China Advances its Tax Regime for Employee Stock Options

1. APPLICATION

The Circular applies to stock option plans implemented by domestic enterprises, foreign invested enterprises (FIEs) and business establishments of foreign enterprises in China. Employees of these entities, regardless of their residency, who receive options to purchase shares in their respective employer, or the holding company of their employer, will be subject to the tax stipulations in the Circular.

Terminology usually associated with option programs, such as `stock option', `grant/exercise price', `grant date', `exercise of option', and `exercise date' are defined in the Circular and are essentially similar to internationally accepted concepts.

It is worth noting that the definition of stock options is confined to options issued by listed companies. Consequently, the Circular does not appear to apply to options issued by private enterprises to their employees.

2. WHAT ARE THE TAXABLE INCOMES?

The Circular recognizes that an employee may derive different streams of income from ownership of options, and the subsequent exercise of them. The Circular spells out the tax treatment for the different types of benefits that can be enjoyed by employees.

2.1 Grant of Option

An employer granting stock options to its employees does not give rise to any tax liability unless PRC laws provide otherwise. To our knowledge, there are no PRC laws that currently impose taxation at the time employees receive their share options.

2.2 Transfer of Options

In some circumstances, an employee may prefer to transfer options prior to exercising the underlying rights. The net proceeds derived from such a transfer will be taxed as income from wages and salaries.

2.3 Exercising the Option

When an employee exercises the options and the exercise price paid to purchase the underlying shares is less than the fair market value of those shares (which is equivalent to the closing share price on the exercise date) the entire discount enjoyed by the employee is recognized as income from wages and salaries earned from the provision of employment services. This difference (and any additional proceeds received from disposal of options as considered under clause 2.2) will be taxed at the progressive income tax rate applicable to the individual.

Share option benefits that are categorized as employment income or "income from wages and salaries" are taxed separately from the customary monthly salary pursuant to the following formula:

The Applicable Tax Rate and Express Deduction Factor values will vary depending on the personal circumstances of the individual and these can be obtained in the schedule in the Issuance of the Circular (ref, Guo Shui Fa [1994] No. 89).

2.4 Dividends Earned From Shares

Receipt of any after tax profits or benefits from holding the underlying shares will be taxed as income from "dividend, interest and bonus". The current prevailing rate is 20%, subject to the provision of the applicable double tax treaty.

2.5 Capital Gains From the Transfer of Shares

Under the Circular, capital gains represent the total proceeds derived from the subsequent sale of the shares by the employee, less the fair market value (on the exercise date) of the shares obtained after exercising the options. Capital gains arising from the disposal of shares are regarded as "income from property transfer" and tax will be levied in accordance with the applicable tax provisions for income derived from transfer of securities in the secondary market. The current prevailing tax rate applicable on such transfers is 20%.

The Circular elaborates that presently no tax is levied on capital gains made on domestic listed companies (i.e. the disposal of A and B Shares), but gains attributable to the disposal of shares of companies listed abroad (such as H Shares) shall be taxed in accordance with the applicable tax rules. This is in line with the current tax regime on capital gains from securities investments. It should be kept in mind, however, that foreign entities (including individuals) are not permitted to invest directly in A Shares, unless the entities qualify under the stringent Qualified Foreign Institutional Investors regime.

In addition, the Circular also re-emphasizes the application of Issues Relevant to Determining the Tax Obligations of Individuals with no Domiciles in China Who Obtain Their Wages or Salaries in the Form of Negotiable Securities Circular (ref. Guo Shui Han [2000] No. 190), which provides for the recognition of domestic and overseas source incomes. If the source of income must be distinguished, then the stock option income should be apportioned by referring to the number of months the employee has worked inside or outside of China.

3. Administration

A PRC company wishing to establish an incentive scheme, such as employee stock options, must at the outset submit the stock option plan/protocol, notice of authorization, and other relevant materials to the tax authority in charge. After that, the company and some individuals will be required to act as a withholding tax agent, ensuring the timely filing of documents and collection and payment of taxes.

The tax authority also requires the submission of certain documents (such as notice of exercise) prior to the exercise of the options. In this context, the tax authority assumes that the share option proposal will set a definitive date as to when the options can be exercised. Alternatively, the company is required to compel their employees to give them advance knowledge of the exercise of the options so that the employer can discharge their notice obligations. Furthermore, at the time the tax return is filed, particulars relating to the status of the options, conditions of the options, exercise price, market price and transfer price must be provided.

4. Conclusion