2 Mr Chan
(a) Taxability of the termination payments
The Hong Kong salaries tax implications arising from the termination of Mr Chan’s employment are as follows:
(1) The terminal payment representing final salary is taxable as it is income from his employment by World Ltd (the
Company).
(2) Compensation for leave is also taxable on the basis that it is income from his employment by the Company.
(3) Compensation for loss of office may be argued as not taxable on the ground that it is a payment for breach of contract
rather than a payment for services rendered. For this ground to be valid, the ‘breach’ must be a real and identifiable
breach, and not a pre-arranged term under the employment contract. However, if the genuine reason for paying the
compensation is to recognise past services, or as a substitute for a reward-type of payment such as a bonus, the
compensation will be taxable.
In Mr Chan’s case, there is a risk of challenge by the Inland Revenue Department (IRD) that the compensation is
effectively a substitute for the discretionary bonus which is in practice equivalent to the compensation amount, both
being based on one month’s salary.
(4) The sum withdrawn from the Occupational Retirement Scheme Ordinance fund upon termination of service, to the extent
it represents previous contributions from the employee and the subsequent return of fund investments, is not taxable.
The portion of the sum withdrawn upon termination representing the employer’s contribution is also not taxable,
provided that it does not exceed the ‘proportionate benefit’ as calculated under the following formula:
Accrued benefit x (number of completed months of service)/120
Accrued benefit in the case of termination is defined as the maximum amount that the person would have been entitled
to receive had he retired at the termination date.
In Mr Chan’s case, as his employment with the Company is less than 120 months (96 months from April 2004 to March
2012), the proportionate benefit would be calculated as $96,000 ($120,000*96/120). Therefore, the Company’s
contribution which exceeds the proportionate benefit in the amount of $54,000 ($300,000/2 – $96,000) needs to be
returned as taxable.
(5) The compensation is paid with the intention of covering the loss suffered by Mr Chan arising from the disposal of his
car in Hong Kong as a result of the termination of his employment. Given that he was actually ‘asked’ to terminate his
employment, the compensation could be argued to be a genuine compensation for the personal damage suffered by
him, which is not an expected reward for his services nor arising in connection with his employment. On this basis,
there is a strong case to argue that the compensation is not taxable.
(6) Compensation for agreeing to enter into a covenant restricting an employee’s activities is a payment for deprivation of
rights, not a payment for employment or services, and thus would not be taxable. However, there have been cases in
recent years illustrating that the IRD is now taking a stance that, if a compensation type of payment has been
pre-arranged as part of the terms of employment, it is, in reality, deferred remuneration from employment. Therefore,
despite its nature being compensation and its actual payment being post-termination, the compensation may be treated
as taxable. In Mr Chan’s case, it is uncertain whether the compensation for this restrictive covenant is in existence in
his employment contract. If it is already part of his employment terms, there is a risk that the IRD would treat it as
taxable.
In terms of the timing of receipt of the compensation being in six months’ time, s.11D provides that a payment from
employment after its termination would be deemed to be received on the last day of employment. Therefore, the
compensation for agreeing to enter into the restrictive covenant would be deemed to be paid on 31 March 2012,
Mr Chan’s last day of employment, and be taxed in the year of assessment 2011/12. However, should Mr Chan elect,
he may relate the compensation payment back for three years so that the sum would be spread over and brought to
assessment for the years of assessment 2011/12, 2010/11 and 2009/10 respectively. If necessary, revised
assessments would be issued for the years of assessment 2010/11 and 2009/10.
(b) Tax implications for the rental income received from properties
(i) If rental income is received from properties which are held by Mr Chan’s daughter as an individual, property tax is
payable under s.5(1). Under this section, property tax is levied on any owner of land or building or land and buildings
situated in Hong Kong, at the standard rate (15%) on the net assessable value of the property. ‘Net assessable value’
18as defined under s.5B includes any consideration payable in money or money’s worth in respect of the right to use the
land or/and buildings, as reduced by two types of deduction:
(a) government rates paid by the owner if it has been so agreed between the owner and the tenant; and
(b) a one-off statutory allowance of 20% of assessable value after deducting rates, if applicable. This statutory
allowance is deemed to cover all related expenses incurred by the owner on the property. All other actual expenses
incurred, such as repairs, management fees and mortgage interest, are not deductible for property tax purposes.
There is no deduction for mortgage interest for property tax. Upon election for personal assessment, the net assessable
value of the property can be reduced by the amount of mortgage interest down to zero, any excess mortgage interest not
so offset cannot be offset against other income, or carried backward or forward to other years (s.42). However, as
Mr Chan’s daughter is not a temporary or permanent resident in Hong Kong, she is not entitled to elect for personal
assessment (s.41).
(ii) If rental income is received from properties which are held by a special purpose company, s.5(1) is still applicable on
the basis that the company will be considered as ‘owner’ of the properties. Any rental income so received is subject to
property tax calculated in the same manner as for an individual (as explained in (i) above).
However, according to s.2, ‘business’ is defined to include the letting or sub-letting of property by a corporation.
Moreover, under s.14, any person who carries on a trade, profession or business in Hong Kong and derives assessable
profits in Hong Kong will be chargeable to profits tax. So in the case of the special purpose company, it will be regarded
as carrying on business by virtue of its property letting in Hong Kong, and it will be chargeable to profits tax on the rental
profits which is sourced from immovable properties in Hong Kong.
The double taxation of the special purpose company, which is subject to both property tax and profits tax by definition,
can be eliminated by the application of s.5(2)(a). Under this section, any corporation which is subject to profits tax in
respect of rental profits can apply for an exemption from property tax in relation to the same rental profits. In the case
of the special purpose company, it will be advisable for it to claim exemption under s.5(2)(a) so that the rental profits
are only subject to profits tax under s.14. Any property tax paid can be offset against profits tax chargeable on the
company for the same rent receivable under s.25, any excess thereof will be refunded.
Profits tax under s.14 is imposed on assessable profits which take into account all relevant expenses and outgoings that
are incurred in the production of those assessable profits (s.16). It is therefore possible to deduct related expenses such
as mortgage interest, management fees and repairs. Depreciation allowances will be calculated on the renovation costs
as well as the qualifying costs of construction of the property (if the property is not a trading stock) and deductible against
the rental profits. In a situation where total deductible expenditure exceeds total rental revenue, the excess loss can be
carried forward to subsequent years and is eligible for deduction against any future taxable profits. In Mr Chan’s case,
this will possibly be the case since the monthly rent is expected to be insufficient to cover the mortgage interest.
Currently, the profits tax rate applicable is 16·5%.
As compared to (i) above, although the applicable tax rate for a company (16·5%) would be higher than that applicable
for an individual (15%), the company’s taxable profits should be lower, possibly even reduced to zero, as more
expenditure is allowable and no limitation is imposed for the tax-deductible mortgage interest incurred.
