Previously, the question of how an individual pays tax under equity incentive schemes was mainly governed by Document 35 (2005) of the Ministry of Finance and STA entitled ‘Notice Concerning the Gathering of Personal Income Tax on Stock Options’ and Document 902 (2006) of the STA entitled ‘Supplementary Notice on the Gathering of Personal Income Tax on Stock Options’.
This article analyses the application of, and changes in, the new laws as they apply to equity incentives in the context of deferred taxation schemes for private companies.
1. Bringing Private Companies under the Deferred Tax Scheme for Equity Incentives
Document No. 101 (2016) of the Ministry of Finance and State Tax Administration (hereinafter Document 101) provides that where private companies provide their staff with stock options, share options, restricted shares and options as rewards, employees enjoy deferred taxation. That is to say, they need not pay any tax during the period of receiving the equity incentive, which tax becomes payable only upon deferral or transfer of the share or stock option.
This document also provides that companies listed on the New Third Board Market enjoy deferred taxation, in much the same way as private companies.
Previously, Document No. 35 (2005) of the Ministry of Finance and State Tax Authority and Document No. 902 (2006) of the State Tax Authority only applied to listed companies. Accordingly, there were no explicit national standards dealing with the issue of paying personal income tax on equity incentives in private companies. This led to chaos with payment by the company and its employees, and even raised the risk of less tax being paid. In response, the current formulation not only specifies the rules governing taxing equity incentives for private companies, but also provides that employees may defer paying tax until such time as they transfer the stock options. This alleviates the burden on employees.
2. From an Income-Based Taxation Scheme to a Profit-Based Taxation Scheme
Document No. 101 provides that in equity incentives of private companies, employees pay 20% of the difference between the selling price of their stock options less the buy-in price and any payable tax thereupon. In contrast, Document No. 35 stipulates that employees of listed companies shall, when accepting stock options, pay progressive tax based on their salaries and earnings.
In practice, companies confer sizeable bonuses on their employees as part of the equity incentives regime. If tax were calculated on the ‘salary and earnings’ basis, the rate payable would be around 35%, representing a heavy burden. On the other hand, if the ‘profits realized’ standard were adopted, the rate payable becomes 20%, some 10-20 points less than the original rate, representing a considerable lightening of the burden.
3. Limited Eligibility of Private Companies
Document 101 provides that, in order to benefit from the tax deferral scheme, private companies must be resident companies within the territory of the People’s Republic of China. Resident companies are those established within China in accordance with applicable laws and regulations. Alternatively, they may be set up outside of China but with their actual management structure located within China.
The Document is primarily designed to place limits on the eligibility of private companies to participate in the tax deferral scheme, such that only employees of resident companies may benefit therefrom. Conversely, employees of non-resident companies are ineligible to participate. This provision precludes companies from dodging tax via illicit means. Because information related to private companies such as the articles of association and internal management are not available to the public, still less is known about the workings of foreign private companies. This dearth of information translates into difficulties in tax collection. Therefore, Document 101 is limited in its scope to resident private companies.
4 The Specificity of Categories of Equity Incentive in Deferred Tax Schemes
While Document 101 limits the equity incentive for private companies to share options, stock options, restricted shares and equity incentives, the categories of equity incentive are more varied in practice. They include the performance-based model, virtual stock model and stock appreciation rights. Document 101 is silent as to how these other types of equity incentive pay tax; therefore, deferred taxation scheme is inapplicable, with the “Personal Income Tax Law” and its implementing regulations coming into play, adopting the ‘salary and earnings’ model. In light of this, and in order to avoid undue risk, private companies must be sure to differentiate between eligible and ineligible equity incentives.
5 Limits on the Targets of the Equity Incentive
Document 101 provides that equity incentives shall only apply to the core of the technological staff and high-level management personnel. Regarding the latter, Article 217 of the Company Law defines ‘high-level management personnel’ as the manager and deputy manager, finance manager, secretary of the Board of Directors for a listed company and other personnel as defined in the articles of association.
In practice, companies (especially those on the NTBM) offer incentives to many and diverse targets. Such persons may include company directors, supervisors and share- holders holding more than 5%. As we have already seen, however, not all participants enjoy deferred taxation, with the class of persons limited to core technological or high- level management personnel. If share-holders with more than 5% of shares do not occupy any such posts at the company, and are solely interested to share in dividends, they may not enjoy the scheme. Current laws and regulations provided that these persons must pay tax on the ‘salaries and earnings’ basis. Whether this restriction is reasonable or whether it goes against policy warrants further study. In implementing equity incentives, companies must take care in clearly stating those eligible to benefit from deferred taxation in order to prevent the non-payment of tax.
6. Special Conditions Attaching to Equity Incentives for Private Companies
Document 101 (2016) stipulates that private companies must also simultaneously satisfy the following conditions:
a. The equity incentive must be approved following examination by the company’s Board of Directors or (general) meeting of shareholders. Further, the shares concerned must be the company’s own, and may not be those of its controlled companies or subsidiaries.
b. Stock options should be held for 3 years from the date of issuance and for 1 year from the date of exercise; restricted shares should be held for 3 years from the date of issuance and for 1 year following the lifting of restrictions placed thereupon; equity incentives should be held for 3 years from the date of awarding. The time between issuing and exercising stock options may not exceed 10 years.
c. The company offering such incentives, the nature of its industry and the company enjoying such scheme may not appear on the “Catalog of Restricted Industries for Tax Deferral in Equity Incentives”.
From six perspectives, this article has analyzed the provisions of Document 101 (2016) on the deferred tax scheme relating to equity incentives for private companies. Therefore, private companies (including those newly floating on the NTMB) should fully consider relevant preferential tax schemes when offering equity incentives to their employees. They should also undertake appropriate financial planning, balancing appropriately the company’s profits and tax burden, thereby implementing equity incentives that are eligible to participate in the deferred tax schemes.