Losing the Job and Pay Tax on Compensation?

Recently a court case regarding the individual income tax (“IIT”) treatment on a compensation payment caused discussion in China. The compensation payment was made by a company in Shanghai who terminated a fixed-term labor contract with a former employee. According to the prevailing Chinese labor contract law, when a fixed-term labor contract expires, if the employer refuses to renew the contract with the same conditions currently offered and thus terminates the employment relationship, the employer is obliged to provide the employee with a statutory compensation which is calculated based on the employee’s current salary level and his/her length of employment with the company.

As a tax preferential policy with wide awareness in China, severance payment provided to an employee up to three times of the local annual average salary of the past year (“Tax-exempted amount”) is exempted from Chinese IIT, only the exceeding portion should be subject to taxation. That means in Shanghai, a severance payment below RMB 315,528 can be provided to an employee as IIT exempted in 2019.

In the court case the compensation to be paid is below the local Tax-exempted amount, then was it paid without personal tax burden? The answer is NO. The employee in the court case made 3 appeals against the tax authority’s assessment but ended up with an unchanged result.

It seems to be an unjustifiable result, which is however, justified by the tax authority. According to the relevant tax regulation, a severance payment which is applicable to the preferential tax treatment is defined as a compensation from dissolution of a labor contract. Referring back to the labor contract law, situations under dissolution of a labor contract do not include termination of a fixed-term labor contract that expires. Therefore, compensation for terminating a fixed-term labor contract when it expires does not fall into the scope of severance payment which is applicable to the tax preferential treatment, and as a result, it is subject to Chinese IIT as regular salary income.

Whether or not it is reasonable, the court case has set out a definite example for the IIT treatment on a compensation from labor contract termination. The IIT treatment is not relevant to the employer’s company cost but would have substantial influence on the employee’s personal tax burden.

With an eye on the human capital and the employer brand, there are various options to optimize the personal tax burden of an employee in such case. For this purpose, both labor and tax aspects should be considered, e.g. to avoid damages to the employer's brand.