Series Discussions on Trial Practice of Equity Incentive Mechanism Disputes (4) ─ Analysis of Equity Incentive Tax Disputes of Non-listed Companies (Mainland China)

May 2023

Jolene Chen and Teresa Huang

The Series Discussions on Trial Practice of Equity Incentive Mechanism Disputes (1) – Employees’ Passive Lay-off, Series Discussions on Trial Practice of Equity Incentive Mechanism Disputes (2) – Determination of Equity Exit Price, and Series Discussions on Trial Practice of Equity Incentive Mechanism Disputes (3) – Whether Equity Incentive Cases are Labor Dispute Cases, all focus on the disputes that may arise during the implementation of the equity incentive plan and the trial practice.  However, in addition to the equity incentive plan itself, the tax issues involved may also give rise to disputes.

As a widely used incentive in today’s corporate world, equity incentive plans are designed to provide employees with equity in the company in order to motivate them to actively participate and contribute to the performance and long-term value of the company.  However, the tax issues involved in the implementation of equity incentive plans are often intricate and complex.  In fact, the tax issues of equity incentives are quite complex, involving various tax-related regulations, tax incentives and tax planning considerations.  This article will take a case as a breakthrough to briefly discuss some tax considerations that may be involved in equity incentive plans.

In the execution reconsideration case of Liu Sihan (the “Employee”) vs. Genor Biopharma Co. Ltd (the “Company”) (Case No. (2022) Hu 01 Zhi Fu No. 238), the Employee claimed that the proceeds cased from the equity incentive shares were from the realization of the equity granted by the Company to the Employee, and the income from the equity incentive should be taxed in accordance the provisions on the item of “property transfer income” and calculated at a tax rate of 20%.  However, the Company claimed that it calculated the individual income tax according to “income from wages and salaries”, which was justified by law and had been withheld and paid on behalf of the Employee.  During the court hearing, the court consulted the taxation authority, who considered that the Company’s tax calculation and declaration were correct, and finally the court did not support the Employee’s application for reconsideration.

The above case involves the understanding of taxation and equity incentive, which is discussed in detail here. 

The principle of equity incentive is to give employees part of the equity to motivate them to work hard, so that the wealth of the employees and the company’s wealth are deeply bound, and the company and their employees share prosperity and bear loss together, to achieve the purpose of win-win.

Once the goal of equity incentive is achieved, how do the employees get the wealth?

There are two steps to get the wealth, the first one is to get the equity, and the second one is to sell the equity to get the money.

In this case, the Employee understands that the equity registered is not wealth, but only through the transfer to the Company or a third party, the equity is converted into money.  Therefore, the Employee thinks that the tax should be collected in the process of repurchase by the Company, so the Employee understands it as “income from transfer of property”.  Obviously, the Employee’s understanding is the second step of wealth acquisition.

The tax authority understands that the change in the registration of equity is the acquisition of wealth, and the equity is transferred from the Company to the Employee’s name, i.e. the Company pays salary and wages through the form of equity, which increases the Employee’s wealth.  This acquired equity should be taxed.  The tax authority’s understanding is the first step of wealth acquisition.

Which of the two understandings is right?

We should look for the relevant legal basis:

Individual Income Tax Law of the People’s Republic of China

Article 2 Individual income tax shall be paid on the following individual income:

(1) Income from wages and salaries;

Regulation on the Implementation of the Individual Income Tax Law of the People’s Republic of China

Article 6 The scope of various categories of individual income as mentioned in the Individual Income Tax Law is as follows:

(1) Income from wages and salaries, which means the income from wages, salaries, bonuses, year-end salary increases, labor dividends, and allowances obtained by individuals due to their job or employment and subsidies and other income related to their job or employment.

The Law clarifies that the equity earned from incentives becomes “income related to the employee’s employment” when the registration is changed, and such equity belongs to the income from wages and salaries in the tax catalog.  According to the Individual Income Tax Law of the People’s Republic of China, the first step to get the equity is considered as wealth income, which is the income from wages and salaries and should be taxed.  Then, according to the tax authority, the acquisition of equity should be taxed.  Which tax rate should apply to the income?  As the author analyzed in the Series Discussions on Trial Practice of Equity Incentive Mechanism Disputes (3) – Whether Equity Incentive Cases are Labor Dispute Cases, laborers’ income from equity incentives is the labor remuneration they get from the employer, which is based on the relationship of employment, and in principle, the tax should be paid as that on the income from wages and salaries.  Therefore, the taxation authority determines that the proceeds cased from the equity incentive shares in this case taxed at a rate up to 45% for income from wages and salaries is in accordance with the law. 

In addition, it is worth noting that the situation in this case should be distinguished from another deferred tax payment policy for equity incentives of non-listed companies, namely, the Notice on Improving the Relevant Income Tax Policies for Equity Incentives and Technology Investments, which stipulates that, for the stock options, equity options, restricted stocks and equity rewards granted by non-listed companies to their employees, if the prescribed conditions are satisfied, the deferred tax payment policy may apply, subject to undergoing recordation formalities with the competent tax authorities, which means that employees may temporarily not pay taxes on the equity incentives they acquire, and tax payment may be deferred until when such equities are transferred.  At the time of equity transfer, the individual income tax on the balance after deducting equity acquirement costs and reasonable taxes and dues from equity transfer income shall be calculated and paid at the rate of 20% in accordance with the provisions on “property transfer income” item.  However, the equity incentives of non-listed companies that enjoy the deferred tax payment policy shall meet a series of conditions at the same time[1], and for the equity incentives or investments by technological achievements that choose to enjoy the deferred tax payment policy, the companies shall fulfill the recordation formalities with the competent taxation authority within the specified period.  Those who do not go through the recordation formalities shall not enjoy the deferred taxation payment policy stipulated in the Notice.

The above provisions may not be directly applied in this case, because in this case, it is the Company’s payment of the proceeds cashed from equity incentive to the Employee through equity incentive buyback, rather than the Employee’s transfer of her equity.  However, the above provision can be applied in other equity incentive cases.  Such provisions will save the employees from paying the individual income tax at a progressive tax rate up to 45% on income from wages and salaries, and will be directly taxed according to the “property transfer income” when the transfer is made.

Thus, tax considerations are critical in equity incentive plans.  Different types of equity incentive plans may involve different tax policies and regulations, including tax deferral, tax rate calculation, recordation formalities, etc.  When implementing an equity incentive plan, enterprises need to pay close attention to the requirements of relevant tax laws and regulations to ensure that they can enjoy tax incentives in a compliant and legal manner and minimize tax risks.

[1] According to Article 1(2) of the Notice on Improving the Relevant Income Tax Policies for Equity Incentives and Technology Investments, The equity incentives of non-listed companies that enjoy the deferred tax payment policy shall concurrently meet the following conditions: (a) They shall fall within the scope of equity incentive plans of resident enterprises within the territory of China; (b) The equity incentive plans have been deliberated and adopted by the board of directors or the shareholders’ meeting of the company at issue; (c) The subject matter of the incentives shall be the corporate equities of the resident enterprises within the territory of China; (d) The persons to whom incentive are granted shall be the technical backbones and senior executives as decided by the board of directors or shareholders’ meeting (or shareholders’ assembly) of the company, and the accumulative number of people receiving the incentive shall not exceed 30% of the average number of in-service employees of the company in the past six months; (e) Stock (equity) options shall be held for three months or more from the date of granting and for one year or more from the exercise date; restricted stocks shall be held for three months or more from the date of granting, and for one year or more after restriction is lifted; and equity rewards shall be held for three years or more from the date of acquirement.  The aforesaid time conditions shall be specified in the equity incentive plans; (f) The duration from the date of granting of stock (equity) options to the exercise date thereof shall not exceed ten years; (g) Neither the companies that implement equity incentives nor the industries to which the subject companies of their equity rewards are included in the Catalogue of Restricted Industries Eligible for Preferential Tax Policies for Equity Rewards (see Annex).  The industry to which a company falls into shall be the industry which takes up the highest proportion in terms of the main business revenue of the company in the previous tax year. 

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