Equity-based compensation

Typical forms

What are the prevalent forms of equity compensation awards in your jurisdiction? What is a typical vesting period? Must the arrangements be offered to a broad group of employees, or can the employer select the participants?

In current practice, the prevalent forms of equity compensation awards are stock options and stock compensation using a trust. In addition, while stock purchase plans using a general partnership used to be prevalent, recently, ‘restricted stocks’ are gradually gaining prevalence.

With respect to stock options, the maximum amount of the fair market value of stock options at the time of issuance must be within the applicable executive compensation amount that is either approved by a shareholders’ meeting, or provided for in the articles of incorporation (in the case of a company with auditors or a company with an audit committee), or approved by the compensation committee (in the case of a company with three committees). The Companies Act sets out mandatory terms and procedures for stock options in general, but leaves the details of the structure of stock options to the company’s discretion.

In terms of restricted stocks, companies will issue ordinary shares in exchange for in-kind contribution of the monetary remuneration claims by allottees. Restricted stocks are typically subject to contractual terms agreed between the company and each allottee, such as a certain share transfer restriction period and conditions for the acquisition of such stock by the company. If the company allots restricted stocks to its executives, the total (maximum) amount of remuneration claims to be paid by the company as executive compensation, the total (maximum) number of shares to be allotted to executives and other details must be approved by the same corporate organ as for stock options.

Stock compensation using a trust is also frequently used as an employee benefit and has also recently become popular as a form of executive compensation. A company will establish separate trusts for employment benefits and executive compensation. The trusts will acquire the company’s shares from the stock market or treasury shares from the company by using the money entrusted, and will distribute shares to the beneficiaries. The beneficiaries are the executives or employees that have satisfied the requirements for benefits set out in predetermined rules on share distributions. The total (maximum) amount of the funds entrusted by the company for executive compensation, the calculation method of the shares and other details must be approved by the same corporate organ as for stock options.

Stock purchase plans using a general partnership used to be the most prevalent form of incentive compensation. Under such plans, eligible executives and employees, respectively, establish or join a general partnership to acquire and hold the company’s shares. The funds necessary for the acquisition of shares and operation of the general partnership are technically contributed by the member executives and employees, but the plan substantially functions as an equity compensation award since the company effectively bears the burden by increasing the compensation or salary to cover the amount of such contribution. In addition, the company is allowed to provide subsidies to employees (not to executives) to be used as part of the contribution to the stock purchase plan for employee benefits.

There is no standard vesting period for the above four types of equity compensation. The award is often structured, however, as a substitute for a retirement allowance for executives (a one-time payment at the time of retirement), and in such cases the vesting date is typically scheduled on or after the retirement date (see question 36 for tax benefits).

The employer can select the participants, taking into consideration applicable requirements regarding deduction and (if they are granted to employees) applicable employment laws requirements.

Must equity-based compensation be granted by the company’s board of directors (or its committee) or can the authority be delegated to officers or employees of the company? Are there limitations or requirements that apply to delegation?

In general, the issuance procedure for stock options or shares as equity-based compensation is the same method as that for third party allotment. With respect to a company with auditors and a company with an audit committee, in principle, its board of directors must decide the total number of stock options or shares to be issued, the amount per stock option or share to be paid in and other fundamental terms set out in the applicable article of the Companies Act. In the case of a company with three committees, these terms must be decided by its board of directors or by an officer authorised by its board of directors. Notwithstanding the above, in cases where the amount to be paid in is particularly favourable to allottees, the approval of a shareholders’ meeting is inevitable.

Tax treatment

Are there forms of equity compensation that are tax-advantageous or disadvantageous to employees or employers?

Tax-qualified stock options are available and are advantageous to employees and executives since only the amount of capital gain arising from a sale of shares obtained through the exercise of a stock option is recognised as taxable income. Only capital gains tax applies, not income tax. In contrast, for non-tax qualified stock options, in addition to the capital gains, income arising from the exercise of stock options is recognised as salary and is subject to income tax. On the other hand, tax-qualified stock options are disadvantageous for employers as this is not a deductible expense under the Corporation Tax Act (the deduction is allowed only if the income on the side of the relevant employee is recognised as salary subject to income tax).

The tax qualified stock options need to satisfy the following:

  • the company issues them by resolution of a shareholders’ meeting or the board of directors (as required under the Companies Act);
  • they are granted to executives or employees of the issuing company or its subsidiary;
  • they are exercised by the executives, employees or their heirs; and
  • the subscription agreement between the issuing company and the executives of employees includes the following conditions:
    • the exercise period must fall within the period commencing from two years and ending 10 years from the date of the resolution regarding the issuance of the stock options;
    • the aggregate exercise price of all tax-qualified stock options will not exceed ¥12 million per year per individual recipient;
    • the exercise price per share is equal to or more than the value of one share at the time of the execution of the subscription agreement;
    • the stock options are non-transferable;
    • the shares should be granted upon the exercise of the stock options in accordance with the resolution of the shareholders’ meeting or board of directors approving the issuance of the stock options; and
    • in accordance with a prior agreement between the company and a financial instrument operator, shares granted upon the exercise of the stock options must be either:
  • duly recorded in the relevant share transfer account registry of the financial instrument operator; or
  • kept in custody or managed in trust by the financial instrument operator.
Registration

Does equity-based compensation require registration or notice? Are exemptions, or simplified or expedited procedures available?

Among the three prevalent equity-based compensation methods, stock options and stock compensation using a trust are subject to the following registration and notice requirements under both the FIEA and Companies Act.

FIEAStock options

Under the FIEA, a foreign or domestic company offering shares, stock options and certain other types of securities designated by FIEA to persons in Japan is required to file a registration statement with the local regulator regarding the offering and deliver a prospectus to each offeree. Thus, stock options are subject to these registration and prospectus requirements when a company offers stock options to its employees and executives in Japan.

The FIEA also provides several exemptions for the requirements. The exemptions need to be considered mainly in connection with companies whose shares are not listed in Japan, because once the company files a registration statement, it is thereafter required to comply with periodic disclosure and reporting requirements under the FIEA. For companies whose shares are listed in Japan, since they are already subject to periodic disclosure and reporting requirements under the FIEA, there is less need to consider the exemptions than for non-listed companies.

The following is an outline of the three types of exemptions for registration statements that are typically examined when a company is considering offering stock options to employees and executives.

Exemption 1: offerees are limited to the company and its wholly owned subsidiaries

Companies are exempted from the registration and prospectus requirements when the newly issued stock options are non-transferable and are granted solely to employees, executives or statutory auditors of:

  • the issuing company;
  • the issuing company’s direct wholly owned subsidiary (first-tier subsidiary); or
  • the wholly owned subsidiary of the first-tier subsidiary (second-tier subsidiary).

As long as all of the offerees in a particular offering are limited to employees, executives, or statutory auditors of the issuing company or its first or second-tier subsidiaries, there are no other criteria for qualifying for the exemption (such as the number of offerees and stock options’ value).

If the aggregate value of the newly issued stock options is ¥100 million or more, companies must file an extraordinary securities report, which is a relatively simple form, even though they are exempted from the registration and prospectus requirements.

Exemption 2: the aggregate value of the newly issued stock options is under ¥100 million

Companies are exempted from the registration and prospectus requirement when the sum of the offer price and exercise price of the newly issued stock options is below ¥100 million.

If, however, the company concurrently makes any other offering of shares, stock options or certain other types of securities designated by the FIEA, or has made such an offering within one year of the date on which the newly issued stock options were issued, the total offer price (and exercise price, if applicable) in such other offerings will need to be included in determining whether the aggregate value of the newly issued stock options has reached the ¥100 million threshold.

Even under this exemption, in cases where the aggregate value of the newly issued stock options is ¥10 million or more, companies must submit a securities notification (which is not disclosed to the public) to the local regulator. Where it is lower than ¥10 million, neither a registration statement nor a securities notification is required.

Exemption 3: the number of offerees is fewer than 50

Companies are exempted from the registration and prospectus requirements when the sum of x and y is fewer than 50, where x is the number of offerees of the newly issued stock options and y is the aggregate number of offerees of the same kind of stock options as in x, which were issued within six months of the date on which the newly issued stock options were issued.

This exemption only applies to a company that is not obliged to file its annual securities report under the regulations of the FIEA.

Whether the previously issued stock options are of the ‘same kind’ as the newly issued stock options is determined by the type of shares subject to both stock options. The previous stock options will be considered of the same type as the newly issued stock option when both options are issued by the same entity, and the surplus dividends, distribution of residual property and items for which they are allowed to exercise voting rights of such shares are the same.

Restricted stock

When a company offers employees and executives its ordinary shares as restricted stocks in Japan, these ordinary shares are subject to slightly different registration and prospectus requirements from the requirements mentioned above. In the case of issuing shares, exemption 1 is unavailable. Therefore, in many cases, companies submit securities notifications or registration statements, depending on the aggregate value of shares to be issued (see exemption 2). With respect to filing a registration statement, a company can use a certain simplified form (eg, names, addresses and other information of allottees can be omitted), if the company allots restricted stocks to employees and executives belonging to the company or its affiliates.

Stock compensation using a trust

With respect to stock compensation using a trust, if a company allocates its shares or disposes of its treasury shares to the trust, such offering to the trust will also be subject to the registration and prospectus requirements. In this case, the exemptions typically examined are exemptions 2 and 3.

Companies Act

By two weeks prior to the allocation date of stock options (in case of stock options) and the payment date of shares (in case of restricted stock and stock compensation using a trust), an issuing company is required to issue a public notice regarding such in a manner designated by its articles of incorporation (for listed companies, electronic announcement or posting in a daily newspaper is common, and for non-listed companies, posting in an official gazette is common). This public notice can be replaced by individual notices to all shareholders. A company can, however, be exempted from this notice requirement if it files a registration statement or obtains a shareholders’ resolution regarding the contemplated issuance.

Withholding tax

Are there tax withholding requirements for equity-based awards?

With respect to equity-based awards, except for tax-qualified stock options (see question 17), the issuing company is subject to withholding tax requirements. However, the timing of withholding differs depending on the structure of the equity-based awards.

Inter-company chargeback

Are inter-company chargeback agreements between a non-local parent company and local affiliate common? What issues arise?

They are commonly used, and are allowed as long as there exists economic substance and a legitimate business purpose for the underlying payments or structure, as such payments often entail a transfer pricing taxation issue.

Stock purchase plans

Are employee stock purchase plans prevalent or available? If so, are there any frequently encountered issues with such arrangements?

Stock purchase plans using a general partnership are available and used to be prevalent. One frequently encountered issue with this arrangement is how to treat the shares owned by the general partnership when the issuing company faces squeeze-out transactions, such as a tender offer.