Individual Income Tax Treatment for Stock Compensation Schemes

October 16, 2009 Posted by China Briefing Reading Time: 3 minutes

Oct. 16 – The Chinese State Administration of Tax has released circular Guoshuihan [2009] 461 clarifying individual income tax treatment for income generated from share appreciation rights and restricted share units granted to employees by listed companies, as well as those from various stock plans.

This circular completes the regulatory requirements for IIT treatment of stock compensation schemes.The circular lists the “Concept of Three Inspired Compensation Schemes” as follows:

SOP – A right that is granted to employees pursuant to prescribed procedures which allow the employee to subscribe to a certain amount of stock of the company at a specific price within a specified period.

SAR – A right granted by a listed company to its employees to obtain the proceeds derived from the increase of stock price in the specified period under agreed conditions. Where an authorized employee exercises his/her right under agreed conditions, the company should compensate the employee equivalent to the price difference between the selling price on the secondary market on the exercised date and the authorization date.

RSU – A certain number of shares distributed by a listed company to its employees under agreed terms. The employees are not allowed to exercise the shares freely unless the restrictions imposed on such shares are removed (i.e. listed companies issue the stock to the employees).

The Circular also defines the recognition and trigger points of taxable income as follows:

SOP – The IIT liability of the employees will not be triggered until the day when the employees exercise the stock options. The taxable income is calculated by the difference between the closing price on the exercise date and the price (if any) paid by the employees for each share. However, if the employees transfer their stock options before the exercise date, the net income derived should be subject immediately to IIT.

SAR – The IIT liability will not be triggered until the day when the proceeds derived from the SARs are paid by the listed company to the employees. The taxable income is calculated by multiplying the number of shares by the stock price and the exercise date.

RSU – The IIT liability of the employees will not be triggered until the listed company issues the prescribed stock to the employees. The taxable income is calculated by first multiplying the number of the shares (A) by the average of the closing price on the date when the restricted shares are registered with the China Securities Depository Clearing Corporation (CSDCC) or its overseas equivalent for shares of overseas listed companies (B), and the closing price on the date when the restriction on the shares is removed (C), and then subtracting the price paid by the employees for the relevant shares (D). The formula can be illustrated as follows: Taxable income = (B+C) / 2 x A – D.

Note that it is less favorable for the individual if price C is less than the price B as it will result in a higher taxable amount than the income derived. However, there may be limited room for planning as there is no way to defer the IIT reporting point till a later time when the price C goes higher than price B.

Technically, taxable income generated from the stock compensation plans discussed above (the equity income) should be included in the salary income of the employees for IIT purposes, which will increase their IIT burden. Employers are required to withhold the IIT on the equity income of their employees.

However, Circular 35 offered a preferential IIT treatment, in that the IIT liability on the taxable equity income could be calculated as a month’s income separate from the regular monthly salary. Without including this into the regular monthly taxable employment income, the income derived from the compensation scheme may potentially be taxed at a lower marginal tax rate.

Registration requirements

SOP and SAR Companies listed in China should register their SOP or SAR scheme with the in-charge Local Tax Bureau and provide necessary supporting documents. They should also report to the LTB information related to the exercise of the SOP or SAR, e.g. number of shares exercised, grant price, closing price on the exercise date, and so on.

RSU Listed companies in China should register the RSU scheme with the in-charge LTB within 15 days after the shares are registered with CSDCC and notices are made public. The above registration requirements are also applicable to overseas listed companies, which should be fulfilled by their associated Chinese entities. Please note that the preferential IIT filing treatment will not be allowed to be applied if the schemes are not duly registered.

For advice on structuring employee benefit packages, and the other relevant tax issues email Sabrina Zhang, national tax partner for Dezan Shira & Associates, at tax@dezshira.com.