If a company intends to CANCEL (解除) or TERMINATE (终止) a labor relationship with certain employees, the company may have to consider the right approach to cancel/terminate. Furthermore, the company may also be concerned about whether it needs to pay severance and how to calculate such severance.
According to the PRC Labor Contract Law, whether the company needs to pay severance would depend substantially on the reason of the cancellation/termination. For example, if an employee materially breaches company rules, or causes substantial loss to the company due to a serious breach of duty, the company may unilaterally CANCEL the labor contract without paying severance
On the other hand, if the company CANCELS the labor contract due to the employee’s incompetence, or material changes of objective circumstances (such as an M&A), the company needs to pay severance to employees with prior written notice of 30 days. At the same time, if the company TERMINATES the labor contract due to the expiration of a labor contract, the company needs to pay severance to the employee as well.
Generally speaking, the amount of severance is based on the number of years the employee has worked for the company multiplied by one-month of the average salary. When a company does pay severance, it should be noted that the tax payment will differ depending on whether the labor contract is being CANCELLED or TERMINATED.
If the labor contract is CANCELLED, the compensation should be divided into two parts when calculating and paying the individual income tax: the tax-free part and the taxed part.
1. The part not exceeding 3 times of the local average social salary of the previous year – shall be exempt from individual income tax.
Caishui  No. 157: The one-time compensation income (including economic compensation, living allowance and other subsidies paid by the employer) obtained by an individual due to the CANCELLATION of a labor relationship with the employer, which is within 3 times of the average salary of local employees in the previous year, shall be exempt from individual income tax;
2. The part exceeding 3 times of the local average salary of the previous year - individual income tax shall be levied according to the regulations.
Guo Shui Fa  No. 178: Considering the large amount of one-time economic compensation income obtained by individuals and the fact that the dismissed personnel may not have a fixed income for a period of time, the one-time economic compensation income obtained by individuals can be regarded as several months' wages and salaries, and shall therefore be averaged within a certain period.
If the labor contract is TERMINATED, the compensation will belong to other personal income related to employment, which shall be incorporated into the comprehensive income for calculation and collection of individual income tax and shall not enjoy the tax exemption policy.
The issue of labor contract cancellation/termination is quite common but may be complicated for companies in China. The correct understanding of laws would greatly assist the company to carry out proper cancellation/termination and avoid penalties. If you are interested in the topic and hope to know more, feel free to contact us by email: email@example.com.