China: Clarifications on individual income tax treatments of employee share appreciation rights and restricted shares plans 

Sep 2009

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On 24 August 2009, the State Administration of Taxation ("SAT") issued Guo Shui Han [2009] No. 461 ("Circular 461") to provide further clarifications on the Chinese individual income tax ("IIT") treatments of employment income derived from share appreciation rights ("SARs") and restricted shares plans.
  
In this Issue of News Flash, we would summarize the salient points of Circular 461 and share our respective insights and recommendations.
  
Salient points of Circular 461:

• Timing of taxation and calculation of taxation income
  
  

  • Circular 461 now makes it clear that SARs are taxed at the time when the rights are exercised and cashed out.  The taxable income is the cash proceeds (i.e. net amount of increase in the share price from the date of grant to the date of exercise) paid to the employees; and
      
    
  • It also clarifies that restricted shares are taxed at the time when the shares are fully vested.  The taxable income is taken as the average price between (i) the closing price on the date when the relevant restricted shares are registered with the China Securities Depository and Clearing Corporation ("CSDCC") or its overseas equivalent ("A") and (ii) the closing price on the date when the restrictions imposed on the relevant shares are removed ("B") multiplied by the number of shares involved ("C") less the prorated price paid for the relevant shares ("D").
      
    Taxable income = (A + B) / 2 X C – D

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• Application of preferential IIT treatments and its limitations
  
  

  • SARs and restricted shares income obtained from listed companies by employees shall be taxed similarly as income from employee's share options plans as stipulated in Cai Shui [2005] No. 35 ("Circular 35") which offers a preferential IIT treatment to tax the equity income as a separate month income and hence at lower marginal IIT rates.  However, Circular 461 also makes it clear that the Circular 35 preferential IIT treatment does not apply to equity plans of unlisted companies, pre-IPO equity plans or equity plans of listed companies which fail to comply with the registration requirements (see below).  This would result in such equity income being taxed less favourably than those derived from listed companies.

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• Multiple taxable events within the same tax year
  
  

  • The Circular 35 preferential IIT treatment shall apply to the SARs, restricted shares and share options income obtained in the same tax year on a "combined basis" and, where there is more than one taxable event occurring in a tax year, the accumulated income is chargeable to IIT according to Guo Shui Han [2006] No 902 ("Circular 902").  This combined basis, in essence, reduces the tax savings potential that the preferential IIT treatment could have achieved had it been applied separately.  Please refer to our Preferential individual income tax treatment: beyond share options for a sample numerical illustration on the application of Circulars 35 and 902.

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• Additional limitations on use of preferential IIT treatment on multi-tiers companies
  
  

  • The Circular 35 preferential IIT treatment is also restricted to listed companies (including branches) and their subsidiaries with shareholding interest of not less than 30%.  However, indirect shareholding interest is only limited to the second-tier subsidiaries.  In calculating the indirect shareholding of multi-tiers companies, the actual shareholding of each tier is multiplied by each other but shareholding of the first-tier subsidiaries of more than 50% is taken as 100% shareholding.

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• Registration of equity plans and provision of relevant information
  
  

  • Companies listed in China should register their share options and SARs plans with the in-charge local tax bureaus ("LTBs") before the plans are implemented.  They should also provide the LTBs with the relevant information before the share options and SARs are exercised (i.e. documents such as exercise notices) and when reporting the taxable income (i.e. information such as quantity of the shares exercised, option price, exercise price, market price, transfer price etc.);
      
    In respect of restricted shares plans, the companies listed in China should register their plans with the LTBs within 15 days after the restricted shares are registered with the CSDCC and public notices are made.  Information including share plans, registration date, closing price of the share on the registration date, "lock-in" period, list of employees receiving the restricted shares should be provided; and
      
    As to the registration requirements imposed on overseas equity plans, Circular 461 also requires the Chinese entities of the overseas listed companies to register their equity plans with the LTBs accordingly.

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PwC observations

• New pricing methodology for restricted shares
  
  

  • The concept of the average pricing for restricted shares is new and may cause unfavourable outcomes to those employees in case the share price has decreased over the restriction period, particularly during the past few years.  For example, if the closing price on the date of registration was USD20 and the closing price on the date when the restrictions are removed is USD10, the relevant shares would be taxed at USD15 per share, i.e. (USD20 + 10) / 2.  Also, it is less favourable to the employees because they normally do not have an option to defer the taxing point (e.g. the date of exercise as in the case of SARs and share options) until the share price bounces back.  Also, the information required for the registration seems to suggest that this average pricing method shall apply only to the restricted shares formally transferred to the employees but subject to a "lock-in" period.  For restricted shares become transferable to the employees only after the vesting, it is not entirely clear as to whether the average pricing method would be applicable.

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• Registration is a must
  
  

  • Circular 461 now makes it clear that the Circular 35 preferential IIT treatment shall apply only to the listed companies (domestic or overseas) with their equity plans registered with the LTBs.  Indeed, in recent months, we have already seen more and more LTBs requiring companies to register their equity plans before the Circular 35 preferential IIT treatment can be adopted.  Hence, companies shall ensure that their equity plans are properly registered with the respective LTBs in order to secure the use of the Circular 35 preferential IIT treatment on their employees' income derived from SARs, restricted shares and share options.  It is also worth-noting that this registration should not be confused with the equity plan registration with the State Administration of Foreign Exchange ("SAFE") as stipulated in Hui Zong Fa [2007] No. 78.  The SAFE registration is a separate requirement and applies to overseas companies intending to implement equity plans to their Chinese employees.
      
    Cai Shui [2009] No. 5 only addressed the equity plan registration requirements for listed companies in China but was silent for overseas listed companies.  Circular 461 now confirms that the registration also applies to overseas listed companies.  However, it appears literally from Circular 461 that the Chinese entities of the overseas listed companies are only required to submit the equity plans to the LTBs but not other relevant documents and information (as mentioned above) as required for companies listed in China.  Nevertheless, based on our experience, the LTBs would require the Chinese entities of the overseas listed companies to submit these relevant documents and information for the purpose for the equity plans registration.

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• Impacts to multi-tiers companies
  
  

  • Circular 461 also restricts the application of the Circular 35 preferential IIT treatment to the employees of the second-tier subsidiaries with the indirect shareholding of not less than 30% by the listed companies.  Despite the shareholding of the first-tier companies of more than 50% would be taken as 100% shareholding interest for this purpose, this will still have significant impacts to those multi-tiers listed companies offering equity incentives to their employees.  It is also not clear whether the 30% threshold must be met throughout the restriction period (in the case of restricted shares) and until the exercise date (in the case of SARs and share options).  Hence, further clarifications on these areas are also required.

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What's next?
  
It should be noted that, despite Circular 461 became effective on 24 August 2009, the respective registration requirements and the IIT treatments also apply to cases where the SARs or restricted shares were granted or awarded prior to the effective date but where the IIT remains unsettled.  Hence, companies must ensure that they fully comply with the necessary registration requirements with the respective LTBs and understand the different methods of calculating the IIT dues to be withheld from the employees on the equity income.  If any communication previously made to the employees is inconsistent with what is now set out in Circular 461, the companies should clarify and explain to the employees promptly.