A tax on being fired

How much tax will you pay on your termination payments? Some advice from PricewaterhouseCoopers.

Will you have to pay tax on termination payments?

If you are unfortunate enough to be on the receiving end of the "Big Envelope" (this is a proverbial Chinese phrase used to describe someone who has just been made redundant), the least of your worries would probably be the amount of tax you have to pay on your termination payments. Well, this might be true if you are unfazed by the low level of taxes in Hong Kong, but with job-hunters outweighing jobs at the moment, it is important to ensure that you don't pay more tax than necessary. Tax would certainly need to be accounted for but the question is, how much?

Here's some good news first. The Hong Kong Inland Revenue Department by concession, allows for the following payments on termination to be paid tax-free:

+ Severance pay or long service pay calculated in accordance with the Employment Ordinance; and
+ Payment-in-lieu-of-notice.

If you are member of a recognized retirement scheme and you receive a lump sum payment from the retirement scheme upon termination of employment, a proportion (or indeed the entire amount) could potentially be tax-free. The exact proportion that is tax-free is dependent on two things: the vesting schedule of the retirement scheme and the number of years of service that you had with your former employer.

If you have completed ten years of service, any lump-sum payment would generally be tax-free. If the recognised retirement scheme benefits vest to you at a rate of not more than 1/10th for every year worked e.g. , if the employer contributes $100 into the scheme and only $10 vests to you after each and every year of service such that $10 vests to you after one year's service, $20 vest to you after two year's service and so on, any lump-sum payment that you receive on termination would, again, be tax-free - this is irrespective of the number of years of service that you were employed.

If you have less than ten years of service and the retirement benefits vest to you at a more generous ratio of 1/10th for every year worked, any proportion paid over and above the 1/10th ratio would generally be taxable.

For example, your employer has contributed HK$100,000 into a recognised retirement scheme. Your employment was terminated after seven years of service and you receive a lump-sum payout of HK$100,000 from the scheme. The tax-free portion would be HK$70,000 (HK$100,000 x 1/10th x seven years) and you will have to pay tax on the balance of HK$30,000.

The withdrawal of your own contributions from a recognized retirement scheme would not be taxable, nor do the Inland Revenue Department tax you on any investment income earned whilst the funds are in the retirement scheme.

The not-so-good news is that everything else not falling into the above categories would generally be taxable. Examples are salary to the last day of employment, untaken leave pay, end of contract gratuity, bonuses and allowances etc.

The Inland Revenue Department sometimes recognises that if your former employer makes a payment to you to compensate for the loss of certain rights that you had enjoyed, or, for the purpose of buying out your existing rights, such payments may not be taxable. They would generally look into the exact nature of the payment and the circumstances in which this was paid before deciding the correct tax treatment.

The Inland Revenue Department would generally have an easier time deciding the correct tax treatment if there is documentation that clearly describes the nature and the circumstances in which the termination payments are made. This is often set out in a termination agreement signed by your former employer and you where it is explained why your employment is being terminated, what payments you will receive and the basis of their calculation. You would normally be asked to sign such an agreement to acknowledge your acceptance to the arrangement "in full and final settlement" of any claims you may have had against your former employer.

Essentially, the Inland Revenue Department would seek to tax any payments made on termination that are either a contractual entitlement or a payment for services you have or will perform.

While there is little that you could do to control what documentation you might be given if you are on the receiving end of the Big Envelope, this is something to bear in mind for those who have made staff redundant or who are anticipating staff lay-offs. Well planned, well executed and well documented terminations would generally give the laid-off employees an easier time with the Inland Revenue Department and hence lessen the impact of the redundancy.

Ami Cheung, Senior Manager, PricewaterhouseCoopers
Email: [email protected]

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