Equity incentives of unlisted companies via shareholding platform

Q: What advantages do shareholding-platform-type equity incentives have? A: An unlisted company may implement an equity incentive in one of two ways, directly or indirectly: (1) in a direct shareholding-type equity incentive, the employees become shareholders registered with the administration for industry and commerce and directly hold equity in the company; and (2) in a shareholding-platform-type equity incentive (platform incentive), employees indirectly hold equity in the company through a shareholding platform.

Comparatively, the platform incentive has the following advantages: (1) employees’ indirect holding of equity through this platform is conducive to maintaining relative stability in the company’s equity structure; (2) by establishing multiple shareholding platforms, it is possible to circumvent the limit on limited liability companies of having no more than 50 shareholders, and expand the scope of the recipients of the equity incentive; and (3) through the establishment of a partnership shareholding platform, the controlling shareholder, as the general partner of the partnership, can strengthen his control over the company and ensure efficient decision-making in the course of its operations.

A platform incentive also has certain drawbacks, including a lack of flexibility when an incentive recipient withdraws, difficulty in recognizing status as a shareholder, etc., in addition to the tax issues, which are the focus of this column.

Q: Does a platform incentive satisfy conditions for tax benefit under Document No 101? A: The notice of the Ministry of Finance and the State Administration of Taxation on Improving Income Tax Policies Relating to Equity Incentives and the Acquisition of Equity Interests Using Technology (Document No. 101) specifies that, where an equity incentive satisfies the conditions, employees enjoy the benefit of deferring tax. At present, numerous tax authorities hold that employees who receive equity incentives through a shareholding platform are not eligible for this tax benefit.

Document No. 101 specifies that the subject matter of an equity incentive is required to be the “equity of the company in question”. Where employees hold equity indirectly through a platform, tax authorities are divided in their opinions. One opinion holds that the “equity of the company in question”, as specified, should be strictly interpreted restrictively so that, as the subject matter of a platform incentive is the equity (units) of the shareholding platform, not the “equity of the company in question”, it does not satisfy the condition for the tax benefit. The other opinion holds that, based on the principle of “substance over form”, the equity (units) of a shareholding platform really is in fact “equity of the company in question”, and should be regarded “penetratively”. Therefore, it satisfies the condition for the tax benefit.

In practice, an increasing number of tax authorities are starting to stand on the side of the first opinion, requiring employees to pay individual income tax on equity as for “wage and salary income” when they receive it and as for “income from the transfer of property” when they transfer such equity. Considering the lack of clarity in the tax policy and the relatively large tax burden, certain companies that have implemented platform incentives and the recipients of such have taken a passive tax-filing-and-payment stance. However, for an enterprise considering a listing, this poses a potential tax compliance risk and adds uncertainty in the future IPO review.

Q: If payment is to be effected in shares for a platform incentive, what effect would that have on the company? A: The management expenses arising from the application of accounting principles relating to payments made with shares will reduce the company’s profit accordingly.

Article 2 of the Enterprise Accounting Principles No. 11 specifies that “the term ‘payment made with shares’ means a transaction wherein an enterprise, for the purposes of obtaining a service an employee or a third party provides, grants him an equity instrument or bears an obligation determined based on an equity instrument”. The objective of a platform incentive is to grant employees equity in the company in order to obtain their services and if, at the time of the grant thereof, the fair value of the subject matter is greater than the price at which the equity is granted. It is to be treated as a payment made with equity and the difference between the grant price and the fair value on the date of the grant is to be counted as part of the management expenses, thereby reducing the company’s profit accordingly.

Pursuant to Principles No. 11, when applying payment made with shares, two circumstances need to be differentiated: (1) where the granted equity can be exercised promptly in the period in question, the management expenses are required to be counted as part of the profits and losses in a single sum; or (2) where the granted equity can be exercised only after a waiting period, the management expenses are required to be allocated reasonably over the equity incentive plan’s waiting period. A company considering a listing may reasonably arrange its equity incentive plan to avoid reducing its profits due to management expenses arising from a payment made with shares, and thereby affecting its future domestic listing.

Q: Can the company expenses arising from implementing a platform incentive be deducted before tax? A: Numerous tax authorities hold that the company expenses stemming from implementing a direct shareholding type equity incentive may be deducted when paying enterprise income tax, but those incurred in connection with a platform incentive may not be so deducted.

Pursuant to the announcement of the State Administration of Taxation on Enterprise Income Tax Treatment Issues Relevant to Equity Investment Plans Implemented by Enterprises Resident in China (Announcement No. 18), a listed company that establishes an equity incentive plan in accordance with Announcement No. 18 and treats the confirmed expenses based on the accounting principles may deduct the same before tax as for the payment of wages or salaries; an unlisted company that establishes an equity incentive plan in accordance with the requirements for the establishment of equity incentive plans by listed companies and treats the same in accordance with the accounting principles, may also handle matters in accordance with the foregoing provision.

However, Announcement No. 18 specifies that the subject matter of such an equity incentive is required to be “stock of the company in question”. Generally, tax authorities hold that the subject matter of a platform incentive cannot be deemed to be “stock of the company in question”. Therefore, it does not satisfy the conditions for the tax benefit and the related expenses incurred may not be deducted before tax.

He Yu is a partner and Shi Guangyao is an associate at AnJie Law Firm