The granting of employee stock options and shares as a form of remuneration is an increasing trend in the People's Republic of China ("PRC" or "China"). This comes as no surprise considering retention of talented employees is critical for any corporation to expand in the Chinese market, a market most companies can ill afford to ignore. With the influx and expansion of foreign multinational corporations, the demand for highlevel management employees in particular is greater than ever. In this regard, for foreign listed multinationals, the ability to grant rights to foreign listed shares to these employees in China as part of their employee share and option plans ("ESPs") is important to their human resource and recruitment strategy. This form of remuneration gives them an added advantage over private company employers since shares are liquid and the valuation of such a benefit is more clear to the employees than with private company shares. Many of these foreign listed multinationals have already implemented employee share and option plans in other jurisdictions as part of their global employee share and option plan initiatives. However, despite the commercial needs, legal restrictions and uncertainties have until now limited the rolling out of ESPs in China. Recent legislative changes in China may, however, change this situation. This note summarizes the recent development of the legal requirements and procedures for registering and implementing ESPs and assesses whether these changes will trigger a take off in the use of such plans for employees in China.
- LEGISLATIVE BACKGROUND
PRC nationals are subject to strict controls over their use of foreign exchange. The Measures for the Administration of Individual Foreign Exchange, promulgated by the People's Bank of China effective 1 February 2007, and the Detailed Rules for the Implementation of the Measures for the Administration of Individual Foreign Exchange promulgated by the State Administration of Foreign Exchange ("SAFE") effective 1 February 2007 primarily regulate the exchange and remittance of foreign exchange by PRC nationals. Under the aforementioned rules and regulations, PRC nationals are required to comply with the relevant regulations and registration procedures when investing in or owning foreign securities directly.
SAFE is the regulatory body in charge of regulating inflow, outflow and conversion of foreign exchange in China and is the primary regulator overseeing the implementation of ESPs. Although the China Securities Regulatory Commission ("CSRC") regulates the securities and futures market in China, it has not actively been involved in regulating ESPs. CSRC approval is, however, required if securities are issued to more than 200 individuals, which is deemed to be an issuance to the public under Article 10 of the People's Republic of China Securities Law effective 1 January 2006.
The concept of ESPs is not new in China. In 2007, SAFE issued the Circular on the Foreign Exchange Administration of the Participation of Domestic Individuals in Foreign Listed Companies' Employee Share Ownership Plans and Share Option Plans  No. 78 ("Circular 78") which took effect on 28 March 2007. Circular 78 was heralded as SAFE's response to the demand for guidelines and regulations allowing foreign listed companies to grant their foreign listed shares to employees of their subsidiaries in China (i.e., ESPs), provided that the ESPs were registered with SAFE in accordance with Circular 78. Registration under Circular 78 allowed the proceeds from the sale of the foreign listed shares to be converted into Renminbi and remitted to the personal bank accounts of the employees in China through a specially designated PRC bank account. However, Circular 78's scope of application was limited and several of the requirements imposed were not easy to satisfy. In addition, there were intensive documentation requirements and uncertainties with the registration process. The result was that the registration of ESPs under Circular 78 was not as effective as hoped for. Many employers whose ESPs did not qualify under Circular 78 had to devise other schemes as alternatives to mirror the effects of ESPs, using phantom share plans and cash bonus plans in an attempt to convey the benefits of stock ownership plans to their employees in China.
On 20 February 2012, SAFE issued the Circular on the Foreign Exchange Administration of Domestic Individuals Participating in Foreign Listed Companies' Employee Share Incentive Plans  No. 7 ("Circular 7"), which took effect on the same day. Similar to Circular 78, Circular 7 requires SAFE registration to be completed in order to implement an ESP in China and supersedes Circular 78. The remainder of this note examines the requirements under Circular 7 and also raises comparisons with Circular 78 to determine if this recent development should be seen as a positive change.
- SCOPE OF APPLICATION
The scope of application under Circular 7 has been expanded beyond that covered by its predecessor, Circular 78 by clarifying and defining a number of key terms that were uncertain under Circular 78.
2.1 Foreign Listed Company and Domestic Company
The definition of a 'foreign listed company' under Circular 7 is basically any company listed on a foreign stock exchange (including Hong Kong, Taiwan and Macao stock exchanges) which is similar to the definition under Circular 78, but the definition of 'domestic company' has been expanded. Under Circular 7, a ‘domestic company’ is defined as a foreign listed company registered in China, branch entity or representative office of the foreign listed company established in China as well as the parent company, a subsidiary or partnership established in China in which the foreign listed company has shareholding control or actual control. Under Circular 78, representative offices were not considered 'domestic companies' and were therefore carved out. Similarly, partnerships were not included and there was no express reference to shareholding control or actual control under Circular 78. From our inquiries with the Beijing branch of SAFE, the shareholding threshold for a PRC company to be considered a subsidiary and therefore a domestic company is fifty percent (50%).
Importantly, there is also express reference to shareholding control under Circular 7. As a result, it may be that a threshold of less than fifty percent (50%) may qualify under Circular 7 since the PRC Company Law (effective 1 January 2006) defines a controlling shareholder as one who holds less than fifty percent (50%) of the shareholdings of a company but nevertheless is able to materially influence the shareholders' meeting. Similarly, with the reference to actual control under Circular 7, a PRC company in which the foreign listed company exerts contractual control may therefore qualify as a domestic company under Circular 7. It remains to be seen whether SAFE will adopt this interpretation.
The expansion of the scope of entities that qualify as a 'domestic company' is prima facie a positive development since it allows more foreign listed companies to benefit from Circular 7's application. Foreign listed companies that have established representative offices in China are now permitted to grant ESPs to their employees. Furthermore, the concept of actual control may be interpreted as control over the board, management or through contracts such as powers of attorney and voting agreements, even without the requisite shareholding thresholds.
2.2 Share Incentive Plan and Qualified Participants
Circular 78 applied to employee share ownership plans and share option plans (which were expressly referred to under Circular 78) but there was no definition of the term 'share incentive plans' as such. Under Circular 7, SAFE has defined 'share incentive plans' as incentive plans (such as employee share ownership plans and share option plans including those permissible under laws and regulations) where the shares of the foreign listed company are offered to individuals who have employment or labour relationships with the domestic company, including directors, supervisors1, senior management employees and other employees of the domestic company. Two key points can be derived from this definition.
First, individuals who can participate in an ESP are not limited to employees, but potentially also include independent contractors (i.e., those that provide services to the domestic company but are not formally in an employment relationship with the domestic company). Circular 78 was not explicit in specifying the requirements for participants. The express inclusion of directors (who may not necessarily be in an employment relationship with the domestic company), supervisors and senior management employees is a positive development as these are often the persons who companies would like to be able to incentivize.
Under Circular 78, reference was only made to employee share ownership plans and share option plans. This led some to conclude that phantom stock option plans or similar plans (where participants would receive only the sale profits in the form of cash and were not at any point issued shares or options) did not fall within the scope of Circular 78. Hence, these were interpreted not to require registration in accordance with the requirements of Circular 78. SAFE acknowledged this trend and the definition of 'share incentive plans' has been expanded explicitly to not just employee share ownership plans and share option plans, but also those permissible under laws and regulations under Circular 7.
More importantly, phantom shares (虚拟股票) and share appreciation rights (股票增值权) are specifically included as 'types of plans' in the registration form to be submitted as part of the application under Circular 7. As a result, Circular 7 may require plans that mirror the economic benefits of ESPs to be registered even though no shares or options are actually issued to the participants. Circular 7 does not define phantom shares or share appreciation rights. However, share appreciation rights have been defined under the Notice on Several Issues Regarding the Levying of the Individual Income Taxation on the Stock Appreciation Rights Income and the Restricted Shares Income issued by the Ministry of Finance and State Administration of Taxation on 7 January 2009 as rights granted by a listed company to an employee ("Grantee"), whereby the listed company will pay to the Grantee an amount equal to the price differential of the shares between the exercise and grant dates in the form of cash upon the fulfilment of certain conditions. This definition is generally in line with the concept of stock appreciation rights in other jurisdictions.
2.3 Nationality of Participants
Another critical issue is whether foreign nationals participating in ESPs are also subject to registration under Circular 7 as 'domestic individuals'. Circular 78 did not define 'domestic individuals' as such and it was commonly viewed that foreign national participants were not subject to registration. Unlike Circular 78, Circular 7 now expressly defines 'domestic individuals' as PRC, Hong Kong, Taiwan and Macao national participants as well as other foreign national participants who qualify as 'domestic individuals' according to Article 52 of the Administrative Regulations of the People's Republic of China on Foreign Exchange effective 5 August 2008 ("Foreign Exchange Regulations"). Article 52 of the Foreign Exchange Regulations stipulates that "domestic individuals" refer to PRC nationals and also foreign nationals who have resided within China for one full year on a continuous basis (连续) with the exception of foreign diplomats in China and the representatives of any international organization in China.
The definition of 'domestic individuals' further expands the scope of Circular 7. Previously, it was clear that PRC nationals (i.e., individuals who hold PRC identification cards and/or passports) were subject to Circular 78 but under Circular 7, Hong Kong Macao and Taiwan nationals are automatically caught (without regard to length of residence) and other foreign nationals may also be subject to registration depending on their length of stay in China.
2.4 Summary on Scope of Application
Based on the analysis above, almost each of the definitions of the key terms that determine the scope of Circular 7 has been expanded directly or indirectly. It is clear that SAFE intends to cast its tentacles as far and wide as possible. This is quite the opposite under Circular 78, which had a much more restrictive approach. Whether or not this is seen as a positive development will depend on the requirements and process for registration of the ESPs under Circular 7. Under Circular 78, many foreign multinationals were keen to implement their global ESP in China and comply with the requirements of Circular 78 but were not allowed to do so since they could not qualify because they did not meet one of the criteria (i.e., because the domestic company was a representative office or if shareholdings in the domestic company did not exceed the benchmark fifty percent (50%) threshold). Others who did qualify were, however, frustrated with the requirements and the document intensive process. As such, the following section examines the specific requirements and process of registering an ESP under Circular 7 and provides comparisons with Circular 78 where relevant.
- CIRCULAR 7
3.1 Agents and Intermediaries
Under Circular 78, one concern was that it required various agencies and intermediaries to be appointed to perform different functions. This created difficulties for foreign listed companies that already had a global ESP in place as it meant that the global ESPs might need to be restructured to satisfy these requirements. The requirements have been simplified under Circular 7.
- Domestic Agent
Under Circular 7, a domestic agent (which can be one of the domestic companies participating in the ESP or a third party domestic entity that is able to provide asset custodian services) is required to be appointed to make the application, open the bank accounts and manage the remittance and transfer of funds. Circular 78 also required a domestic agent to be appointed to essentially serve the same functions.
- Foreign Entrusted Entity
In addition to a domestic agent, Circular 7 further requires a foreign entrusted entity to be appointed to be responsible for the exercise, purchase and sale of shares or interests as well as the transfer of funds. The foreign entrusted entity role is similar to that of a domestic asset manager role under Circular 78.
As mentioned above, Circular 7 has reduced and simplified the requirements for intermediaries and agencies as compared to Circular 78. Under Circular 78, in addition to the above two entities, a foreign custody bank was also required to be appointed. Also, different requirements applied to share option plans whereby a trustee was to be appointed to manage the purchase and sale of options and shares. The simplification of these requirements is helpful since many foreign listed multinationals may not have the different entities appointed under their global employee share plans as required under Circular 78. To address this issue, although Circular 78 allowed the domestic asset manager role to be dispensed with if there is already a global employee share plan in place with a foreign asset manager and custodian bank appointed, the changes brought about by Circular 7 further simplify the requirements.
A major concern of foreign listed multinationals who applied under Circular 78 was the documentary requirements. Circular 7 has to a large extent reduced the number of required documents, which are listed below:
- (a) application form in Schedule 1 of Circular 7 attaching the application letter (in our experience, the application letter is required to include explanations, details and forecasts of the ESP);
- disclosure documents issued by the foreign listed company to evidence the authenticity of ESPs (in our experience, this will include award letters, brochures, etc.)
- letter or agreement issued by the domestic company entrusting the domestic agent in relation to the ESP;
- undertaking letter issued by the domestic company verifying the relationship with the participants (also attaching the name lists, identification card numbers and shares/options held by the participants); and
- any other supplementary materials required by SAFE.
The documentary requirements under Circular 78 were much more extensive. It also required in addition to the above, agreements entered into with the various agents and intermediaries, board resolutions and documentation regarding internal control systems on risk control and information disclosure of the domestic agent. As with the submission of documents to any PRC government authority, Chinese translations will need to be provided which is a requirement under both Circulars.
However, under Circular 7, SAFE requires that all submitted documents be notarised and legalized which was not previously required under Circular 78. This further complicates the documentation process considering the lengthy time frame required for notarisation and legalisation. Importantly, Circular 7 also states that the Chinese version of a notarised and legalised document prevails in the event of any inconsistency with a document translated from/into another language (Circular 78 was silent on this point). There is an obvious concern with this requirement since most materials will originally be drafted in a foreign language (award letters, brochures, etc.). It is important, therefore, to have professional translators involved throughout the process in the event of a dispute with participants relying on the Chinese versions.
3.3 Application for Proof of Foreign Exchange Registration of Stock Incentive Plan and Annual Quotas
The application for registration under Circular 7 is to be made to the SAFE bureau or department where the domestic agent is located ("Local SAFE"). Upon registration, the Local SAFE will issue the "Proof of Foreign Exchange Registration of Stock Incentive Plan" ("Registration Document"). The domestic agent will then need to submit the Registration Document and other materials to the Local SAFE to apply for an annual quota of foreign exchange required for purposes of remittance and conversion of foreign exchange under the registered ESP for that particular year. These requirements are generally the same as those under Circular 78 except that the approval authority is SAFE under Circular 78 instead of its local counterpart under Circular 7. This could be seen as a simplification of the approval process because local authorities generally take a shorter time period and are less strict when reviewing applications.
3.4 Special Purpose Account
Under both Circulars 7 and 78, there is a requirement that a special purpose domestic foreign exchange account ("Special Purpose Account") be opened with a bank. The account will need to be opened by the domestic agent under Circular 7. The process for the inflow and outflow of funds involving the Special Purpose Account is generally similar under both Circulars 7 and 78.
3.5 Material Changes and De-registration
Circular 7 lists a number of scenarios that will require the domestic agent to make an application to the Local SAFE to amend its ESP registration (Circular 78 did not contain similar provisions). These include any changes to the key conditions of the ESP, additional plans being included, restructuring or merger of the foreign listed company or the domestic company, and material changes to the foreign entrusted entity or the domestic company. The application to amend the registration must be made within three (3) months of the occurrence of the event.
Furthermore, in the event of expiration of the ESP term, delisting of the shares or restructuring of the domestic company resulting in the termination of the ESP, the domestic agent must apply for deregistration of the ESP with the Local SAFE within twenty (20) business days thereof.
The reporting requirements are slightly more onerous under Circular 7 than they were under Circular 78. Under Circular 7, the domestic agent is required to submit a completed form describing the status of the ESP (a template of which is attached to Schedule 2 of Circular 7) to the Local SAFE within the first three (3) Business Days of each quarter. Separately, the relevant bank engaged by the domestic agent for the opening of the Special Purpose Account is required to submit two forms to the Local SAFE within three (3) business days of each month relating to the status and cash flow of the Special Purpose Account (templates of which are attached to Schedules 3 and 4 of Circular 7). Circular 78 did not require these reports to be made by the banks.
- RETROSPECTIVE REGISTRATION
A key question is whether existing ESPs registered under Circular 78 need to be registered again under Circular 7. If required, this will certainly be a major burden for those companies that have spent time and resources in complying with Circular 78. Unfortunately, Circular 7 does not address this issue so we suggest consulting with the Local SAFE where the registration has been made to determine if indeed another application needs to be made under Circular 7. Presumably, the process will be more straightforward since the authorities will already be aware of the applicant's circumstances.
Circular 7 also did not confirm whether existing phantom share plans, share appreciation rights and other similar plans that may not have fallen under Circular 78 need to be registered under Circular 7. It also did not impose any deadline by which these registrations need to be completed (unlike Circular 78 which expressly required registrations be completed within 3 months of its issuance). Logically, this should be the intention of SAFE considering the expanded scope of application. Moreover, registration under Circular 7 will help resolve the remittance and conversion of foreign exchange difficulties often faced by applicants in China.
It is clear that Circular 7 has significantly expanded the types of plans that are subject to SAFE's oversight. This is welcome news since it will allow more foreign multinationals to implement their global ESPs in China. However, the requirements for compliance with Circular 7, although arguably less cumbersome than Circular 78, may still be considered too much of an investment of time and resources for foreign multinationals, particularly with the newly imposed notarisation and legalisation requirements. Moreover, since the participants that companies seek to cover in China are limited to only a small number of senior management employees, it may not be worthwhile to apply for registration under Circular 7.
Separately, a common problem faced by many of the applicants under Circular 78 was that a lot of time and resources were spent explaining to the authorities the terms of the ESPs. It is important to bear in mind that because the Local SAFE is the main approval authority, interpretation of Circular 7 may differ from jurisdiction to jurisdiction. Therefore, it is critical to consult with the Local SAFE in the relevant jurisdiction on their requirements (which may differ from our analysis in this note) before submitting an application. Due to these uncertainties, until there are clear and specific guidelines and a uniform approach is promulgated by SAFE, it is still too early to determine whether Circular 7 will open a new chapter for implementation of ESPs in China.