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In the recent Board of Review case D26/07, an interesting question on whether employment income, which has been paid to an employee with a minimum service period requirement and has been assessed to tax in the year of receipt, should be excluded from taxable income in respect of the portion which the employee has subsequently repaid to the employer because of resignation during the minimum service period, has been reviewed.
The background
A sign-on bonus ("SOB") and a settling-in allowance ("SIA") was paid to an employee in the first month of his employment in February 2005, on the terms that if he resigned within 12 months from the commencement of his employment, he would be required to repay to the employer the SOB and SIA on a pro rata basis.
The employee subsequently resigned in June 2005 and terminated his employment in September 2005. Accordingly, he refunded to his employer a portion of the SOB and SIA.
The employer reported the full amount of the SOB and SIA on the 2004/05 Employer's Return which was submitted to the Hong Kong Inland Revenue Department ("IRD") in May 2005. In December 2005, the employer filed a revised 2004/05 Employer's Return to the IRD to report the revised amounts of the SOB and SIA after the employee's repayment. The IRD accepted the revised Employer's Return.
The employee reported the full amount of the SOB and SIA in his 2004/05 Individual Tax Return ("ITR"). After receiving the revised Employer's Return from his employer, he wrote to the IRD requesting the corresponding revision of his 2004/05 assessment, which the IRD rejected.
The issue
The issue to consider is whether the whole amount of the SOB and SIA should be treated as the employee's income for the year of assessment 2004/05 (i.e., from 1 April 2004 to 31 March 2005) having considered the partial repayment made by the employee.
The tax law
Generally speaking, an individual will be chargeable to Hong Kong salaries tax ("HKST") under Section 8(1) of the Inland Revenue Ordinance for each year of assessment in respect of his income arising in or derived from Hong Kong from (i) any office or employment of profit and (ii) any pension. Section 9(1)(a) defines that income from any office or employment includes any wages, salary, leave pay, fee, commission, bonus, gratuity, perquisite, or allowance, whether derived from the employer or others. As regards the timing of taxation, it is provided (i) under Section 11B that the assessable income of a person in any year of assessment shall be the aggregate amount of income accruing to him from all sources in that year of assessment and (ii) under Section 11D(b) that income accrues to a person when he becomes entitled to claim payment thereof.
Under Section 12(1)(a), all outgoings and expenses (other than expenses of a domestic or private nature and capital expenditure) which are wholly, exclusively and necessarily incurred in the production of assessable income are deductible from the assessable income.
The IRD's argument
The IRD focused on whether the amount repaid by the employee was a deductible expense under Section 12(1)(a). The IRD argued that the portion of the SOB and SIA repaid by the employee represented the price which he had to pay for not having fulfilled his obligation to serve for 12 months and is not deductible under Section 12(1)(a). The IRD referred to the Board of Review Case D15/88 where the Board rejected the taxpayer's claim to deduct from her assessable income the final month's salary which she repaid to her employer as a payment in lieu of notice.
The Board's analysis
The Board considered that the present case is different from the facts of D15/88. In D15/88, the taxpayer chose not to serve the one month's notice period by giving a payment in lieu of notice. She was fully entitled to the final month's salary and did receive it but as a matter of fact she immediately "returned" it to her employer to discharge her liability to make the payment in lieu of notice for termination of her employment.
While the Board disagreed with the IRD's argument, the Board considered that the refund made by the employee is not deductible under Section 12(1)(a) as it was not incurred wholly, exclusively and necessarily in the production of assessable income and was of a capital rather than recurrent nature. The Board went further to review whether the employee had received, in reality, the full amount or only the prorated portion of the SOB and SIA, which would be assessable under the charging provision of Section 8(1).
The Board explained the importance of looking first at the fundamental question of whether there is "income" arising in or derived from Hong Kong under Section 8(1), rather than Section 11D(b) which looks at when the employee is entitled to claim payment of the income to assists in determining "when" or in which year of assessment an item of income should have accrued and become taxable.
The Board elaborated this concept with an example where an individual who has worked for three months with an employer but has never received any payment because the employer was bankrupt at the end of the three months concerned. While the individual is entitled to claim payment of his salary (which has satisfied Section 11D(b)), it would be very surprised if Section 8(1) could be interpreted to impose a tax liability on him to pay salaries tax on income which he has never received.
The Board's conclusion
The Board rejected the IRD's argument that the amount repaid by the employee was damages for termination of contract. The Board concluded that the employment contract should be construed to read that the employee was only entitled to receive the full amount of the SOB and SIA contingent on his having served the full 12 months of service. As such, the employee was not entitled to the full amount of the SOB and SIA but was only entitled to the prorated portion of them and should be assessed on that prorated portion accordingly.
The Board also highlighted the oddity in this case in that the IRD accepted the revised Employer's Return on the one hand but rejected the employee's objection on the other hand.
PwC's commentary
While the basis of reporting for any income item should be reviewed to determine the amount and the year of assessment for reporting to the IRD, as a rule of thumb, contingent payments that have been made to and received by an employee but with future service requirements similar to the present case should still be reported to the IRD in the year of receipt - with the appropriate remarks that the contingent payments are made subject to the fulfilment of the awarding conditions failing which the whole or the prorated portion (as applicable) of the payments would be repayable by the employee.
Employers are also recommended to read and understand the new Departmental Interpretation & Practice Notes No.38 (revised) issued by the IRD on 20 March 2008 regarding Employee Share-Based Benefits where the IRD has set out its position on the general reporting basis for share based benefit subject to forfeiture risk. |
