06 September 2015

Individual Income Tax Considerations for Equity Incentive Plans

This article was written by Tony Dong(Partner) Daisy Duan(Partner) and Philip Liu(Associate)

Equity incentive plans are a long-term incentive mechanism adopted by enterprises to motivate and retain their core talent. Enterprises conditionally provide incentives to participants by way of a shareholding or a right to a shareholding or other interest related to the business. By sharing the growth in earnings and value of the enterprise, participants are expected to increase their focus on growing the business and to continue to be employed by the enterprise. Since equity incentive plans aim to offer conditional payments to participants by means of specific arrangements, individual income tax (IIT) is a major consideration in their implementation. These plans not only affect the after-tax income of participants, but are an important tax compliance matter for enterprises in their role as statutory tax withholding agents.

Current PRC tax laws treat non-listed and listed companies differently in regard to the IIT treatment of income derived from equity incentive plans. For non-listed companies tax rules are not detailed and contain no explicit but only in principle provisions relating to incentive plans, while regulations for listed companies are relatively detailed in addressing both processes and substance, and expressly provide that an IIT calculation method may be eligible for preferential treatment if certain conditions are met. In this article, we will discuss IIT treatment and related issues in relation to the equity incentive plans of both non-listed and listed companies.

IIT considerations for equity incentive in non-listed companies

Since the equity value of non-listed companies is not set by an open market nor regulated by the rules of a security exchange market, the forms and pricing methods of the equity incentive plans are flexible. When implementing equity incentive plans, non-listed companies and incentivized individuals should take the following tax issues into consideration.

1. General tax treatment of equity incentive plans of non-listed companies

Equity incentive arrangements of non-listed companies may include the direct granting of equities, stock options, virtual equities, equity appreciation rights or similar arrangements which may be devised and implemented based on the specific circumstances of each company. From a tax perspective, the equity incentive plans of non-listed companies can be placed in three categories:

  • Direct shareholding: to directly grant or sell equities to participants at a low price;
  • Options: to give participants a right to purchase equities at an agreed price (or for free) at a date in the future, such as a stock option scheme.; and
  • Virtual equity: to give participants a return (usually in cash) based on the growth of an index which reflects the equity value or other financial data of the company, for example an equity appreciation right.

Current China tax law does not provide specific IIT treatment for these incentive plans implemented by non-listed companies. The salient points of Individual Income Tax Law and Circular Guoshuifa [1998] No. 9 (Circular 9), are:

  • Taxable income of a participant shall include cash and non-cash income; therefore individuals will be subject to IIT when they receive cash or equity income from equity incentive plans. However, participants will not be subject to IIT payment liability when they are only entitled to rights to obtain certain cash or non-cash income (e.g. an equity option) in the future instead of actually receiving cash or non-cash income;
  • Income in all forms received in connection with a position held in a company or an employment relationship with a company is deemed to be "wage and salary income" for IIT purpose. Therefore cash or equity income earnt from an equity incentive plan is in the nature of monthly wage and salary income which is subject to progressive IIT rates ranging from 3%-45%;
  • For non-cash income (e.g. equity), taxable income is to be calculated by the equity value agreed by both parties; if the equity value is undetermined or determined at an obviously low price, the tax authority may set or adjust the taxable income according to the fair market value of the equity;
  • When a participant sells equities obtained in accordance with an equity incentive plan, it is subject to IIT for the income derived from the equities transfer as “income from the transfer of property”, and the IIT rate is 20%;
  • The company implementing an equity incentive plan must withhold and pay IIT for a participant’s income in the nature of a wage and salary.

When implementing equity incentive plans, companies should bear these principles in mind when considering the IIT liabilities of the participants.

2. IIT calculation: applicability of preferential IIT calculation method

As mentioned above, companies implementing equity incentive plans must calculate participants’ IIT liabilities and must withhold IIT when participants receive their wage and salary income from the plan. In general, income of participants must be calculated as monthly income which is subject to progressive IIT rates ranging from 3%-45%.

It is worth noting that Circular 9 also provides that when calculating the IIT liability on the discounts or subsidies granted by employers to employees for their subscription to equities and other securities, if employees find it difficult to pay a large amount of tax arising from fully computing such income into their monthly wage income, then the tax authority may approve the spreading of that income over up to six months from the date of receipt of the securities. Since the amount of income from an equity incentive plan can be large, it is possible to reduce the applicable tax rate of each month, and thus reduce the tax burden if the income is allocated evenly over six months.

However, there are different understandings in practice about whether the said provisions of Circular 9 are applicable to the equity incentive plans of non-listed companies. For instance, although Circular 9 does not expressly restrict its application to listed companies, the objects listed in Circular 9 are “stocks” or “securities”, which usually do not include equities of non-listed companies in the context of China’s tax laws. Moreover, Circular Guoshuihan [2009] No. 461 (Circular 461) provides a preferential tax calculation method which does not apply to income that is obtained by employees from equity incentive plans of non-listed companies; such income must be included in their current monthly income. These points are used in practice by some tax authorities to disallow the preferential tax calculation method in Circular 9. Therefore, although Circular 9 is still an effective tax regulation in China, we suggest that when implementing an equity incentive plan companies should seek confirmation from the relevant tax authority on the applicability of Circular 9.

The State Administration of Taxation (SAT) official response on the Alibaba Case in Guoshuihan [2007] No. 1030 was that the IIT on the wage and salary income received by employees from equity options of non-listed companies can be calculated by the year-end bonus[1] method. As Guoshuihan [2007] No. 1030 expired after 2011, there is no longer a legal basis to use this method to calculate the income from an equity incentive plan in terms of the year-end bonus. In our experience, some tax authorities still accept the application of the year-end bonus method to calculate income from an equity incentive, but pursuant to relevant tax regulations, this calculation method can only be applied once in a tax year per taxpayer. As a result, if it is used for an equity incentive tax calculation, the preferential calculation method cannot be applied to any other bonus received by the taxpayer in that year.

IIT considerations for equity incentives of listed companies

Unlike equities of non-listed companies, equities of listed companies are bought and sold in public markets. The selling price is publicized, and listed companies are regulated by the rules of securities exchange markets. The types and details of equity incentive plans of listed companies are laid out explicitly and tax laws also stipulate clearly the IIT treatment of the income of employees from the stock incentive plans of listed companies (including overseas listed companies).

The China tax regime’s regulations including Circular Caishui [2005] No. 35 (Circular 35), Circular Caishui [2006] No. 902 (Circular 902), Circular Caishui [2009] No. 5 (Circular 5), and Circular 461, etc. together form a complete system of IIT treatment of the income of employees received from stock incentive plans of listed companies. In summary the basic principles of IIT on the income of three common types of stock incentive plans are:  

           

Type of stock incentive

Concept

IIT liabilities at different stages (applicable taxable item)

Granted

Exercised/ released

Transfer of acquired stocks

Stock option

A right granted by a listed company to its employees to subscribe for certain shares of the company at a specific price within a period ahead.

None

Wage and salary income (tax rate: 3% - 45%)

Income from transfer of property (tax rate: 20%)

Stock appreciation right

The right granted by a listed company to its employees, to receive the value of a future price rise of a prescribed number of shares and under agreed conditions. When an employee exercises the right, the company pays to the employee an amount equivalent to the difference between the stock price on the exercise date  and the stock price on the grant date multiplied by the prescribed number of shares.

None

Wage and salary income (tax rate: 3% - 45%)

N/A

Restricted stock

Refers to a prescribed number of shares which a listed company grants to employees under conditions set out in an equity incentive plan.

None

Wage and salary income (tax rate: 3% - 45%)

Income from transfer of property (tax rate: 20%)

The principles for IIT on the income received from the stock incentive plans of listed companies are similar to those of non-listed companies:

  • Individuals who participate in stock incentive plans but have not obtained any actual income (including cash and non-cash income) have no IIT liability;
  • Individuals who participate in stock incentive plans and obtain actual income (including cash and non-cash earnings, such as from excising stock options or stock appreciation rights, or from the release of restricted stock) shall declare their income as “wage and salary income” and adopt the progressive tax rate ranging from 3% to 45% (the preferential calculation method may be applicable if the conditions can be satisfied, see below for details);
  • When the individuals re-transfer their stock obtained from stock incentive plans in the future, the income from such transfer shall incur tax at the rate of 20%[2] as an “income from transfer of property” (Since individual income from the transfer of stock of domestic listed companies is exempted from IIT[3] , such tax treatment is only applicable to the stock incentive plans of overseas listed companies).

Unlike non-listed companies, since the stock price of listed companies is open and transparent, the regulations clearly stipulate the applicable market price used for calculating the tax payable at different stages. Moreover, the regulations provide that where certain substantive and procedural requirements are met, the wage and salary income of employees received from stock incentive plans of listed companies may be eligible for application of the preferential calculation method. Therefore, listed companies or domestic subsidiaries of overseas listed companies are advised to pay special attention to the following points when dealing with the IIT assessment of stock incentive plans:

1. Application of preferential IIT calculation method

Circular 461 provides that the preferential IIT calculation method can be used for the employees of a listed company and enterprises it controls while the listed company holds at least a 30% of the shares[4]. Therefore, as long as overseas listed companies hold more than 30% of the shares of a domestic subsidiary, the preferential IIT calculation method can be applied to the income of global employees from a stock incentive plan. Domestic companies implementing incentive plans must submit the information necessary in order to apply the preferential IIT calculation method.

The preferential IIT calculation method permits wage or salary income obtained from the exercising of share options or share appreciation rights or the releasing of restricted shares in certain months to be segregated from regular wage or salary income, and a tax rate to be determined by the quotient of dividing taxable income by “prescribed number of months”. "Prescribed number of months" refers to the number of months during which the employees worked in China and derived the option income; if the number of months as specified above is longer than 12 months, it will be calculated as 12 months.

For instance, assuming an employee has worked in a listed company for 5 years and participated in the company’s share incentive plan 2 years ago, he was granted 10,000 options at a price of RMB 25 per share and exercised options according to the incentive plan at the price of RMB 50 per share. Then,

Taxable income = (exercise price RMB 50 per share – grant price RMB 25 per share) × stock amount 10,000 shares = RMB 250,000

The resulting IIT payable by the general calculation and preferential calculation methods are as follows:

  • General IIT calculation method
    Share option income is included in current wage and salary income, regardless of other income
    IIT payable = (taxable income RMB 250,000 – standard deduction RMB 3,500) × applicable IIT rate 45% - quick calculation deduction RMB 13,505 = RMB 97,420
  • Preferential IIT calculation method
    Since the months during which the employee worked in China and derived the option income exceeded 12 months, the “prescribed number of months” is 12. Therefore, if the options meet the requirements of the preferential IIT calculation method, the applicable tax rate is 25% determined by dividing taxable income by 12 (RMB 20,833), with a quick calculation deduction of RMB 1,005. Therefore,
    IIT payable = (taxable income from exercising share option RMB 250,000 / prescribed number of months 12 × applicable tax rate 25% - quick calculation deduction RMB 1,005) × prescribed number of months = RMB 50,440

In this case, by using the preferential IIT calculation method, an individual can save RMB 46,980 (97,420 – 50,440) compared with using the general calculation method. The participant’s tax burden is significantly reduced and the incentive effects of the option improved accordingly.

2. Documentation

Domestic entities implementing incentive plans for listed companies must prepare documents and report to the tax authorities before the preferential calculation method can be adopted. The documentation obligations can be summarized in the following steps: The company must submit to the tax authorities:

  • Its share incentive plan or agreement and other related material prior to the implementation of the incentive plan (for restricted shares: within 15 days after the restricted shares are registered and a public announcement is made);
  • Such documents as a notice of option exercise or notice of adjustment of exercise price, prior to a right being exercised;
  • Detailed information about the shares concerned during the tax reporting period when the option or the share appreciation right was exercised or the restricted tax was released.

The regulations impose strict documentation obligations for implementing the share incentive plans of listed companies. These not only include reporting at several stages but also require multiple documents and information. Tax authorities are continuing to strengthen their administration of incentive plan documentation. For instance, some tax authorities at district level in Shanghai have already conducted ledger management to strengthen the supervision of the use of preferential IIT calculations. Based on our practical experience, documentation reporting faces the following challenges:

  • Timing: documents must be submitted to the tax authorities prior to the implementation of an option plan. However, it is difficult for most incentive plans, especially those of overseas listed companies to have the documents filed with Chinese tax authorities before their implementation. Usually it is not the company but the employees who determine the exercise timing, and it is after the conditions for exercising are met. Therefore it is also very difficult for companies to submit relevant documents to the tax authorities before a right is exercised;
  • The differences between the complete arrangements and recording of incentive plans and the requirements of document reporting: Circular 35 and Circular 461 specify the documents that need to be submitted at all stages; but since the arrangements of incentive plans of listed multinationals differ worldwide, they may not meet all document reporting requirements. In this new age of internet, the media of recording plans is more diverse and the form of information that tax authorities find acceptable may be a significant issue.

To meet these challenges, companies implementing incentive plans should liaise with and seek confirmation from tax authorities to ensure the application of the preferential IIT calculation method.

3. Proper tax planning of multiple share option exercises in a calendar year

It is worth noting that wages and salary income received from incentives in one calendar month is considered a single exercise. Wage and salary incomes from multiple option exercises in a calendar year, are combined before applying the preferential IIT calculation method. In other words, the tax liability will be the same no matter whether the individual exercises share options many times a year or just in one month.

If options have become exercisable, individuals can sometimes choose to exercise them in different tax years to take advantage of a lower tax rate. Companies can provide guidance to participants to help them understand the tax implications of exercising options, so as to maximize the incentive benefits.

4. Tax treatment of non-Chinese residents

For companies that implement share incentive plans especially overseas listed companies, the tax treatment of non-Chinese participants (e.g. foreign expatriates) needs careful handling.

In principle, taxation of wage and salary income is determined by the places where the work and services are rendered. Therefore, if a non-Chinese employee (e.g. foreign expatriate) works in China for a period during the implementation of a share incentive plan, his/her domestic income and foreign income may be split by the proportion of the months they worked in China and abroad, and only the domestic income is subject to IIT in China. Even if the individual did not exercise his/her options in China, he/she shall bear IIT liability if the income is obtained partially due to employment in China. However, if the wage and salary income is not paid by an enterprise from a place within the territory of China, the IIT thereon may be exempted.[5] Since there is no specific calculation method concerning the income of non-Chinese residents participating in equity incentive plans in current tax laws and regulations, we suggest companies communicate with the tax authorities so as to reduce the potential tax risk.

To sum up, equity incentive plans may differ greatly in their specific arrangements. Enterprises should consider whether their equity incentive plans can make use of the preferential IIT calculation method so as to maximize the benefit to employees’ and incentive effects. Enterprises should seek professional taxation advice where appropriate.


[1]Pursuant to Guoshuifa [2005] No. 9, the year-end bonus can be considered as income separate from each month's wages and salaries for the calculation of IIT payable. The applicable tax rate and the sum of quick calculation deduction would be determined by 1/12 of the amount of year-end bonus

[2]Pursuant to Circular 35, if an individual obtains income derived from the transfer of stock of a domestic listed company after he/she exercises an option, such stock transfer will be exempt from IIT.

[3]See Circular Caishuizi [1998] No. 61

[4]Pursuant to Circular 461, the proportion of the indirect shareholding shall be computed by multiplying the proportion of shares controlled by each level. If a listed company controls more than 50 % of the shares of its level-1 subsidiary, the indirect shareholding shall be computed at 100%.

[5]See Guoshuihan [2000] No. 190

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