Understanding the taxation of severance payments in challenging times

In the current economic slowdown where retrenchments may rise, a recent case provides insights on the taxability of severance payments.

In the current difficult economic climate, managing employment costs is in the forefront of business continuity. Headcount reduction is often taken as a last resort and an employer may offer to pay a severance payment to compensate employees for the abrupt loss of employment. How will such severance payments be taxed and are there tax mitigating opportunities?

On 21 May 2020, the Singapore Income Tax Board of Review (the Board) issued a decision on the taxability of severance payment in the case of GCT v Comptroller of Income Tax [2020] SGITBR 3. The Board, in this case, rejected the long-standing position taken by the Comptroller of Income Tax (the Comptroller) that ex-gratia payment provided for in an employment agreement would be subject to tax. Instead, the Board addressed the key considerations of establishing the characteristics of the termination payment, regardless of how the payment is termed, in determining if it can constitute a payment for loss of employment or restrictive covenant. A payment for loss of employment or restrictive covenant is regarded as capital receipt and not subject to income tax.

Background of the case

The taxpayer was employed from 1 August 2013 to 31 December 2016 as Managing Director of a Singapore-incorporated company. 

In August 2016, the taxpayer was abruptly informed of his termination of employment by the Company due to a strategic decision to wind up the Company’s business and was subsequently released from his duties on the same day.

According to the taxpayer’s Employment Agreement, he was entitled to an ex-gratia payment in the event of termination of his employment, provided that a deed of release is executed by him following his termination. The ex-gratia payment would be computed based on a fixed number of months of base salary and a prorated sum of the annual bonus.

However, no deed of release was executed upon the termination. Instead, the taxpayer and the Company entered into a Separation Agreement to relinquish his rights under his original Employment Agreement. The Separation Agreement stated that both parties mutually agreed to the termination of employment with effect from the termination date.

Under the Separation Agreement, the taxpayer was entitled to the following payments:

• Monthly base salary for the full year until the termination date and repatriation benefits; and
• A lump sum severance payment referred to as “discretionary ex-gratia payment” of S$2,475,000, which was payable in two instalments. This severance payment included all entitlements that may have been due to the taxpayer under the original employment contract, including the original ex-gratia payment.

In determining the tax treatment, the Comptroller sought to break down the severance payment into two portions as follows:

• S$1,350,000 as employment income, which would have been the ex-gratia payment due in accordance with the ex-gratia payment clause under the original Employment Agreement. Tax was imposed on this portion by the Comptroller.
• S$1,125,000, being the remainder of the lump sum amount made pursuant to the Separation Agreement, which was deemed as payment for restrictive covenant and not subject to tax on the basis that the payment was regarded as capital receipt.

The issues

The Board had to consider the following two issues presented by both parties:

• Whether the aggregated severance payment of S$2,475,000 in the Separation Agreement relates to compensation for loss of office and is consequently not taxable as employment income.
• Whether the Comptroller was correct in breaking down the severance payment and assessing the ex-gratia payment of S$1,350,000 as employment income and the remaining S$1,125,000 as non-income (capital) in nature.

Decision of the Board

The subject of appeal was the payment of S$1,350,000 that the Comptroller had separated from the lump sum severance payment and linked by reference to the ex-gratia payment clause in the original Employment Agreement. The Board held that the payment of S$1,350,000 was capital in nature and accordingly allowed the appeal, and ordered the Comptroller to revise the tax assessment to exclude it from tax.

In arriving at its decision, the Board emphasised the importance of anchoring the analysis for tax treatment of the severance payment on the taxing statue, i.e., the Income Tax Act (Cap. 134) (the Act).

Under section 10(1)(b) of the Act, gains and profits from employment are assessable to tax. Section 10(2)(a) further defines the following nine categories of payments as falling under “gains or profits from employment” – “any wages, salary, leave pay, fee, commission, bonus, gratuity, perquisite or allowance...”.

In order for a receipt to qualify as “gains or profits from employment”, the character of the receipt (regardless of its term) has to fall strictly within the definition of any of the nine categories of payment identified in section 10(2)(a). These categories refer to payments made in recognition of past, present and future services performed. The provision does not list what falls outside “gains or profits from employment”. In particular, it does not cite redundancy payment or compensation for loss of office. Consequently, payments for redundancy or compensation for loss of office would not constitute gains or profits from employment.

The Board highlighted that it is important to look beyond how the payment is termed but into the true characteristic of the payment to determine whether the payment in this case falls under the ambit of section 10(2)(a). Similarly, the Board was of the view that whether or not a payment is specified in the Employment Agreement is a factor, but is not conclusive in determining its nature.

The Board examined both the ex-gratia payment clause in the original Employment Agreement and the severance payment clause in the Separation Agreement and found that both payments were only payable upon termination by the employer and not in the event of voluntary resignation by the taxpayer. This was a strong supporting factor in differentiating the payment as compensation for loss of office on the basis that it did not relate to past, present or future services rendered, which was already compensated separately.

Furthermore, the taxpayer had to execute the deed of release in order to become eligible for the ex-gratia payment under the original Employment Agreement. The deed appeared to be in the nature of a restrictive covenant, and payment for a restrictive covenant, which is generally capital in nature, would not be taxable in any case.

In conclusion, the Board held that:

• The taxpayer was terminated from employment and suffered a loss of office.
• The Separation Agreement arose from the termination and the payments therein were of the nature of compensation for a loss of office and for a non-competition covenant.
• The character of the payments remained the same, regardless of whether one categorises them under the terms of the Separation Agreement, or under the ex-gratia clause of the Employment Agreement.

The above conclusion is aligned with the Comptroller’s position published on its website that payments made to compensate for the loss of employment are not taxable as they are regarded as capital receipts.

It is interesting to note that the Comptroller maintained that it was not bound by the statements on its own website, as practice is not law. The Board views that the Comptroller has stated its interpretation of the law on its website and the statements cannot be a mere practice that differs from the legal position. As such, the Board believes that these statements are correct as a matter of law.

Key takeaways

The facts of this case and the differing views of the Board and the Comptroller demonstrate the importance of establishing the underlying nature and intent of a payment made under the separation agreement before concluding that any payment provided for in an employment agreement or termed as “ex-gratia payment” would necessarily be subject to tax.

The Board’s decision provides much appreciated clarity on the key characteristics for severance payment to be considered as capital (non-income) in nature.

In the current global economic slowdown due to the COVID-19 pandemic, retrenchments are likely to rise as businesses struggle to survive during this challenging period. This landmark case law is timely for taxpayers in a similar situation.

Employers who intend to undertake a redundancy exercise can seek to confirm with the Comptroller upfront on the taxability of the payments once a redundancy package has been finalised. Upon receipt of confirmation of a non-taxability position given by the Comptroller, the employer can include the date of approval from the Comptroller in the employer’s tax return (e.g., Form IR8A/IR21). This will help to expedite the finalisation of assessments by the Comptroller, especially for tax clearance filing (in the cessation of employment of a foreign national employee who is on an employment pass). In addition, this will provide assurance to the departing employee of the tax liability, if any, arising from the payments.

The co-authors of this article are Panneer Selvam, EY People Advisory Services — Mobility (Tax and Immigration) Leader, and Kerrie Chang, EY People Advisory Services — Mobility Tax Partner, both from Ernst & Young Solutions LLP.