Offshore equity incentive schemes raise exchange control issues

By Gillian Miao,Martin Hu & Partners
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Many offshore listed companies are extending their equity incentive schemes to the Chinese employees of their PRC subsidiaries. PRC law expressly provides for the creation of such schemes by offshore listed companies. Schemes usually take the form of employee stockholding plans and employee stock option plans.

Gillian Miao,Martin Hu & Partners
Gillian Miao
Associate
Martin Hu & Partners

The holding by a Chinese employee of stocks or options in an offshore listed company is, in essence, a direct investment by that individual in foreign securities. However, China currently restricts capital account transactions, and direct investment in foreign securities by Chinese individuals has not been completely deregulated. Accordingly, the equity incentive schemes of offshore listed companies have drawn the attention of the PRC’s exchange control authorities.

The jurisdiction of the foreign exchange control authorities over the employee equity incentive schemes of offshore listed companies is established by the following laws and regulations:

  • the PRC Foreign Exchange Administrative Regulations (Order No. 532 of 2008 of the State Council);
  • the Individuals’ Foreign Exchange Administrative Measures (Order No. 3 of 2006 of the People’s Bank of China);
  • the State Administration of Foreign Exchange Issuance of the Individuals’ Foreign Exchange Administrative Measures Implementing Rules (Hui Fa [2007] No. 1),
  • the General Affairs Department of the State Administration of Foreign Exchange Issuance of the Domestic Individuals’ Participation in Overseas Listed Company Employee Stockholding Plans and Stock Option Plans Etc. Foreign Exchange Management Operating Procedures Notice (Hui Zong Fa [2007] No. 78); and
  • the General Affairs Department of the State Administration of Foreign Exchange Delegation of the Examination and Approval Authority for Initial Foreign Exchange Quotas for Purchase and Payment and Opening of Foreign Exchange Accounts in Connection with the Participation by Domestic Individuals in the Employee Stockholding Plans of Listed Companies Notice (Hui Zong Fa [2008] No. 2).

The authority for oversight by the tax authorities of the employee equity incentive schemes of offshore listed companies is established by the following notices:

  • the Ministry of Finance and State Administration of Taxation Issues Concerning the Levy of Individual Income Tax on Income Derived by Individuals from Stock Options Notice (Cai Shui [2005] No. 35);
  • the State Administration of Taxation Issues Concerning the Payment of Individual Income Tax on Income Derived from Stock Options Supplementary Notice (Guo Shui Han [2006] No. 902);
  • the Ministry of Finance and the State Administration of Taxation Issues Concerning the Levying of Individual Income Tax on Income Derived from Stock Appreciation Rights and Restricted Stock Notice (Cai Shui [2009] No. 5); and
  • the State Administration of Taxation Issues Concerning Individual Income Tax on Equity Incentives Notice (Guo Shui Han [2009] No. 461).

Scope of jurisdiction

Under current law, the PRC’s foreign exchange control authorities only have authority over listed companies and PRC individuals located in PRC if they participate in employee equity incentive schemes.

However, PRC taxpayers include PRC nationals; residents of Taiwan, Hong Kong and Macao; and nationals of countries other than the PRC. Therefore, the scope of jurisdiction over employee equity incentive schemes exercised by the tax authorities is not the same as that exercised by the foreign exchange control authorities. Residents of Taiwan, Hong Kong and Macao, and foreign nationals who work in China, are not subject to the abovementioned document 78 (as regards foreign exchange), but may be subject to documents 35 and 461 (for tax purposes).

Oversight by SAFE

SAFE exercises oversight in a number of ways.

First, approval of annual foreign exchange purchase and payment limits, and conversion limits. As the limits apply nationwide, companies need to appoint a single agent in China responsible for their nationwide operations. In practice, most offshore listed companies appoint one of their subsidiaries in the PRC as their PRC agent.

The PRC agent acts on behalf of the employees in applying to the local SAFE for an annual foreign exchange purchase and payment, and conversion, limits. The offshore listed company first needs to estimate the limits based on the number of participating employees and the possible market value. Once the limits have been approved, the PRC agent will carry out the purchase and payment, and conversion, procedures on behalf of the employees with a designated foreign exchange bank within the approved limits.

Second, approval of individual amounts of foreign exchange which are to be converted during the year. Even though the agent has secured approval of the foreign exchange conversion limit for the year, it must apply for SAFE approval each time it converts currency within that limit.

Third, management of dedicated domestic foreign exchange accounts. The agent is required to apply to the local SAFE on the behalf of the employees to open dedicated foreign exchange accounts to receive any payments of foreign exchange made in connection with the employee equity incentive schemes.

Fourth, quarterly reporting of the use of the funds. The agent must submit a form recording the participation of each individual in an employee stockholding plan or stock option plan to the local SAFE within the first 10 working days of each quarter.

Tax

Any income that an employee in the PRC derives from an equity incentive scheme is subject to individual income tax on the same basis as wage income, in accordance with document 35. The employer must files details with the competent tax authority. Currently, the Shanghai tax authorities have relatively clear regulations on the taxation of equity incentive schemes of offshore listed companies, but other cities have yet to issue specific measures. Accordingly, the documents and time required differ from place to place.

In order to avoid administrative penalties for failure to secure approval or registration, and to enable employees who participate in equity incentive schemes to enjoy the available tax breaks, offshore listed companies must ensure that their equity incentive schemes comply fully with tax regulations.

Gillian Miao is an associate at Martin Hu & Partners (MHP Law Firm)

MHP

8/F, Kerry Parkside Office, 1155 Fangdian Road

Pudong New Area, Shanghai 201204, China

Tel: +86 21 5010 1666

Fax: +86 21 5010 1222

www.mhplawyer.com

Martin Hu

Tel: +86 21 5010 1666*966

E-mail: martin.hu@mhplawyer.com

Gillian Miao

Tel: +86 21 5010 1666*999

E-mail: gillian.miao@mhplawyer.com

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