Hong Kong Tax Alert: 29 August 2013

What qualifies as a refund of rent eligible for the preferential tax treatment?

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Two recent decisions of the Board of Review (BOR) concerned whether amounts received by taxpayers should be taxed preferentially as rent refunded, or taxed in full as cash allowances or salaries. 

These two cases indicate that the control exercised by an employer over the amount that an employee has spent on rental expenses will assist in substantiating the intention of the employer that payments are in respect of the refund of rent. 

In addition, the terms of employment governing the entitlement to housing benefit may also be important. While the terms of the taxpayers’ entitlement to the housing benefit in these two cases were very similar, the BOR in D34/12 held in favor of the taxpayer whilst the decision in D35/12 went against the taxpayer.   

Given the controversies surrounding the issues involved, in addition to exercising control over such payments, clients who operate rental reimbursement schemes with terms of employment similar to these two BOR cases should seek professional tax advice. 

The employment terms governing the housing benefit at issue 

D34/12 and D35/12 both concerned employees being paid a housing benefit capped at a certain amount. The amounts of rent claimed to have been incurred by the two employees in respect of their residence were less than the maximum amount of the housing benefit to which they were entitled under the terms of their employment. 

For tax purposes, both the employers and the employees treated the amount that actually covered the rental expenses as a rental refund (thus qualifying for the preferential tax treatment explained below) and the unutilized portion of the entitlement to the housing benefit as a cash allowance or salary to be taxed in full. 

The CIR however determined in both cases that the whole of the housing benefit paid should be taxed in full, contending that no part of it qualified as a refund of rent. 

The preferential tax treatment 

Where an employer pays an employee an amount intended to reimburse him for the rent he has incurred in respect of his residence, the amount paid is not taxed in full as a cash allowance or salary.  Instead, regardless of the actual amount paid, such housing benefit in the form of a rental refund is taxed preferentially, generally at 10% of the other relevant taxable remuneration of the employee.

Where an employer pays an employee an amount regardless of whether the employee has actually incurred rent in respect of his residence, the amount is taxed in full as a cash allowance or salary. 

Case D34/12

Was there a legally binding tenancy agreement and was rent actually paid?

The taxpayer leased a flat as his family residence from his wife. The CIR contended that given the relationship, there was no intention to create a legally binding tenancy agreement between the taxpayer and his wife.

In addition to noting certain unusual terms and inconsistencies contained in the tenancy agreement, the CIR also contended that there was no actual payment of rent by the taxpayer to his wife. In particular, the CIR noted that the monies paid, being paid on dates different from the dates stipulated in the tenancy agreement and in amounts different from those appearing in the tenancy agreement, could have simply been household expenses paid by the taxpayer to his wife.  

The BOR however found the taxpayer and his wife to be honest and credible witnesses. The BOR accepted the taxpayer’s explanation that the inconsistencies contained in the tenancy agreement were caused by oversights arising due to the adoption of a standard tenancy agreement which did not reflect the true terms of their leasing arrangement. 

Given their relationship, the BOR also accepted the taxpayer’s explanation that he paid rent to his wife every two months and the payment was lumped together with other types of payment. 

The BOR therefore held that there was a legally binding tenancy agreement and rent was actually paid. 

Did the employer intend that the amount be a refund of rent?

The BOR held that the amount that covered the rental expenses qualified as the refund of rent eligible for the preferential tax treatment. As a result, only the unutilized portion of the housing benefit was to be taxed in full as a cash allowance or salary.

The BOR reasoned that because the employer had exercised control over whether and how much the employee spent on leasing his residence, it proved that the intention of the employer at the relevant time was to pay the amount as a refund of rent.

In this regard, the BOR noted that the employer required, and the employee did submit, declaration forms, a duly stamped tenancy agreement and rental and other relevant receipts at the appropriate time in order to substantiate the claim for the rent refund.

Case D35/12

Was there a legally binding tenancy agreement and was rent actually paid?

The taxpayer leased a flat from her mother as her residence. Based on the evidence given by the taxpayer, the BOR panel, which was constituted differently from the one in D34/12, was not convinced that there was a legally binding tenancy agreement and rent was actually paid by the taxpayer to her mother.

The BOR noted that one of the purported tenancy agreements was undated and unstamped and was generally inadmissible as evidence. The others were entered into either after or shortly before the expiry of the term of the tenancy.

In addition, the sums and dates upon which payments were made by the taxpayer to her mother differed from the amounts and dates specified for the monthly payment of rent under the tenancy agreements.

The BOR also found that the rental receipts, some being issued prior to the payment of the alleged rent, were not contemporaneous records. The BOR also noted that it appeared unusual that the period covered by certain of the tenancy agreements coincided exactly with the taxpayer’s date of commencement or termination of employment. As such, the BOR held that any sum paid by the taxpayer to her mother was not rent and could well be maintenance contribution or household expenses.  

Given the findings above, the BOR could have simply dismissed the taxpayer’s case and held that the amount claimed could not be regarded as a refund of rent because no rent was actually paid.  Nonetheless, in the event that their decision was incorrect and the taxpayer had paid rent, the BOR went on to consider whether the amount claimed might be treated as rent refund for tax purposes. 

Did the employer intend that the amount be a refund of rent?

The BOR found that there was no evidence that the taxpayer had submitted the relevant tenancy agreements to the employer upon her participation in the rental reimbursement scheme as required by the relevant staff manual covering the operation of the scheme. Nor was the BOR satisfied that the employer made the payment on the basis of rental receipts produced by the taxpayer.

Based on these findings, the BOR held that the employer did not intend the amount involved to be a refund of rent, the employer having exercised no control over whether and how much was spent by the taxpayer on rental expenses.

In this regard, the BOR also noted that under the terms of the employment, the taxpayer would be paid the maximum amount of her housing entitlement regardless of whether she paid rent, any amount unutilized as a rental refund being paid as a cash allowance or salary. The BOR concluded that by reference to the terms of the employment, the taxpayer was entitled to receive, and her employer was obliged to pay, the amount claimed as a rental refund irrespective of how much rent she had actually paid, or whether she had paid any rent at all.

On the above basis, the BOR held that even if rent was paid by the taxpayer to her mother, the amount involved did not qualify as a rental refund for tax purposes.

Commentary

Taxpayers who pay rent to connected persons for their residence should ensure that the terms of the tenancy agreement, duly stamped, are reasonable and commercial and contemporaneously record the intention of the parties concerned. In addition, all the stated terms therein should be duly observed if taxpayers are to avoid the challenges mounted by the CIR in these two cases.  

Furthermore, in order to assist in arguing that an employer intends to pay an amount as a rent refund, the employer should exercise control over whether and how much the employee spends on rent before the employer reimburses the same to the employee. 

In addition, the terms of employment governing an employee’s entitlement to the housing benefit may also be important. 

In this regard, the court decision in CIR v Peter Leslie Page may be illustrative. Mr. Recorder Edward Chan SC stated in the aforesaid court decision that “…the arrangement between [the taxpayer] and the employer was such that he was entitled to the same housing benefit even if he did not rent any property or rented a property at a rent lower than the [maximum] amount of housing benefit…In such circumstances, it would be difficult to see how the housing benefit received by him [which was actually less than the rental expenses incurred by the taxpayer] could be a rental refund..”

While the terms of employment of the two taxpayers as regards the housing benefit in these two cases were very similar, the decisions of the two BOR panels, each with different members, were different.  

In D35/12, following the Peter Leslie Page decision, the BOR appeared to indicate that the relevant amount could not be a rental refund because the taxpayer was entitled to receive the maximum amount of her housing entitlement in any case (i.e., any amount unutilized as a rental refund was to be paid as a cash allowance or salary). 

However, the BOR in D34/12 did not take the approach adopted by the BOR in D35/12. The BOR in D34/12 distinguished the facts of the case from those of Peter Leslie Page, noting that the employer in the court case did not exercise any control over whether and how much of the amount was spent by the taxpayer on leasing his residence.

The BOR then held that because the employer in D34/12 had exercised control over the amount that the taxpayer had spent on housing expenses, the amount paid can be regarded as a rental refund. 

In this regard, the BOR in D34/12 does not appear to have specifically addressed the issue that based on the terms of the employment, the employee would receive the same remuneration whether by way of a rental refund where he had paid rent, or as a cash allowance or salary where he had not paid rent. 

Given the controversies surrounding the issues involved, in addition to exercising control over such payments, clients who operate rental reimbursement schemes with terms of employment similar to these two BOR cases should seek professional tax advice.