If a taxpayer employed in Hong Kong performs services within and outside Hong Kong during the relevant period, how should his income be allocated as taxable income for salaries tax purposes in the absence of any contractual allocation of services within and outside Hong Kong?

In May 2022, the Court of Appeals ruled that the IRD’s appeal was partially allowed and the case was remanded to the Board of Tax Appeals.

Background

The Commissioner Of Inland Revenue v Lo Wa Ming Patrick

For the year of assessment 2014/15, the taxpayer was an employee of a Hong Kong limited company and during an 8-month period from August 2014 to March 2015, the taxpayer was repeatedly seconded to an associated company in Guangdong Province but continued to be employed by the said Hong Kong limited company. During the secondment period, the taxpayer was required to return to Hong Kong from time to time to perform duties such as attending meetings, reporting to the management and supporting work, etc. The above duties were part of his secondment. According to the employment contract, the taxpayer is entitled to paid rest days during weekends and PRC public holidays, and annual leave. He will return to Hong Kong for vacation during the holiday period.

The taxpayer’s entire salary during the period of secondment is subject to personal income tax in the PRC, and he has paid such tax.

However, the IRD applies the “day in, day out” principle by applying the ratio of the number of days the taxpayer spends in the PRC in each month to the number of days in that month to determine the proportion of the taxpayer’s monthly salary that is exempt under section 8(1A)(c) of the IRO. The ratio of monthly salary exempted under section 8(1A)(c) of the IRS.

The taxpayer appealed the IRB’s decision to the Board of Tax Appeals. The Board did not apply the “day-to-day” principle and adopted a different allocation. The Board calculates the number of days per month that a taxpayer performs services in Hong Kong, and the remaining days of the month are considered to be the number of days that the taxpayer performs services in the PRC. The number of days of service performed in China in each month, as a percentage of the number of days in that month, is the percentage exempted for that month.

IRD filed an appeal with the Court of First Instance, but the appeal was denied. IRD appealed the decision to the Court of Appeal.

Controversy

Section 8(1A)(c) of the IRO was enacted to reduce double taxation. Under certain specified conditions, a person is not liable to salaries tax on income derived from services rendered in any territory outside Hong Kong. But in the absence of any contractual allocation of inland and outland services, how should that person’s income be allocated as assessable income for the purposes of salaries tax?

The Court of Appeal’s decision

In considering this case, the Court of Appeal analyzed four time allocation methods to calculate the relevant income to be excluded:

Based on the number of days the taxpayer worked outside Hong Kong

Under section 9(1)(a) of the IRO, vacation pay should be included in employment income. Therefore, under section 8(1A)(c) of the IRO, there is no reason to consider that income derived from services rendered outside Hong Kong should exclude any paid leave as an incentive for such services. The Court of Appeal therefore did not accept that only the number of days the taxpayer worked outside Hong Kong should be used to calculate the relevant income that should be excluded from tax;

Counting the number of days the taxpayer worked within Hong Kong

This approach did not take into account paid leave attributable to services rendered by the taxpayer in Hong Kong. The Court of First Instance also erroneously held that all paid leave was granted on the basis of services rendered by the taxpayer in the PRC, but there is no factual basis for this assertion;

The number of days the taxpayer stayed outside of Hong Kong is counted regardless of whether it is a working day or not

The underlying assumption of this approach is that the taxpayer’s presence in Hong Kong on a particular day only means that income from that day cannot be excluded. The absence of the taxpayer from Hong Kong means that the income on that day is derived from services rendered outside Hong Kong by the taxpayer. Under this assumption, the taxpayer would be subject to Hong Kong salaries tax on all vacation pay because he was on vacation in Hong Kong; conversely, another employee on vacation outside of Hong Kong could claim an exclusion of his paid vacation from his taxable income for salaries tax purposes. This assumption has the potential to cause injustice;

The number of days the taxpayer worked outside Hong Kong, together with the number of days of paid leave attributable thereto, is taken into account

Although the taxpayer does not perform services for the company during the leave period, the pay for the leave period is effectively a reward for the services performed by the taxpayer on other days. Therefore, the pay for the vacation period is also income received for services rendered by the taxpayer. This approach is consistent with the wording of section 8(1A)(c) of the IRO.

For the above reasons, the Court of Appeal allowed the IRD’s appeal. The Court of Appeal held that the Board of Review did commit an error of law in invoking the above-mentioned method of time allocation No. 2. In applying the “day-after-day” principle, the IRS could have led to arbitrary and unjust results.

The Court of Appeal considered that the above-mentioned 4th method of time allocation was consistent with the wording of section 8(1A)(c) of the IRO. Which leave is attributable to services rendered outside Hong Kong by the taxpayer in each case remains a question of fact and the Court of Appeal cannot make any determination as to the method of time allocation. The case is remanded to the Board of Review for a determination of the allocation of days based on the fourth method of time allocation described above.

Conclusion

It should be noted that with effect from the year of assessment 2018/19, section 8(1A)(c) of the IRO will no longer apply to income derived from services rendered by a taxpayer in a territory with which Hong Kong has entered into a comprehensive avoidance of double taxation agreement or arrangement. Where a taxpayer derives income from the provision of services in the relevant territory, the taxpayer may claim a tax credit under section 50 of the IRO in respect of the foreign tax paid on the income. The taxpayer should keep clear and complete records and documentary proof of travel and stay in and out of Hong Kong for the purpose of claiming the foreign tax credit.

Companies or taxpayers should seek professional tax and legal advice where appropriate.