According to the relevant provisions of the current laws and regulations, enterprises usually need to pay compensation to employees who they want to terminate or dismiss their labor relations. What’s more, if enterprises dismiss labor relations illegally, they may have to pay indemnity to employees. This article will focus on the compensation and indemnities and the relevant taxation issues when enterprises terminate or dismiss labor relations with their employees.

It should be noted that tax reduction or exemption shall follow the statutory principles. Therefore, employees shall pay individual income tax for the compensation or indemnities they receive in accordance with relevant provisions if there are no preferential policies to reduce or exempt such tax. The current preferential tax policies relating to this are mainly provided for in the Circular on Issues concerning the Connection of Relevant Preferential Policies after the Revision of the Law on Individual Income Tax (Cai Shui [2018] No.164), and the applicability of it shall be considered from the following two circumstances:

1. Dissolution of Labor Relations 

From the perspective of the relevant provisions of Labor Law, the dissolution of a labor relations includes 3 situations: cancellation by mutual agreement, cancellation by the employee, and unilateral cancellation by the company. It usually occurs before the expiration of the labor contract and enterprises shall bear the payment obligations of corresponding compensation or indemnities, which are different in nature, in accordance with relevant provisions of Labor Law. From the perspective of finance and taxation, there is no distinction between compensation or indemnity, instead, such payments have been summarized as the circumstance of " dissolution of labor relations" to clarify the tax obligations. 

According to Clause 1 of Article 5 of the Circular on Issues concerning the Connection of Relevant Preferential Policies after the Revision of the Law on Individual Income Tax (Cai Shui [2018] No.164), "One-Time compensatory received by individuals from the termination of labor relations with their employer (including the economic compensation issued by the employing units, living subsidies, and other subsidies), and if the amount of their compensation is within 3 times the amount of the local annual average wages of last year, then it shall be exempted from the individual income tax. The exceeding part shall be subjected to the taxable individual income and shall be considered separately from the consolidated annual income tax calculation."

2. Termination Upon the Expiration of Labor Contract Terms

It should be noted that dissolution of labor relations and termination of labor contract are different legal concepts. Termination of labor contract upon the expiration of labor contract date generally includes situations including: the expiration of the labor contract, employees starting to enjoy basic pension insurance benefits in accordance with the law, employees passing away or are declared dead or missing by one of the People’s Courts of China, a company is declared bankrupt in accordance with the law, a company’s business licenses is revoked, a company is ordered to close down, or a company decides to dissolve in advance, as well as other circumstances prescribed by laws and administrative regulations. 

The policy of reducing and exempting individual income tax on a one-time compensation income obtained due to the dissolution of labor relations involved in the aforementioned preferential tax policies is based on the termination of activities between individuals and employers. The aforesaid preferential tax policies could not apply to the circumstance that the parties do not renew the labor contract upon expiration. The income received by employees due to termination of labor contracts upon expiration shall be calculated and paid on the basis of the wages and salaries in the month in the current month. 

D'Andrea & Partners Legal Counsel and PHC Advisory Tax & Accounting (companies of DP Group) offer full-scale legal compliance, tax advisory support and consultancy to address any concerns related to this issue. If you are interested, please feel free to contact us at info@dpgroup.biz.