We have previously reviewed¹ the Court of First Instance’s judgments in Heath Brian Zarin v. The Commissioner of Inland Revenue.² In these judgments, the court found in favour of the taxpayer, Mr Zarin, and held that certain payments made by an employer to a departing employee under a termination agreement are not chargeable to salaries tax.

On 16 March 2022, the Court of Appeal upheld the Court of First Instance’s decisions and revisited the legal principles in construing the meaning of "from employment" in the context of salaries tax.³

Case background

Mr Zarin was employed by a bank in May 2010. As part of his discretionary bonus for the performance year 2011, on 12 March 2012, he was granted a restricted share award of shares (2012 Shares). Those shares were to vest in March 2013, 2014 and 2015 respectively.

The restricted share plan (the Plan) provided that:

• if the participant left his employment before the vesting date(s) as a good leaver, subject to the approval of the committee and the bank's policy, the awards would vest in full on the vesting date(s);
• good leaver reasons included redundancy; and
• where the rule of good leaver is applied and the participant had entered into a termination agreement in connection with the cessation of employment, the awards would not vest until the participant had complied with, or was released from his obligations under, the termination agreement.

The bank terminated Mr Zarin’s employment on the ground of redundancy. In June 2013, the bank and Mr Zarin entered into a termination agreement. According to the termination agreement:

• Mr Zarin would be treated as a good leaver;
• any release of the unvested 2012 Shares would be conditional on Mr Zarin having not committed a breach of any of the terms of the termination agreement; and
• Mr Zarin would be obliged to provide reasonable assistance in litigation proceedings in which the bank was involved.

The bank subsequently filed notifications with the Inland Revenue by an employer in which it reported Mr Zarin received the final two tranches of the 2012 Shares (Bonus Shares) and the per diem payment compensating Mr Zarin in relation to the litigation.

The Board of the Commissioner of Inland Revenue considered the Bonus Shares and the per diem payment were "income from employment" chargeable to salaries tax. Mr Zarin appealed and his appeals were allowed by the Court of First Instance. The Commissioner appealed the Court of First Instance’s decisions to Court of Appeal.

Court of Appeal’s decision

As mentioned in our previous articles, the applicable principles are those set out by the Court of Final Appeal in Fuchs v. Commissioner of Inland Revenue:⁴

• Not every payment which an employee receives from his employer is necessarily income "from his employment". It is not sufficient to qualify a payment in that way simply because the employee would not have received the sum in question if he had not been an employee.
• The vital question is: What is the "substance of the bargain" made between the employer and the taxpayer for the payments in question?
• In the context of payments made upon termination of employment, the same consideration applies: 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)?

Bearing in mind the above principles and after examination of the facts, the Court of Appeal dismissed the Commissioner’s appeals and held the following:

• The Bonus Shares were granted as part of Mr Zarin’s performance in the performance year of 2011. However, things have moved on with the termination agreement. The termination agreement specifically provided any release of unvested Bonus Shares would be conditional on Mr Zarin having not committed a breach of any terms of the termination agreement.
• The share award would not vest unless and until the participant had complied with or was released from his obligations under the termination agreement. So it was envisaged that the participant might have to provide fresh consideration in entering into a termination agreement to become entitled to vesting of the award. Such fresh consideration might have nothing to do with employment.
• A fresh bargain was made in the termination agreement by which both parties assumed new obligations. Mr Zarin undertook to render reasonable assistance in the litigation proceedings and the bank undertook to pay him compensation. Accordingly, the per diem payment was not in substance derived "from employment".

Comments

This case reconfirms that not all payments from an employer to an employee or a former employee are taxable. There must be some casual connection between the payments and the employment in question. It is not sufficient that the payment would not have been paid if the recipient had not been an employee. The vital question remains: What is the "substance of the bargain" made between the employer and the taxpayer for the payments in question?

In the present case, Mr Zarin’s undertaking to assist in the litigation proceedings was regarded as good consideration for a fresh bargain and was extraneous to his previous service as an employee.  The fact that the new obligations might be regarded as customary of post-termination undertakings that a highly paid employee with first-hand knowledge of the matters might be required to undertake is irrelevant. Likewise, Mr Zarin’s willingness to render assistance before entering into the termination agreement was immaterial.

In determining whether the payment is "from employment", each case must be considered on its own particular facts. Therefore, if these issues arise, it is prudent for employers and employees to seek legal advice.

1. Post-employment compensation – is it taxable? and Recent High Court decision on taxability of bonus shares vested after termination of employment
2. [2020] HKCFI 330 (per Coleman J) and [2021] HKCFI 1846 (per Coleman J)
3. [2022] HKCA 412
4. [2011] 14 HKCFAR 74