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Tax Exemption for Severance Payments?

2021-11-23

It is definitely favourable if you are able to find a job in a prospecting company that can give full play to your strengths, but when the economy is in recession or when the company is not doing well, it is necessary to lay off employees or reorganize the company. Having a good amount of severance payment is a consolation, but when filing tax returns, does that payment need to be included as taxable income? We hope that this article can answer your questions regarding this topic and avoid paying unnecessarily additional amounts of tax.

Severance Payment and Long Service Payment

According to Chapter 57 of the Employment Ordinance, if an employee meets the following conditions, the employer is required to pay severance payments or long service payments:

1) Severance payments

I. Continuous contract employment for not less than 24 months; and

ii. Meet one of the following conditions:

  • Dismissed due to layoffs;
  • After the contract expires, the contract is not renewed due to layoffs; or
  • Suspended.

2) Long service payments

i. 5 years of continuous employment; and

ii. Meet one of the following conditions

  • Was not summarily dismissed because of layoffs or serious negligence;
  • The fixed-term contract will not be renewed after expiration;
  • Death during employment;
  • Resign from a designated certificate issued by a registered medical practitioner or registered Chinese medicine practitioner proving that he is permanently unfit for the current job; or
  • 65 years of age or older and resigning due to old age.

Both severance payments and long service payments are guaranteed by Hong Kong laws, so if the payment you have received is calculated in accordance with the Employment Ordinance, it does not have to be taxed. However, if the compensation you receive exceeds the amount of severance payments or long service payments calculated and guaranteed in accordance with the Employment Ordinance, you will need to pay salaries tax for the excess amount. Below are examples showing how to calculate whether severance payments and long service payments exceed the guaranteed amounts:

A. If you are an employee with monthly salary

Last month’s salary × 2/3 (Note 1) × Retrospective years of service (Note 2)

Note 1: Employees can also choose to calculate based on their average wages in the 12 months immediately before the termination date of their contract.

Note 2: Service periods of less than 1 year are calculated on a pro rata basis.

A sample calculation is as follows:

Mr. Li worked in Company A for 6 years and 3 months, and his monthly salary for the last month was HKD18,000 (His average salary for the 12 months immediately before the termination date of his contract is HKD17,400)

Calculation of Mr. Li’s non-taxable severance payment or long service payment:

HKD18,000 × 2/3 × 6.25 years = HKD75,000

So if Mr. Li receives more than HKD75,000, he will have to be taxed for the excess.

Compensation Received for Contract Termination

In addition to severance payments and long service payments, sometimes you may receive compensation when your contract is terminated. Whether that sum of compensation is taxable or not is determined by the purpose for that compensation. As a starting point, according to the Inland Revenue Ordinance, all income derived from employment is taxable. Compensation received when a contract of employment is terminated thus does not need to be taxed.

  1. Contract gratuity – taxable, regardless of whether the payment is paid to the employee in accordance with the employment contract, because the payment is related to past and/or current services.
  2. Payment in lieu of notice – taxable, because payment in lieu of notice is income from employment.
  3. Compensation for early termination of contract – not taxable, as the compensation is obtained because the employee waives the right to be employed, and not as income earned by the employment.
  4. Compensation for not being allowed to engage in work related to the original job for a period of time after resignation – not taxable, because the compensation is obtained by the employee through giving up the right to engage in the original job, and not as income earned by the employment.

Conclusion

Nobody wants to lose a job with a stable income, but you have to be aware of your labor rights and understand your tax matters, so you can protect yourself if you encounter these issues. Not only do you avoid paying unnecessary tax, but you also avoid unnecessary fines. That is why filing tax wisely starts with you!

Pacers is a company that provides multifaceted and professional consulting services. We are eager to grow with our clients, so if you encounter any issues on taxation, you’re welcome to contact us through our website or email at info@pacersconsulting.com.

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