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New individual income tax rule for stock option plan
On 30 September 2006, the State Administration of Taxation ("SAT") issued a supplementary notice, Guo Shui Han [2006] 902, to provide further clarifications on the application of the Cai Shui [2005] 35 which was issued by the Ministry of Finance on 28 March 2005 to address the individual income tax ("IIT") treatment on benefits obtained from share option schemes by employees. Circular 902 now, inter alia, clarifies that:-
- Circular 35 applies to share options in respect of shares listed on the China or overseas stock exchange market. It does not matter whether the employer who grants the share options is a listed company or not. This would mean Circular 35 does not apply to share options relating to shares in a private company. However, the exercise of the share options granted by the employer with reference to its holding company or headquarters listed overseas is caught by Circular 35;
- In the situation where the employee chooses to dispose the share options acquired at a discount, the net proceeds derived from the transfer of share options is the difference between the amount received from the sale and the amount paid for the purchase of the share options ("purchase price"). Should the employee decide to exercise the discounted share options, the purchase price can be added onto the exercise price in determining the taxable income. Hence, the taxable income would be the market price at the date of exercise - (purchase price + exercise price);
- If the employee is granted with the share options and earns the spread from the employer without going through actual purchase or sale of the shares on the date of vesting (i.e. the first available date when the employee is entitled to exercise the share options), the difference will also be treated as employment income and should be taxed in accordance with Circular 35. The spread refers to the market price and the exercise price of the shares at the date of vesting;
- The source of the share option income is determined with reference to the relevant period which is now clarified as the period from the date of option grant to the date of vesting of the share options; and
- Where the employees are given share options which are readily tradable on the stock exchange market, the gain (i.e. market value of the share options less any amount paid for the share options) will be taxable at the date of grant in accordance with the formula set out in Circular 35. Subsequent disposals of the tradable share options will be subject to IIT as income from transfer of property but subsequent exercise of the said share options will be exempt from IIT.
In addition to the above, the new Circular 902 does go further to "modify" the original calculation formula as laid down in Circular 35 which would have implications to employees exercising share options more than once in a calendar year. The new calculation formula is as follows:-
IIT payable on share option income =
(A / B X Applicable Marginal Tax Rate - Quick Deduction Factor) X B
- accumulated IIT paid in the calendar year on share option income
Factor A has changed from "Share option income" to "Accumulated share option income in the calendar year concerned"
Factor B is the prescribed total number of months in which the Accumulated share option income can spread over. It is calculated based on summation of (share option income multiplied by the vesting period spent in China), divided by the total share option income. As in before, Factor B is capped at 12.
To illustrate:
|
Employee exercises |
Taxable share option income (RMB) (i) |
Vesting period in China
(months) (ii) |
Total
(i) X (ii) |
|
Option Y in Nov 2006 |
10,000 |
6 |
60,000 |
|
Option Z in Dec 2006 |
40,000 |
18 |
720,000 |
|
Total |
50,000 |
|
780,000 |
In November 2006
IIT on share option Y = [RMB10,000 / 6 X 10% - 25] X 6 = RMB850
In December 2006
IIT on share option Z = [RMB50,000 / 12** X 15% - 125] X 12 - RMB850 = RMB5,150
** Factor B = 780,000 / 50,000 = 15.6 (capped at 12)
In view of the above, the IIT calculation on share option income now becomes more complicated and the cumulative effect as a result of the new calculation method will also offer less tax planning opportunity of multiple exercises of share options. In addition, Circular 902 does not have an effective date and hence it is possible that it will have retrospective effect from 1 July 2005 (i.e. the effective date of Circular 35).
Thus, there is an urgent need for companies to review their share option reporting in China on the exercising of share options since 1 July 2005 and consider whether it is necessary to make amendments given there will be a new annual IIT filing requirement by individual employees with annual income exceeding RMB120,000 effective from the calendar year 2006. At the same time, companies should review the current IIT planning strategies that have been adopted for share option income and consider whether it is necessary to modify the strategies to cope with the new requirements. |
