Hong Kong: Tax Authority Seeks to Tax Payments in Lieu of Notice
Hong Kong’s Inland Revenue Department (IRD) has recently revised the cessation form IR56F1 and departure form IR56G2 to require employers to report all “Payments in Lieu of Notice” (PILON) as income from employment if they accrued on or after 1 April 2012. Employers have also received a note, accompanying the 2011/2012 form BIR56A, which states that PILON “including payments made under Section 7 of the Employment Ordinance” will be assessed to Salaries Tax.
This revision will require employers to update their filing positions in respect of PILON to ensure the IRD’s requirement is complied with. In addition, the assessment of PILON to Salaries Tax means potentially higher tax burdens on employees.
Background: Prior Practice and Impetus for Change
The IRD’s previous practice was, generally, not to assess a PILON. In their guidance notes, the IRD stated that a PILON was not income from employment and that the employer was not required to report the payment in the employer’s return.
The IRD has revised the notes and instructions for employer’s return forms BIR56A and IR56B and the related guidelines (including the Employer’s FAQ) in respect of PILON due to a recent court decision (see below) involving the taxation of termination payments.
Court Decisions
In the case of Fuchs, Walter Alfred Heinz and Commissioner of Inland Revenue, the Court of Final Appeal in Hong Kong held that payments made “in return for acting as or being an employee” or “as a reward for past services or as an inducement to enter into employment and provide future services” are income chargeable to tax under section 8(1) of the Inland Revenue Ordinance. A payment is assessable as income from employment where the sum represents an entitlement under the contract of employment.
In fact, in an earlier case, Murad,3 the High Court in Hong Kong held that sums paid pursuant to a service agreement form part of the taxpayer’s assured entitlements under his terms of employment, represents income from employment, and are therefore chargeable to Salaries Tax.
Although the payments in question in the above two cases were not specifically related to PILON, the judges in both cases refer to an English court case EMI Group Electronics v Coldicott, which ruled on the taxation of PILON. The judge in Murad had made the following comments towards the end of his judgement:
“Four categories of payment made at the termination of employment (referred to as “payment in lieu of notice”) have been set out in Delaney v Staples [1992] 1 AC 687:
‘ … (1) an employer gives proper notice of termination to his employee, tells the employee that he need not work until the termination date and gives him the wages attributable to the notice period in a lump sum. In this case (commonly called ‘garden leave’) there is no breach of contract by the employer. … the lump sum payment is simply advance payment of wages. (2) The contract of employment provides expressly that the employment may be terminated either by notice or, on payment of a sum in lieu of notice, summarily. In such a case if the employer summarily dismisses the employee he is not in breach … provided he makes the payment in lieu. But the payment in lieu is not a payment of wages in the ordinary sense … (3) At the end of the employment, the employer and the employee agree that the employment is to terminate forthwith on payment of a sum in lieu of notice. Again, the employer is not in breach of contract by dismissing summarily and the payment in lieu is not strictly wages … (4) Without the agreement of the employee, the employer summarily dismisses the employee and tenders a payment in lieu of proper notice…’
The English court of appeal opined in EMI v Coldicott that the first category payment is taxable…. It would appear the court regarded the second category payment as equally taxable… However, it is unclear if the court in EMI v Coldicott would regard the third and fourth category payment as taxable…In Henley v. Murray ((1950) 31 TC 351, 363), the court appears to opine otherwise as regards the fourth category…”
The judge’s comments have left the taxation position in respect of a non-contractual PILON uncertain.
KPMG Note
The courts have established the principle that PILON made under a contractual provision, which was agreed at the outset of the employment and which enables the employer to terminate the employment on making that payment, is income from employment. The IRD appears to have taken this further, requiring that all PILON be reported as income from the employment and stating that a PILON made in accordance with the Employment Ordinance will be treated as a contractual payment and will be assessable to Salaries Tax.
It is unclear how PILON for overseas employees with employment contracts governed by laws in overseas jurisdictions will be treated by the IRD.
The IRD has indicated that it would examine carefully the foreign law which regulates the employment including the right to PILON. The sum may be assessed to Salaries Tax if it is income from employment, whether paid under the express or implied term of an employment contract.
The IRD now requires employers to report PILON which accrue to employees on or after 1 April 2012. However, if the facts support the contention, employees may decide to include a claim in their Individual Tax Returns that the PILON should not to be considered to be income from employment.
Source: KPMG