Euan Fergusson (London), Bian Jiang and Liu Tian (Beijing) consider the SAFE filing requirements and tax treatment of employee incentives in China.

Background

Hui Zong Fa [2007] “Circular 78” requires overseas companies to register with the State Administration of Foreign Exchange (SAFE) when implementing equity plans for their employees in China. SAFE registration can generate significant costs for companies when preparing and translating the required documents, going through the application procedure and renewing on an annual basis. It may, however, be possible for companies to avoid the SAFE obligations altogether when implementing award plans for their employees in China whilst still preserving a more favourable income tax position. This may be achieved by structuring the awards in such a way that individuals will not have any entitlement to shares but will receive a cash value representing either the value of a fixed number of shares at vesting (i.e. “phantom shares” or “cash-settled RSUs”) or the increase in value of a fixed number of shares between grant and vesting/exercise (i.e. “stock appreciation rights” or “phantom options” (“SARS”).

Either structure may be an attractive method for those companies who wish to reward their employees in China, as it will save both the time and expense of having to comply with the obligations under SAFE.

Avoiding the need to file under SAFE

Companies can avoid the onerous filing requirements under the SAFE system if they can demonstrate that awards to their employees in China are not equity settled but take the form of SARS and/or phantom shares. Since no equity is issued, these plans are characterised in China as “bonus plans” and therefore fall outside the requirements to file under SAFE.  

For companies to ensure that the awards fall outside the SAFE filing requirements, it is important to make clear in all documentation concerning the awards that participants will not be acquiring any shares or any rights to shares and shares must not be used to fund any payments made to participants under the awards.

The tax position of employee incentive plans

Cai Shui [2005] “Circular 35”, Cai Shui [2009] “Circular 5” and Guo Shai Han [2009] “Circular 461” provide for preferential tax treatment of the proceeds from stock options and other share based awards and allow these proceeds to be treated as employment income which can be taxed separately from an employee’s monthly salary income. This means that a lower tax rate can be applied to that element of income derived from share based awards.

In order to benefit from this preferential treatment, locally listed companies or the local subsidiaries of overseas companies must register the relevant plans with the Local Tax Bureau (“LTB”) and comply with certain other filing requirements on the exercise of the awards. The proceeds of awards under plans not registered with the LTB will be taxed together with the participant’s salary, meaning a much higher tax rate will ordinarily apply.

To register with the LTB, companies must translate into Mandarin and submit a copy of the related documents, including the following (wherever applicable):

  • the plan;
  • standard form award agreement;
  • grant notice; and
  • exercise notice.

Application of the favourable income tax treatment to cash awards

It is understood that local employing entities will still have to register their plans and documents outlined above with the LTB to take advantage of a lower tax rate for their employees. However, we consider that these requirements are far less demanding than those under the SAFE system and the tax advantages afforded to employees are expected to outweigh the additional costs and burdens associated with LTB filings.

Therefore, continued use of cash awards (linked to underlying share performance) to incentivise employees will have the benefit of attracting favourable tax treatment whilst still avoiding any requirement on the company to file these plans under SAFE.