the substance, not the form or formulae or labels which might have been adopted by the parties.
In contending that the value of the shares should not be chargeable to salaries tax, the employee advanced 18 points to support his position. In essence, the employee argued that this was a case where he was not entitled to the shares, either contractually or beneficially, as at the date of termination of his employment and he only acquired the right to be paid the shares upon agreeing to enter into and performing a termination agreement.
Although the subject shares were granted to the employee on 12 March 2012, while he was employed, the shares did not vest at the same time. Instead, those shares were to vest as to 33%, 33% and 34% in March 2013, 2014 and 2015 respectively. The grant of shares did not entitle the employee to a transfer of those shares, so that the grantee received nothing of value unless and until the shares are vested in accordance with the relevant rules of the share award plan.
The relevant rules of the share award plan provided, among other things, that the employer apparently had unfettered discretion to impose vesting conditions as it saw fit, which might or might not relate to performance in employment.
Where the employee entered into a termination agreement in connection with the cessation of his employment, and subject to the discretion of the employer unilaterally to cancel a grant of shares or otherwise to impose such further conditions as it saw fit, the award in question would not vest until the outgoing employee had complied with the terms of that termination agreement.
The rules and operation of the plan did not form part of the contract of employment, and that rights and obligations arising from the employment relationship were separate.
No employee had a right to compensation for any loss in relation to the plan, including loss or reduction of rights or expectations in the circumstances of the termination of employment.
The employer terminated the employee’s employment on the grounds of redundancy in January 2013. About five months later, the parties entered into a termination agreement providing for the terms and conditions regarding the employee’s termination of employment.
The continued vesting of the shares was expressly stated to be in consideration for the contractual obligations agreed under the termination agreement, which contained covenants and undertakings from the employee as to various matters, including providing active assistance in the employer’s litigation for up to five years. Those covenants and undertakings were fresh consideration provided by the employee in order to procure the employer to agree to matters including the vesting of the shares.
Although the Court took the view that this case was “very much a borderline case”, it ultimately accepted that the value of the shares was not “from the employee's employment” and ruled that the sums released for the value of the shares should not be subject to salaries tax.
Takeaways for employers and HR practitioners
In so concluding, the Court placed an emphasis on the terms of the plan that envisaged that a participant/ employee might have to provide fresh consideration to become entitled to the vesting of shares, and such fresh consideration might have nothing to do with the employment.
The Court was persuaded on the basis that the termination agreement identified that the purpose for releasing the shares was, among other things, to procure the employee to provide potentially long-term assistance in the employer’s litigation.
The case of Heath Brian Zarin illustrates that, in an appropriate case, it is possible to structure posttermination packages containing vesting of shares options so that any such shares vested may be excluded from the assessment of salaries tax. This may be achieved through the careful negotiation of an amicable exit and drafting of a termination agreement. However, employers should bear in mind that each case will be considered by the Court on its particular facts.
Note: : The information contained herein is intended to be a general guide only and is not intended to provide legal advice. This journal, its publisher and the HKIHRM do not assume any legal responsibility in respect of any comments provided in this article, which do not constitute legal advice and should not be taken or construed as such. Independent professional legal advice should be sought as necessary in respect of legal matters and issues raised in this article.