Tax deferral in designing equity incentive plans

By Sun Hongxin, Zhilin Law Firm
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Tax risks in equity incentives have long been a concern, especially since tax deferral has a significant effect on equity incentives. Special attention should therefore be paid to the tax deferral policy when designing equity incentive plans.

POLICY FOR DEFERRAL

Effective policy is according to article 2.10 of the Notice of Several Measures for Further Deepening the Reform of “Simplifying Procedures, Decentralising Powers, Combining Decentralisation with Appropriate Control, and Optimising Services,” and Cultivating and Stimulating the Vitality of Market Participants (notice No. 69), issued by the State Tax Administration (STA) in 2021.

Sun Hongxin, Zhilin Law Firm
Sun Hongxin
Associate
Zhilin Law Firm

This requires enterprises launching equity incentive plans to, within 15 days of the next month, submit a report on equity incentives and relevant material to the competent tax authorities, in accordance with the Notice on Issues relating to the Levy of Individual Income Tax on Personal Income from Stock Options (notice No. 35), and the Notice on Improving the Relevant Income Tax Policies for Equity Incentives and Technology Investments (notice No. 101), both issued by the Ministry of Finance (MOF) and the STA.

Where a domestic enterprise incentivises its employees with equity interests in an overseas enterprise, such incentives shall be deemed as income from wages and salaries, subject to individual income tax withholding, in accordance with the above-mentioned requirements.

Notice Nos 35 and 101 serve as the main policy basis for tax deferral, setting out participant eligibility criteria, calculation, and declaration requirements, providing important references for the scope of participants, exercise of options, purchase of shares, transfer and other arrangements in the equity incentive plan.

IS EMPLOYEE TAX REDUCED?

Taking incentive policies of non-listed companies as an example, according to notice No. 101, if stock options, equity options and restricted stock/equity awards granted to employees by a non-listed company meet prescribed conditions, the tax deferral policy can be applied after filing with the competent tax authorities.

In other words, employees are entitled not to pay tax when they obtain equity incentives, and defer tax payment until equity transfer.

On completion of the transfer, individual income tax is calculated and paid at a rate of 20% based on the income from an equity transfer, which falls within the scope of “income from property transfer”, less the cost of equity acquisition and reasonable taxes and fees.

When stock/equity is transferred, the acquisition cost of the stock/equity option is determined at the exercise price; the acquisition cost of restricted stock/equity is determined at the actual amount of capital contribution; and the acquisition cost of stock/equity awards is zero.

It is obvious that employees entitled to tax deferral only pay individual income tax after the transfer, and the main factor influencing individual income tax is the difference between the transfer price and purchase price.

For employees of non-listed companies ineligible for tax deferral, according to notice No. 35, if an employee obtains shares/equity at a price lower than the fair market price, the difference between the actual purchase price paid by the employee and the fair market price will also be subject to individual income tax, calculated on the exercise of the option based on the “income from wages and salaries”.

The taxable income from wages and salaries of an employee during the period of exercising the option is calculated according to the following formula: Taxable income from wages and salaries in the form of stock options = (market price per share of the exercised stock option minus purchase price per share of the stock option paid by the employee) times the number of shares.

In addition, employees ineligible for tax deferral are obliged to pay individual income tax on completion of the transfer at a rate of 20% if the future transfer price exceeds the exercise price.

To sum up, the individual income tax calculation for both deferral and non-deferral cases includes the effects of the difference between the transfer price and exercise price on individual income tax.

Therefore, when determining which method is more conducive to tax saving, calculation should be determined case by case.

WHO CAN DEFER TAX?

Not all employees of non-listed companies entitled to equity incentives are eligible for tax deferral.

According to notice No. 101, the equity incentive plan must meet all following conditions to be eligible for tax deferral:

    1. Equity incentive plan is for a domestic resident enterprise;
    2. Plan has been reviewed and approved by the board of directors and shareholders’ meeting;
    3. Incentive asset is equity interests in a domestic resident enterprise;
    4. Participants must be core technical staff and senior management members identified by the board of directors or the shareholders’ meeting, and total number of participants shall not exceed 30% of the company’s average headcount in the past six months;
    5. Stock/equity option shall be held for three years from the grant date, and one year from the exercise date; restricted shares held for three years from the date of grant and one year after restriction is lifted; and equity awards held for three years from the date of award. All these timeframe requirements shall be specified in the equity incentive plan;
    6. Time interval between the grant date to the exercise date of the stock/equity option shall not exceed 10 years; and
    7. Neither a company granting equity awards nor a company in which equity interest is awarded falls within the scope of the Catalogue of Restricted Industries for Preferential Tax Policies on Equity Awards.

In addition, if equity rewards are given to technical staff of a high-tech firm, they shall be:

    1. Technical staff who have made outstanding contributions to research, development and commercialisation of sci-tech achievements, including principal author, person in charge of major development projects, and main technical personnel behind major innovations or improvements in signature products, core technologies or technological processes; or
    2. Management personnel who have made outstanding contributions to corporate development, including senior officer in charge of overall production and operation, and middle-ranking/senior officers in charge of production and operation of the firm’s main products (services), accounting for more than 50% of income (or profit) from principal business activity.

Therefore, high-tech firms entitled to tax deferral must properly plan for personnel selection and maintain sound document management in terms of internal staff appointment and project assignment, readying them for inspection.

Sun Hongxin is an associate at Zhilin Law Firm

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