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| Mar 2008 |
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In brief
In March 2008, the Hong Kong Inland Revenue Department ("IRD") issued a revised Departmental Interpretation & Practice Note ("DIPN") No.38 - Employee Share-Based Benefits. In addition to addressing the IRD's position on share option benefits which has been included in the previous version, this DIPN also covers the IRD's assessment approach on share award benefits, which can be categorized broadly as the "upfront" and the "back end" approaches.
"Upfront" vs "Back end" approach
While there is no dispute that share award benefits are taxable as "perquisite", the crux of the matter is when the perquisite accrues to the employees and what value should be attached to it. The IRD indicates that the fair market value of the shares at the time of accrual should constitute taxable income to the employees, which generally refers to the closing quotation value on the stock market.
Regarding the timing of accrual, it is either "upfront" i.e. at the time the employer makes an award of shares to the employee; or "back end", when the shares are actually vested in the employee free of any conditions. It is crucial to determine when the employee is regarded as fully entitled to ownership of the shares. The IRD will usually look at when the employee is entitled to the full economic benefit of the shares and when he/she has all the rights of a normal shareholder in this context; for instance, when the employee's name would be entered in the shareholders' register, entitled to vote in general meetings, receive dividends, pledge the shares to banks for loans, etc.
Below is a comparison of the two approaches:
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Upfront approach |
Back end approach |
| Vesting period applies? |
No |
Yes |
| Time of assessment |
Upfront (at the time of grant) |
Back end (upon fulfilment of conditions) |
| Valuation |
Market value at grant |
Market value at fulfilment of conditions |
| Discount in valuation |
Potentially - if there is sale restriction of shares after grant (usually 5% per year) |
No |
| Distributions (e.g. dividends, bonus shares) received during sale restriction / vesting period |
Not taxable - investment income (employee is already entitled to the shares upfront albeit sales restriction may occur) |
Taxable - employment income (since the employee is only entitled to the shares at the end of the vesting period) |
"Deemed Vesting" provisions
Similar to share option benefits, taxpayers leaving Hong Kong permanently can make a "deemed vesting" election (i.e. taxed as if the unvested shares had been vested on departure). A person may elect to be assessed on either (a) the deemed value on a day within seven days of the final tax return submission date or (b) the deemed value on the date of departure if the election is made at any time within three months after the date of departure. A standard form is provided for taxpayers to make the election.
A deemed vesting election cannot be withdrawn and is an "all or nothing" election (partial elections are not allowed).
Once the deemed vesting election is made and an assessment is issued, a subsequent request to revise the assessment will not be entertained unless lodged within the statutory objection time period (which is usually 1 month). This is different from the "deemed exercise" election on share options of which the IRD will "favourably consider" a re-assessment if the actual exercise of the options result in a lower taxable income than the deemed exercise. |
Source of share award benefits
The IRD's view is that sourcing of such benefits would be the same as that applicable to other perquisites. As such, the days in Hong Kong in the year of assessment that vesting takes place would be taken into account, which is different from share option gain that the IRD will take into account the days in Hong Kong during the whole vesting period.
In addition, shares vested after cessation of employment are deemed to accrue on the last day of employment as other perquisite.
In respect of employees under non-Hong Kong employment, except for inbound and outbound employees, the time-apportionment factor will be i) the days in Hong Kong in the year of assessment that vesting takes place over ii) total days in the year of assessment that vesting takes place.
For inbound and outbound employees which transfer in/out of Hong Kong during the vesting period, under the "back end approach", it is possible to first exclude the portion of the benefits attributable to their pre/post-Hong Kong assignment period and then take into account the time-apportionment factor in the year of vesting for inbound employees or the time-apportionment factor in the year of departure for outbound employees.
Other matters
The guidelines on share option benefits are basically the same as the previous version of the DIPN issued in March 2005.
Similar to share option benefits, employers are required to provide details of the share award benefits in commencement cases (Form IR 56E), continuous employment cases (Form IR 56B) and cessation/departure cases (Form IR 56F/G). However, if share awards are vested in the employee after cessation of employment, a "Replacement" Form IR 56F/G should be filed to the IRD as the income would be deemed as if received at the last date of employment.
Gross amount of the share award benefits should be reported in the Employer's Return even though the employee may be eligible for time-apportionment.
Unless the "deemed vesting" and/or "deemed exercise" election has been made, departed employees should advise the IRD as soon as possible when they have exercised share options or vested shares which are attributable to their previous assignment in Hong Kong. This obligation does not depend on whether a tax return is issued to the individual.
When an assessment was made prior to the issuance of this revised DIPN, it will not be reopened for the purpose of making an adjustment to reflect any change of practice detailed in the DIPN.
Phantom share plans are addressed slightly in the revised DIPN. In general, no salaries tax should be imposed if no actual value is passed to the employees at the time of allotment. Cash payment (i.e. in lieu of shares) should be taxed together with other income in the year of payment.
PwC's commentary
With the increasing popularity of remunerating employees by share award benefits, this revised DIPN provides detailed guidelines on the taxability of such benefits which should be very useful to taxpayers and their employers. One should notice that in general, share award benefits are taxed in the same way as other "perquisites" whereas share option gain is taxed under a separate section of the Inland Revenue Ordinance (Section 9(1)(d)). The IRD has also highlighted the difference in the tax positions of these two items in the revised DIPN.
In addition, employers should revisit their current reporting positions on share award benefits and make the appropriate changes, if necessary, on such benefits awarded to their employees in the future. For departing employees, they may consider elect the "deemed vesting" option of their unvested share award benefits of which such option is not available prior to the issuance of this revised DIPN. Otherwise, a tracking system should be put in place to report share award benefits vested after an employee's departure from Hong Kong.
The IRD has also made it clear that there would be many other scenarios more complicated than those highlighted in the revised DIPN. One should review the terms of each share award scheme to ascertain the related tax implication. If in doubt, employers may consult the IRD in writing or by way of an advance tax ruling.
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