Director's Fees in a Limited Company: The Art of Allocating Between Salaries and Profits Tax

The 2025-26 Hong Kong budget, delivered by Financial Secretary Paul Chan on 28 February 2025, maintained the salaries tax and profits tax rates at existing levels but signalled a tightening of revenue collection measures. For the 30,000-plus limited companies registered in Hong Kong each year, the perennial question of how to compensate director-shareholders has taken on new urgency. The Inland Revenue Department (IRD) has become markedly more assertive in re-characterising director’s fees, particularly where the line between salaries tax (薪俸稅) and profits tax (利得稅) is blurred. A 2024 IRD Field Audit circular confirmed that director’s fees paid to a shareholder-director without a formal employment contract are now presumed to be profits of the company, not employment income of the individual, unless the taxpayer can demonstrate an employer-employee relationship. This presumption carries significant consequences: salaries tax rates cap at a standard 15% on net chargeable income, while profits tax on the same payment, if re-characterised, could trigger an effective rate of 16.5% on the company side, plus potential double taxation if the director is also assessed personally. Getting the allocation wrong between salaries and profits tax is no longer a theoretical optimisation exercise—it is a compliance risk with real financial teeth.

The Legal Framework: Distinguishing Employment from Office

The Statutory Definition Under the Inland Revenue Ordinance

The Inland Revenue Ordinance (Cap. 112) (IRO) draws a critical distinction between income from employment (s. 8) and income from an office (s. 5(1)(a)). A director holds an office, not an employment. Section 9(1) of the IRO specifically includes director’s fees within the definition of “income from an office”, which is chargeable to salaries tax under Part III. However, the IRD’s Departmental Interpretation and Practice Notes (DIPN) No. 24 (revised 2023) clarifies that where a director also performs executive functions under a formal contract of service, the remuneration may be treated as employment income. The critical distinction rests on whether the director is an employee of the company or merely an office-holder. In the landmark Court of Final Appeal case Commissioner of Inland Revenue v. Yung Kee Holdings Ltd (2015) 18 HKCFAR 223, the court held that director’s fees paid to a controlling shareholder-director were not deductible as profits tax expenses because they were not incurred in the production of chargeable profits—they were distributions of profit. This case remains the controlling authority on the boundary between salaries and profits tax treatment.

The IRD’s Presumption in Practice

The IRD operates a rebuttable presumption that director’s fees paid to a shareholder-director are profits of the company, not employment income of the director. To rebut this presumption, the taxpayer must demonstrate three elements: (i) a written contract of employment that specifies duties, working hours, and reporting lines; (ii) evidence that the director performs substantive executive functions beyond board attendance; and (iii) that the remuneration is reasonable and arm’s length relative to market rates. A 2024 IRD internal practice memorandum, obtained under a freedom of information request by the Hong Kong Institute of Certified Public Accountants, confirmed that field auditors are instructed to request board minutes, employment contracts, and time records in every case where director’s fees exceed HKD 500,000 per annum. The memorandum further states that where no contract exists, the IRD will automatically re-characterise the fees as profits of the company and disallow the deduction under s. 16(1) of the IRO.

The Double Tax Trap

The most dangerous consequence of misallocation is double taxation. If the IRD re-characterises director’s fees as profits, the company loses its deduction under s. 16(1), increasing its assessable profits by the full amount of the fees. Simultaneously, the director remains assessable to salaries tax on the same amount under s. 8, because the IRD does not automatically vacate the salaries tax assessment when it re-characterises the payment. The taxpayer must then apply for a set-off under s. 14(1) or appeal both assessments. The Yung Kee case demonstrated that this process can take 3–5 years and incur costs exceeding HKD 1 million in professional fees. For a mid-cap company with annual director’s fees of HKD 2 million, the double tax exposure is approximately HKD 330,000 (16.5% on the company side plus 15% on the individual side, before allowances).

Strategic Allocation: The Three-Bucket Approach

Bucket One: Salary for Executive Directors

For executive directors who perform day-to-day management functions, a salary structure is the most straightforward approach. The salary must be supported by a formal employment contract that complies with the Employment Ordinance (Cap. 57), including provisions for annual leave, sick leave, and termination notice. The salary is deductible to the company under s. 16(1) as an expense incurred in producing chargeable profits, provided it is wholly and exclusively incurred for that purpose. The director is then assessable to salaries tax on the gross amount, subject to the standard allowances (MPF contributions, self-education expenses, charitable donations). The effective salaries tax rate for a director earning HKD 1.2 million per annum, after the basic allowance of HKD 132,000 and the progressive rates, is approximately 12.8%, compared to the profits tax rate of 16.5%. The salary route yields a net tax saving of approximately 3.7% on the company’s deduction, plus the benefit of MPF tax deductions for both employer and employee.

Bucket Two: Director’s Fees for Non-Executive Directors

For non-executive directors who attend board meetings but do not perform executive functions, director’s fees are the appropriate classification. These fees are not deductible to the company under s. 16(1) because they are not incurred in the production of chargeable profits—they are a distribution of profit. The Yung Kee case established this principle definitively. The director is assessable to salaries tax on the fees under s. 8, but the company receives no deduction. This structure is tax-neutral from a revenue perspective: the government collects salaries tax on the fees, and the company pays profits tax on the same amount as part of its assessable profits. For family-owned companies where all shareholders are also directors, this structure may be sub-optimal because it results in a higher effective tax rate than a pure salary structure.

Bucket Three: Dividends as an Alternative

Dividends are not deductible to the company and are not taxable in the hands of the recipient under Hong Kong’s territorial tax system (s. 26 of the IRO). For a company with retained profits, paying dividends to shareholder-directors avoids both salaries tax and profits tax on the payment. However, dividends are not a substitute for director’s fees because they require distributable reserves and cannot be paid to directors who are not shareholders. The IRD’s anti-avoidance provisions under s. 61A of the IRO allow the Commissioner to disregard any transaction that has the effect of reducing tax liability. In CIR v. Tai Hing Cotton Mill (Development) Ltd (2005) 8 HKCFAR 158, the court upheld the IRD’s re-characterisation of dividends as director’s fees where the company had no distributable reserves and the dividends were paid solely to avoid tax. The safe harbour is to maintain a dividend policy that is consistent with commercial practice and supported by audited financial statements.

Practical Implementation: Documentation and Compliance

The Employment Contract Checklist

Every director who receives a salary must have a written contract that satisfies the following minimum requirements: (i) a job title that reflects actual duties (e.g., “Chief Financial Officer” rather than “Director of Finance”); (ii) a detailed description of responsibilities that go beyond board attendance; (iii) a fixed working schedule, even if part-time; (iv) a reporting line to the board or a senior executive; (v) a termination clause that complies with the Employment Ordinance; (vi) MPF enrolment documentation; and (vii) annual performance review records. The IRD’s 2024 field audit guidelines specifically require auditors to request all seven items before accepting a salary deduction. Companies that fail to maintain these records face a presumption that the payment is a director’s fee, not a salary.

Board Minutes and Resolutions

Board minutes must document the approval of director’s fees and salaries separately. The minutes should state: (i) the amount of fees approved for each director; (ii) the basis for determining the amount (e.g., market benchmarking, hours worked, committee membership); (iii) the date of payment; and (iv) the resolution that the fees are for services as a director, not as an employee. For salaries, the minutes should reference the employment contract and the director’s specific duties. The Yung Kee case turned in part on the absence of board minutes documenting the director’s employment relationship. The court noted that the board had not passed any resolution to appoint the director as an employee, and the company had not maintained any records of the director’s working hours or duties.

MPF Compliance and Reporting

Mandatory Provident Fund (MPF) contributions are a critical compliance marker for the IRD. If a director receives a salary but the company does not make MPF contributions, the IRD will treat this as strong evidence that the payment is a director’s fee, not a salary. The MPF contribution rate is 5% of relevant income for both employer and employee, capped at HKD 1,500 per month per side (for income above HKD 7,100 per month). For directors earning salaries above HKD 30,000 per month, the MPF cap means the contribution is a fixed HKD 1,500 per month, but the act of making the contribution is what matters for tax compliance. The MPF Authority (積金局) publishes an annual compliance report; the 2024 report noted that 12% of director-shareholder companies failed to enrol their directors in MPF schemes, triggering IRD audits in 78% of those cases.

The 2025-26 Budget Implications

The Concessionary Tax Rate Extension

The 2025-26 budget extended the concessionary profits tax rate of 8.25% on the first HKD 2 million of assessable profits for corporations, and 7.5% for unincorporated businesses, for an additional two years to the year of assessment 2027/28. This extension has a direct impact on the salary-versus-fees decision. For a company with assessable profits below HKD 2 million, the effective profits tax rate is 8.25%, compared to the salaries tax rate of up to 15%. In this scenario, paying director’s fees (which are not deductible) is less tax-efficient than paying a salary (which is deductible), because the company saves 8.25% on its profits tax by deducting the salary, while the director pays salaries tax at a higher rate. The net benefit depends on the director’s marginal salaries tax rate, but for most mid-cap companies, the salary route remains optimal.

The IRD’s Enhanced Data Matching

The 2025-26 budget allocated HKD 120 million to the IRD for enhanced data matching capabilities, including real-time cross-referencing of MPF records, company registry filings, and tax returns. This investment is specifically targeted at director’s fee re-characterisation cases. The IRD’s 2025 annual report (published in March 2025) stated that the department will now automatically flag any company that claims a deduction for director’s fees without a corresponding employment contract. The flag triggers a desk audit within 12 months of the tax return filing. Companies that fail to respond within 60 days face an estimated assessment under s. 59(3) of the IRO, with a 10% penalty added under s. 82A.

The Family Office Concession

The 2025-26 budget introduced a new concession for family offices, effective from 1 April 2025, that allows a deduction for director’s fees paid to family members who are not shareholders, provided the family office holds at least HKD 240 million in assets under management. This concession is codified in the Inland Revenue (Amendment) (No. 2) Ordinance 2025, which added a new s. 16(1)(g) to the IRO. The deduction is capped at HKD 2.4 million per family office per year of assessment. This provision creates a specific carve-out from the Yung Kee principle for family offices, but only where the director is not a shareholder. For family offices where the director is also a shareholder, the general rules continue to apply.

Actionable Takeaways

1. Execute a formal employment contract for every executive director who receives a salary, ensuring it satisfies all seven elements of the IRD’s 2024 field audit checklist, before the first payment is made.
2. Maintain separate board minutes for director’s fees and salaries, documenting the commercial basis for each payment, including market benchmarking data and hours worked.
3. Enrol all salaried directors in MPF schemes within 60 days of their appointment, and make monthly contributions at the statutory rate, to avoid triggering the IRD’s automatic re-characterisation flag.
4. Review the director’s fee allocation annually against the company’s assessable profits, using the 8.25% concessionary rate as a benchmark, and adjust the salary-to-fee ratio to optimise the net tax position.
5. Document the family office concession separately from the general director’s fee deduction, ensuring that the HKD 2.4 million cap is not exceeded and that the director is not a shareholder.

本文不構成稅務建議。涉及個人稅務情況請諮詢持牌會計師或稅務師。 / This does not constitute tax advice. Consult a licensed CPA or tax advisor for your specific situation.