Ensuring there is clear documentation identifying the different elements of the termination package paid to an employee on the termination of employment may lead to payments such as compensation for loss of office being received tax free by the employee.

Contractual obligations
Any amount contractually due to an employee under his employment contract up to the date of the termination of his contract, such as salary, will be subject to Salaries Tax.

However, long service pay calculated in accordance with the Employment Ordinance is non taxable if there has been an actual termination of employment by the employer.

Salary in lieu of notice
Employers who terminate an employee's employment contract often ask the employee to leave immediately, without working his notice period, and pay the employee his contractual remuneration for the unworked notice period. Such payments, or "Salary in lieu of notice", are non taxable if the employee provides no services to the employer in the notice period.

If a payment is described as salary in lieu of notice, but is for a period exceeding the notice period, the additional amount is taxable.

Compensation for loss of office
Termination payments that are neither contractual, nor a reward for services, whether past, present or future, but which represent liquidated damages or "compensation for loss of office" due to the breach of the employment contract by the employer, are non taxable.

Proper identification and documentation
Where a termination payment includes one or more of the above types of payment it is important to separately identify and document each payment, if salary in lieu of notice or compensation for loss of office is to be accepted as non taxable by the Inland Revenue Department ("IRD"). Failing which, the employee may not be able to discharge the burden of proof that the compensation for loss of office is non taxable, and the IRD will tax the entire termination payment.

When an employee resigns voluntarily there is no reason for the employer to pay the employee compensation for loss of office and any termination payments made by the employer will be taxable unless it represents salary in lieu of notice. However, where a "resignation" is not voluntary, but is a termination of employment at the request of the employer, the rules regarding compensation for loss of office apply.

Payments by an employee
Where an employee resigns and does not wish to work his contractual notice period, he may offer to pay the employer in lieu of notice.

In the Board of Review case D124/02, the taxpayer resigned from his employment with Co A to take up employment with Co B, and wished to leave Co A immediately. The employee was required to pay Co A three months salary in lieu of notice of $260,477. However, Co B paid $243,780 to Co A on the employee's behalf and the employee paid the balance of $16,697.

The Board held that the taxpayer was subject to Salaries Tax on the $243,780 paid by Co B, as Co B had discharged the taxpayer's personal liability to Co A. The Board also held that the payment of $16,697 by the taxpayer was not wholly, exclusively and necessarily incurred in the production of his assessable income and was therefore not deductible.

Summary
The nature of payments made on the termination of employment can vary according to the particular circumstances of each termination. To achieve the most tax efficient treatment, each part of the payment should be identified, reviewed and documented.