In the context of the digital economy and entrepreneurial wave, more and more companies are considering and putting into place equity-based incentives for employees. A sound equity-based incentive plan plays an important role in binding the interests of enterprises with those of the managers and core employees, retaining, attracting talent and realizing the win-win situation between enterprises and employees. In this process, selecting a suitable shareholding platform according to the incentive purpose and tax burden is the key to implementing a sound equity-based incentive plan.
At present, the employee stock ownership plan (ESOP) can be divided into two types: direct and indirect holding. Direct holding means that employees hold shares of the company in their own name and directly exercise the rights of shareholders. Indirect holding means that employees do not directly hold shares of the company in their own name but indirectly hold their shares through others acting on their behalf or by setting up a shareholding platform. The main form of indirect holding is to set up a shareholding platform, mainly through limited liability companies, limited partnerships or the issuance of financial products. For shareholders, their income from the equity they hold includes “equity transfer income” and “dividends”. The tax burdens carried by the two kinds of income are also different.
Direct holding by employees
Employees’ direct holding of shares means that employees directly hold shares or equity of a company to be listed in their own name through the transfer or granting of equity by the original shareholders or by increasing capital and shares of the company. In this way, employees directly hold the equity of the company and exercise corresponding shareholders’ rights according to their equity ratio, with no need to set up a shareholding platform, so the procedure is fairly simple. However, too many shareholders will cause equity dispersion, which is not conducive to the centralized decision-making and management of the company; and the change of equity needs to be registered with the Administration for Industry and Commerce, which is a cumbersome procedure.
With employees’ direct holding of shares, the tax burden is as follows:
(1) In the equity transfer stage, according to article 4 of the Administrative Measures for Individual Income Tax on Incomes from Equity Transfer (Trial), “For individual transfer of equity, the balance of equity transfer income minus the original value of equity and reasonable fees shall be the amount of taxable income, and individual income tax shall be paid on the basis of the ‘property transfer income’.” That is to say, natural person shareholders shall pay individual income tax on the basis of the “property transfer income” for the equity transfer. According to the Individual Income Tax Law (amended in 2018), the tax rate on the property transfer income is 20%.
(2) In the dividend stage of the equity incentive, according to the Individual Income Tax Law, the tax rate on interest and dividends is 20%. Individuals who obtain dividends from the unlisted company shall pay the individual income tax in full.
Indirect holding in the form of a company
Holding shares in the form of a company means that employees hold shares in the form of a limited liability company or a joint-stock company through capital contribution by employees. In terms of the upper limit of shareholders, the number of employees holding shares in a limited liability company shall not exceed 50, and the number of employees holding shares in a joint-stock company shall not exceed 200. Meanwhile, for the shareholding platform in the form of a company, its governance structure, responsibility form, transfer of rights and interests and capital increase or reduction are all regulated by the Company Law.
In terms of the tax burden, in the mode of the shareholding platform in the form of a company, the shareholding platform itself is a taxpayer, while the shareholder of the platform is another taxpayer, which means that double income tax will be levied from the company and individuals at the same time. Specifically, in the equity transfer stage, the shareholding company is required to pay corporate income tax at a tax rate of 25%, while the shareholders are required to pay individual income tax at a tax rate of 20%. With the double taxation, the composite tax rate is: 25% + (1-25%) * 20% = 40%. In the dividend stage of equity incentive, the shareholding platform is exempted from corporate income tax when it obtains dividends, but when the platform pays dividends to employees, the natural person shareholders shall pay the individual income tax at a tax rate of 20%.
Indirect holding in the form of a limited partnership
The establishment of a limited partnership through employees’ capital contribution is a more common way for enterprises to carry out equity-based incentives. In this mode, partners will define the rights and obligations of general partners and limited partners by signing a partnership agreement. The internal governance structure of the partnership, the transfer of rights and interests, capital increase or reduction and other matters can be flexibly agreed on based on the Partnership Law.
In terms of the tax burden, for the shareholding platform in the form of a limited partnership, the penetration principle is applied to its taxpayers, which means that the shareholding platform itself is not a taxpayer, but the tax declaration is conducted by way of penetrating to each partner. In the equity transfer stage, the excess progressive tax rate of 5%-35% applies, and taxpayers can enjoy certain preferential tax rates according to different regional policies. If a partner is a natural person, they shall pay individual income tax. When the partnership obtains dividends, it need not pay tax, but each partner shall pay the individual income tax at a tax rate of 20%.
To sum up, from the perspective of the final income of the incentivized employees, compared with individual direct holding and indirect holding in the form of a limited liability company, the tax burden of limited partnership is relatively low, and the registration place of the shareholding platform can be flexibly set in areas enjoying some preferential tax policies. In addition, according to data on listed enterprises, most listed companies selected shareholding platforms for employees, accounting for 10%-20% of the total share capital of such companies. This is one of the factors that shall be specially controlled in the process of implementing an equity-based incentive plan.
Li Weiming is a partner at Tiantai Law Firm
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