Murad v Commissioner of Inland Revenue

Out-Law Guide | 28 Jun 2010 | 12:24 pm | 7 min. read

Where an employment contract provides for payments to be made to an employee upon termination, the payments will be taxable. Payments made in consideration for the abandonment of contractual rights under the employment contract are not taxable. But it is not enough to say in the contract that the payments are as a result of loss of office: the true nature of the payments is the determining factor, not the label attached to them by the contract.

Barbara Ellen Murad, Mona Frances Ward, Mark Basiem Murad and John Carl Strickroot (Executors of the estate of Mike Murad) v Commissioner of Inland Revenue

  • HCIA No. 1 of 2009
  • Judgment of the Court of First Instance (Chung J) dated 19th November 2009

Help with citations

Facts

Mike Murad (the Taxpayer) was employed by a bank in Hong Kong (the Bank) from the late 1980s to 20th July 2004. He is now deceased and the appellants are the executors of his estate.

The service agreement between the Taxpayer and the Bank, dated 20th April 1999, contained the following clauses:

  • Clause 3.1: "The term of employment under [the service agreement] ... shall from the date of [the service agreement] continue until 30 September 2004 unless terminated by either party giving to the other not less than 3 months' notice in writing."
  • Clause 3.2: "If the [Bank] requests [the Taxpayer] to resign …, then the [Bank] undertakes without condition to honour in full the terms and conditions of [the service agreement] … up to and including [30 September 2006] and in this regard the [Bank] shall make an immediate lump sum payment to [the Taxpayer] on the date of his departure from employment, being an amount equal to the total basic annual salary, fixed bonus payment and housing allowance which [the Taxpayer] should have received if he continued without interruption in the employment of the [Bank] until [30 September 2006] ..."
  • Clause 12: "The [Bank] shall (in the event that the [Bank] shall request [the Taxpayer] to resign …) reimburse to [the Taxpayer]:
    • 12.7 all removal and shipping expenses directly or reasonably incurred by [the Taxpayer] by reason of having to re-locate from Hong Kong to Miami, Florida, USA ...; and
    • 12.8 the cost of one first-class airfare from Hong Kong to Miami, Florida, USA …"

Owing to corporate restructuring, the Bank requested and the Taxpayer agreed to resign with effect from 20th July 2004 and they entered into a separation agreement which contained the following terms:

  • Recital C: "[The separation agreement] contains the agreement reached between the parties and operates inter alia as an amendment of certain provisions of [the service agreement] relating to termination of the Employment, the financial consequences of termination and certain pre- and post-termination obligations of [the Taxpayer] as more fully described below …"
  • Clause 2.1: "[The Bank] and [the Taxpayer] agree that [the Taxpayer] will be asked to resign … the resignation will be treated as a resignation at the request of [the Bank] for the purposes of Clause 3.2 of the Service Agreement."
  • Clause 3.1.1: "[The Bank] will make a payment of US$1,946,057.62 which represents an amount equal to the total basic annual salary [the Taxpayer] would have received had he continued without interruption in the Employment …"
  • Clause 3.1.2: "[The Bank] will make a payment of US$1,347,270.66 which represents an amount equal to the total fixed bonus payments [the Taxpayer] would have received had he continued without interruption in the Employment …"
  • Clause 3.5: "[The Bank] will make a payment of US$30,000 to [the Taxpayer] in respect of all removal and shipping expenses in respect of his entitlement under Clause 12.7 of the Service Agreement."
  • Clause 3.6: "[The Bank] will make a payment of US$5,720 being an amount equivalent to the cost of one single first class airfare from Hong Kong to Miami, Florida, USA …"

On 4 February 2009, the Deputy Commissioner of Inland Revenue (the "Commissioner") determined that the sums received by the Taxpayer pursuant to Clauses 3.1.1, 3.1.2 (excluding US$374,241.85), 3.5 and 3.6 of the separation agreement were all taxable under S.8 of the Inland Revenue Ordinance because the Taxpayer's entitlement to these sums arose out of the service agreement.

The appellants were of the view that the Commissioner erred in concluding that the severance payments received by the Taxpayer under the separation agreement did not arise from breach of the service agreement, but from the terms of the service agreement. They brought an appeal against the Commissioner's ruling.

The judgment

Chung J rejected the appellant's argument that the four sums received by the Taxpayer were "compensation for loss of office" and thus not taxable.

Following the various authorities, including Henley v Murray (1950) 31 TC 351 and Dale v de Soissons (1950) 32 TC 118, Chung J confirmed that the emphasis of the test as to the taxability of the termination payment should be on the "abandonment or abrogation of the contractual rights" i.e. if the termination payments were paid for the total abandonment or abrogation of the contractual rights, then those payments would not be taxable.

Applying that test in the present case, Chung J held that the four sums received by the Taxpayer were all subject to salaries tax because:

  • the taxed sums were paid pursuant to the sums agreed in the service agreement, which were part of the Taxpayer's assured entitlements under his terms of employment;
  • the taxed sums were neither payment of damages for the breach of the service agreement, nor paid in abrogation of the service agreement; and
  • the taxed sums were paid to the Taxpayer in return for his acting as, being, or becoming an employee of the employer.

In the final part of the judgment, Chung J also analyzed the taxability of four categories of termination payment as referred to in the case of Delaney v Stapes [1992] 1 AC 687, namely:

  1. When an employer gives proper notice of termination to the employee, tells the employee not to work until the termination date and gives him the wages attributable to the notice period in a lump sum;
  2. When 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, and the employer summarily dismisses the employee with the payment of sum in lieu of notice;
  3. When 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; and
  4. When, without the employee's agreement, the employer summarily dismisses the employee and tenders a payment in lieu of proper notice.

The Judge concluded that the payments under the first and second categories should be taxable and the payment under the fourth category should not. 

In respect of the payment under the third category, the Judge said that its taxability is left open.

Commentary

Mr. Murad (now deceased) entered into an employment contract with a bank in Hong Kong in April 1999. In this contract, it stipulated that Mr. Murad would be entitled to a number of payments upon the early termination of his employment. These included total basic annual salary, fixed bonus payment, removal and shipping expenses as well as costs of airfare (collectively the "Payments"). In 2004, Mr. Murad's employment was terminated and the parties entered into a separation agreement. This agreement made specific reference to the original employment contract and described the Payments.

The Inland Revenue Department assessed taxes on the Payments, the rationale being that the Payments arose out of the employment agreement and thus were part of the terms of employment. Conversely, it was argued on behalf of Mr. Murad's estate that the Payments were actually compensation for loss of office and accordingly should not be taxed.

The Court of First Instance concluded that the Payments were indeed subject to taxation and in doing so the Court confirmed the principles enunciated in a slightly earlier decision, Fuchs, Walter Alfred Heinz, v. C.I.R. In the Fuchs case, the facts were very similar to Mr. Murad's situation. As a result of these two cases, some clear legal principles have been established in determining whether payments made upon termination of employment are subject to taxation.

The fundamental principle is as to whether or not the payments are made pursuant to a provision in the employment contract (thus, taxable) or whether such payments are not specifically covered under the employment contract but are being paid in consideration for the abandonment of contractual rights under the employment contract (not taxable).

Simply including in some sort of termination or separation agreement payment obligations which have been provided for in the employment contract does not change the fundamental principles. If they were provided for in the original employment contract, they are taxable.

In the past, there seemed to be a belief that by stipulating in a termination agreement that certain payments were to be made to the employee as a result of loss of office, it would result in the payments not being subject to taxation. This is clearly no longer the case.

The Courts have said that the "label" attached to such payments is not the determining factor but rather the actual nature of the payments.

If a taxpayer is entitled to receive certain payments under his employment contract at the outset of his employment, then these payments, even though they may be duplicated or referenced in an agreement upon termination of employment, will be subject to taxation. That said, it is possible that the following payments may not be taxable:

  • payments which are agreed between the parties at the time of termination of employment but have not been stipulated in the original employment agreement;
  • payments which are genuinely made to the employee at the time of termination in consideration of the employee abandoning or releasing specific obligations of the employer under the employment contract or in consideration of damages for breach of such employment contract; and
  • payments which may be made to essentially buy out a contractual right. 

As a result of the decision in the Murad case, it is important that both the employer and the employee consider, at the time of entering into an employee contract, whether or not it is the intention of the parties that such payments should be received tax-free in the hands of the employee.

If this is the intent, then it may be that the amounts which are intended to be paid will need to be grossed up to allow for taxation. In addition, when entering into termination or separation agreements, careful consideration should be given to the principles confirmed in the Murad case, so as to structure payments in as tax efficient a manner as possible.