China: China Enacts Preferential Income Tax Toward Non-Listed Companies Who Carry Out Equity Incentive Plans To Promote Development Of Science And Technology Enterprises

Last Updated: 20 October 2016
Article by Justin Cai

In order to promote China's science and technology innovation, as well as industrial upgrading, on September 22, 2016, Ministry of Finance ("MOF") and the State Administration of Taxation ("SAT") jointly issued the "Notice on Improving the Income Tax Policies Applicable to Equity Incentives and Share Purchase with Technology" (the "Notice"). On September 28, 2016, SAT further issued the "Announcement of Collection of Income Tax Policies Concerning Equity Incentives and Share Purchase with Technology" (the "Announcement") to clarify implementation details. The main purpose of the Notice is to let Chinese domestic non-listed companies better attract and retain their senior managers, as well as the key technical personnel, through reducing relevant tax burdens associated with equity incentive plans. Since the Notice is generally applicable to domestic resident enterprises (except for those in the Negative List), most of the technology-concentrated foreign-invested enterprises can also enjoy this preferential treatment, which may benefit them in their implementation of localized equity incentive plans, in addition to rewarding and retaining local senior managers and key technical personnel. At the same time, for those who registered the equity incentive plans in accordance with the Notice, if they are to be acquired by other investors in the future, the transaction cost will be reduced accordingly and the deal structure will be more concise. In projects involving acquisition of Chinese domestic companies by foreign investors where the target Chinese enterprises had existing equity incentive plans for core managers and key technical personnel, the key issues for the deal structure often came down to how to minimize tax duties for their share transfer. Now with the tax incentives offered by the Notice, these key issues can likely be settled in a much easier way. 

The Notice mainly applies to stock options, restricted stocks and stock rewards granted to employees of non-listed companies. For the non-listed companies that can meet the requirements set forth in the Notice, after their filing of equity incentive plans with the relevant tax bureau, the tax bureau may then implement a deferred tax policy toward the equity incentive plans. This means that the employees do not need to pay the tax immediately once they receive the equity incentive, but rather, they may defer their tax payment until transfer of their shares. When their shares are transferred, the tax bureau will apply the "property transfer tax" rate (i.e., "Capital Gain"), which is 20 percent of the difference between the total revenues and original costs/reasonable fees, to calculate such employees' personal income tax.

According to Article 2 of the Notice, the preferential treatment applies only to equity incentive plans that can meet the following requirements:

  1. They must be implemented by domestic resident enterprises in China (thus not applicable to companies registered overseas);
  2. They must be ratified by the board of directors and the shareholders' (general) meeting;
  3. The underlying assets of the incentives shall be the equities of the domestic resident enterprises. However, the underlying assets of equity rewards may be the equities obtained by investing in other domestic resident enterprises by purchasing their shares with technological achievements;
  4. The recipients of equity incentive plans shall be the senior managers and key technical personnel, but the total number of recipients shall not exceed 30 percent of the total employees;
  5. The recipients shall hold the equity/options/rewards for three years after the grant date and shall hold the equity for one year after exercising the rights, lifting the restrictions or obtaining the rewards;
  6. The period from the grant date to the exercise date shall not exceed 10 years; and
  7. The industry of the company shall not fall within the scope of industries listed in the appendix list ("Negative List"—mainly to exclude the application of the preferential treatment to non-technology enterprises).

Prior to the issuance of the Notice, the general rule of taxation toward the equity incentive plans of the non-listed companies is as follows: When the recipients exercise their option rights, lift the share restrictions or obtain the share rewards, the tax bureau will categorize the corresponding income as "wages and salaries" and then tax them based on the seven-level progressive individual income tax rates (3 percent to 45 percent of the difference between the actual purchase price and the fair market price). Further, when the recipients transfer such shares, if the transfer price is higher than the fair market price, to that value-added portion, the tax bureau will categorize it as "property transfer income," and apply the tax rate of 20 percent to collect tax. Hence, the overall income tax burden is relatively heavy to the recipients/taxpayers. After policy adjustment of the Notice, the original two phases of tax collection ("wages and salaries income" and "property transfer income") have merged into one phase. Temporarily, taxpayers do not need to pay the tax when obtaining the equity; instead they can pay the income tax in one lump sum during the equity transfer stage (i.e., 20 percent of the property transfer income). The potential advantages of the Notice are: (i) effectively solving taxpayers' cash flow shortage problems in the context of exercising their rights and (ii) effectively lowering taxpayers' tax burdens (the tax reduction ranges from 10 percent to 20 percent). These measures may provide significant incentives to the technical personnel's passion of innovation.

According to the Announcement, non-listed companies should complete the filing of deferred tax application with relevant tax authorities within 15 days starting from the following month where the employees exercised options, lifted share restrictions or obtained share rewards. Thus, eligible Chinese domestic resident enterprises (including foreign-invested enterprises) should consider filing their equity incentive plans with tax authorities as soon as possible.

If you have any questions about this Alert, please contact Justin J.X. Cai, any of the attorneys in the Duane Morris & Selvam LLP Shanghai office  or the attorney in the firm with whom you are regularly in contact.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.

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