For many companies, providing rental reimbursement to employees as part of their pay has been normal practice for many years without any problems. It does not require any additional cost outlay by the company. The employee receives the same amount of pay each month but pays less tax than someone else earning the same who does not get rental reimbursement. Is this too good to be true? Well, as some taxpayers have found out to their cost, it is too good to be true if the employer does not provide the rental reimbursement correctly.
Rental reimbursement arrangements operated by companies in Hong Kong have largely gone unchallenged by the Inland Revenue Department (IRD) in the past. Such lack of IRD challenge and the fact that so many other companies are doing the same thing has lured employers into a false sense of security about the arrangements they operate. Employers and employees continue to report the arrangements to the IRD as though they are effective for tax purposes and the employee enjoys often quite substantial tax advantages as a result.
Consider for a minute the implications of the IRD successfully challenging your housing benefit arrangements. As well as the additional tax going back as many as six tax years for the taxpayer and the possible penalties imposed by the IRD against both the taxpayer and employer for filing incorrect returns, the employer is also going to face some significant staff morale issues.
In many cases, the arrangements are being rejected by the IRD for reasons that could be avoided simply by spending some time at the outset on proper planning and documentation.
What is the tax benefit?
The tax consequences of receiving housing benefits vary depending on how the benefit is provided. For example, payment of a cash housing allowance has no tax advantage, and such amounts are fully taxable even if part or all of the allowance is actually used against housing costs incurred. However, rent-free housing or rental reimbursements provided by an employer, if implemented appropriately, would be chargeable to tax based on a favourable deemed 'rental value'.
This notional rental value is calculated as a percentage of the employee's other taxable remuneration received during the period in which the accommodation was provided. For an apartment, the percentage is 10%. The actual amount of the rental costs incurred or reimbursed is ignored. However, where the rental value exceeds the rateable value of the residence, the rateable value may be used instead of the rental value.
To illustrate how this works and the tax savings that can result, let us look at an example. An individual with remuneration of HK$1,000,000 per annum resides in an apartment and pays rent of HK$400,000 per annum (with rates and management fees included in the rent charged) to a third-party landlord. Assuming a flat tax rate of 15% for simplicity, the table below compares the tax liability of this individual if:
- the individual does not receive any housing benefit from the employer, and;
- the individual receives HK$400,000 of the remuneration under an effective rental reimbursement arrangement from the employer for rental expenses incurred during the year.
Comparison of tax liability | (i) No Housing Benefit (HK$) | (ii) With Housing Benefit (HK$) |
Remuneration | 1,000,000 | 600,000 |
Rental value (10%) | 0 | 60,000 |
Total assessable income | 1,000,000 | 660,000 |
Tax payable (assume 15%) | 150,000 | 99,000 |
Tax saving | 51,000 |
Common pitfalls in rental reimbursement policies
As the Government continues to grapple with the budget deficit and seeks ways to bridge the gap, it seems inevitable that the IRD will step up efforts to enforce compliance with the tax legislation and maximise the collection of tax from companies and individuals.
In recent months, there has been a marked increase in the number of enquiries issued by the IRD to companies and individuals in relation to their rental reimbursement arrangements. In many cases, the IRD has found that the arrangements are not 'effective' for tax purposes and, as a result, has raised additional tax assessments on the amounts previously claimed as 'rental reimbursement'.
Whilst the following should not be considered as an exhaustive list of the common failings of rental reimbursement arrangements, these are the areas where the IRD is likely to focus its attention: -
No contractual entitlement to receive a rental reimbursement
In many cases, the terms and conditions of employment do not identify an amount that will be paid for rental reimbursement. If the contract does identify an amount to be paid for housing, often it is loosely described as a 'housing allowance', the inference from which is that the employee is free to spend the allowance (or not) as they see fit.
The 'rental reimbursement' is carved out from salary at the end of the tax year
The employer pays the employee their contractual salary each month and then reclassifies part of that salary as 'rental reimbursement' at the end of the tax year.
Insufficient or no supporting documentation to prove that the 'rent reimbursed' has actually been incurred by the employee
The IRD would expect the employee to provide the employer with a stamped tenancy agreement and rental receipts to support the rent reimbursed.
Lack of adequate control exercised by the employer over rent reimbursed to employees
Under the tax legislation, the rent must be reimbursed by the employer and therefore, as with any other expenses the employer reimburses, the IRD would expect the employer to be satisfied that the amount being reimbursed was actually incurred by the employee prior to the reimbursement being made.
Do any of the above arrangements or problems sound familiar? If so, you may be sitting on a tax time bomb just waiting to explode.
Ways to avoid the pitfalls
To avoid these common pitfalls, companies should clearly set out the administrative procedures and requirements under which rental reimbursement will be provided. Often it is easier to do this in a formal policy provided to all participating employees. Amongst other things, the policy would set out the responsibilities of the employer and the employee, what is allowed and what is not under the policy, what documentation needs to be provided, when to provide it and who to provide it to. As well as clarifying the administrative responsibilities for the employer and the employee, a formal policy will also make it easier to demonstrate to the IRD the controls applied by the company to the rental reimbursement arrangements.
It is equally important to ensure that the employee's entitlement to a specified amount of rental reimbursement is clearly documented in the terms and conditions of employment. This does not need to involve rewriting the employment contract but, instead, can be done as an addendum to the employment contract in a similar way to the annual pay review.
Once the arrangements have been established and implemented, the payroll and accounting procedures must accurately reflect the rental reimbursement arrangements. The amounts paid for salary and rental reimbursement should be clearly and separately identified on the payslip and in the company's books.
Although this article has focused largely on the pitfalls of rental reimbursement arrangements, it is important to remember that such arrangements can be provided tax efficiently. If you are not already providing housing benefits to your employees, it is certainly worth considering. But if you decide to do so or are already operating such an arrangement, it is imperative that it is done properly. If you get it wrong, the implications could be both costly and time consuming.
