Tax benefits

One big tax loophole that the Government left open in today's budget is the Housing Loophole - as a result, Hong Kong taxes people not on the basis of how much they are paid, but how they are paid. A person who would otherwise reach the top rate of 16% can cut that to just 6.87%, with the employer's co-operation. We take you through the numbers.

Tax Benefits
10th March 2004

One of the things that Financial Secretary Henry Tang could have done in today's budget, but didn't, was to start taxing employees on the basis of how much they are paid rather than how they are paid.

This is a subtle but key point. For a salaries tax system to be fair, it should require two individuals, who receive remuneration of identical value but in different forms, to pay the same amount of tax. That's not the case in HK, where the tax an employee pays depends more on how they are paid, not how much they are paid.

The Inland Revenue Ordinance has a specific provision in Section 9 that any housing which is paid for by an employer is deemed for tax purposes to be worth 10% of the employee's other cash remuneration (net of deductions). This is regardless of whether you are living in a mansion or a hovel - the taxable value bears absolutely no relationship to the value of the property. It results in a discriminatory tax system in which those who are provided housing pay far less tax than those who receive the equivalent in cash. Such arrangements tend to favour high income workers who would otherwise pay up to 20% on the incremental value.

Why deem the value to be 10% of salary? We have no idea. Perhaps back in the distant past, it was thought that nobody would spend more than about 10% of their income on housing, but that is surely not the case now. For many, the figure is probably closer to 50%.

Salaries Tax overview

HK has a system of staggered income tax rates which begins at 2% and rises to 20% (rates for 2004/05), but subject to a cap of 16% of "net total income" (after deductions but before allowances). After allowances, for anyone with taxable income over $90k, the first $90k per year is taxed at 8% and anything above that is taxed at 20%, subject to the 16% overall cap.

Each person has an allowance of $100,000 of tax-free income per annum, and married couples can allocate their combined $200,000 in the most tax-efficient manner. There are also various allowances for dependent children, parents, grandparents and siblings.

Webb-site.com has derived a simple formula to determine the point at which the tax rate levels out at 16%:

For example, a married person with 2 children would have to earn $1.582m per year (or just under $132k per month) in top-line income (including employee's MPF contributions) before reaching the 16% tax rate on his pay.

The Housing Loophole

To illustrate our case, let's take two persons, Worker A and Worker B. Each does the same job as a senior manager in competing companies, each is married with two children, and his or her spouse doesn't have any income. Each worker can claim total allowances of $200k for the couple and $60k for the children, total $260k. He or she can also deduct the $12k per year put into the mandatory provident fund (5% of the first $20k of each monthly salary) before calculating taxable income.

Worker A is given $132k per month, but Worker B is given $66,000 per month, and provided with housing worth another $66,000 per month. Then his housing would only be taxed as 10% of his income (net of MPF), or $6,500 per month. His assessable income would be $71,500 per month instead of $131,000 per month, saving him 20% of the difference in tax.

HK$	Worker A	Worker B
Monthly salary	132,000	66,000
Monthly housing benefit	0	66,000
Total monthly remuneration	132,000	132,000
MPF deduction	-1,000	-1,000
Value of housing	0	6,500
Assessable monthly income	131,000	71,500
Total annual remuneration	1,584,000	1,584,000
Annual tax	251,520	108,800
Effective tax rate	16.00%	6.87%

Yes, it's true. Worker B pays the same tax that someone earning just $72,500 per month would pay, all because of the Housing Loophole, and Worker B pays only 43% of the tax paid by Worker A, even though both are doing the same job for the same remuneration.

In fact, if a married worker with two children is able to take half his income as housing, then he would not pay his highest rate of tax until he earns $2.876m per year, or say $240k per month, including living in a home costing $120k per month. That would put him in a large house somewhere on the Peak. And his tax bill would be just $251,328, or 8.73% of his compensation.

Furthermore, the 16% cap on the tax rate effectively reduces the marginal rate of tax above the threshold, because the 20% tax rate ceases to have effect. So if he gets another $1 added to housing and $1 added to salary, then the deemed income is $1.10, taxed at 16% for an effective tax rate of only 8.8% on the increase. What this means is that someone who gets half their compensation in housing will never pay more than 8.8% in effective tax rate.

The system also allows a lot of lower-income people to escape the tax net altogether, but only if the employer co-operates. For example, a married person with two children earning $20k per month and receiving $20k in housing would have a total compensation of $480k but pay no tax, but a person earning the same amount in cash would pay tax of $30,800, or 6.42%, almost the same rate as our high-income Worker B above, who earns 3.3 times as much.

So why do they keep the system?

Why does the government persist with this scheme? There are several possible reasons (apart from the obvious ones - incompetence or laziness):

Other untaxed benefits

The Government has also not been taxing any benefit so long as it cannot be converted to cash and does not settle an obligation of the employee. So if you are provided with use of a company car (but not given the car), or if the employer puts utility bills of the home in its name and pays them, then those are tax free too. This is also unfair and discriminatory.

Recommendation

We don't have figures on how much income is declared each year as housing benefit, but it is a fair bet that the majority of medium and high earners structure their pay in this way. Government should close the Housing Loophole by taxing housing and all other employment benefits at their fair market value. In the case of housing, this should either be the rent paid (including any management fees and rates), or the rateable value assessed by the Rating and Valuation Department, whichever is higher.

If all employment benefits were taxed at their fair value, then the Government would have substantially higher income without raising salaries tax rates at all, and could even afford to lower the rates over time.

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Tax Benefits 10th March 2004

Salaries Tax overview

The Housing Loophole

So why do they keep the system?

Other untaxed benefits

Recommendation

Tax Benefits
10th March 2004