Preferential IIT treatment for certain equity incentive plans further extended

On 16 January 2023, China's Ministry of Finance and State Taxation Administration issued Bulletin No. 2 of 2023, which further extends the preferential individual income tax (IIT) treatment for equity incentive plans offered by listed companies. The policy, which was set to expire on 31 December 2022, has been extended to 31 December 2023.

The preferential treatment applies to equity incentive plan compensation (e.g., stock options, stock appreciation rights, restricted shares) offered by listed companies to resident individuals based on their employment. Such compensation is taxed separately from the individual's other comprehensive income, with the tax determined based on the following formula: equity incentive plan compensation multiplied by the applicable tax rate less the quick deduction. All such compensation derived by a resident individual in a calendar year must be consolidated for assessment purposes. Affected taxpayers generally benefit from this separate taxing method since the IIT burden on such compensation may be lowered as compared to including it in comprehensive income. 

Equity incentive plans have become an important tool for talent attraction and retention and have been widely adopted by both domestic and foreign enterprises. The extension of the preferential treatment should reduce the tax burden of equity incentive plan compensation and enhance the effectiveness of such plans. With intensified tax administration and collection on equity incentive plan compensation, enterprises and employees should consider the following issues.

Registration and reporting obligations

Circular Cai Shui [2005] No. 35 and other relevant regulations require domestic enterprises operating equity incentive plans to register with the tax authorities prior to implementation of the plan. Furthermore, detailed information, including participants’ names, the type of equity instrument, number of shares granted, and grant price, must be reported to the tax authorities.

The State Taxation Administration also issued a circular in late 2021 to strengthen the IIT administration of equity incentive plans, which requires enterprises operating equity incentive plans to submit the "Equity Incentive
Information Reporting Form" to the tax authorities within 15 days following the month when the decision to implement the plan is made.

Such reporting obligations are recurring, and failure to fulfill the obligations in a timely manner may lead to disqualification of preferential treatment and a potential tax audit focusing on historical compliance. Enterprises with equity incentive plans should establish a well-developed process and leverage digital solutions to ensure such reporting obligations are timely and properly fulfilled.

Scope of coverage of preferential treatment

The preferential treatment applies to equity incentive plan compensation offered by listed companies to resident individuals. As a result, the IIT treatment varies under other circumstances.

Nonresident individuals

IIT on equity incentive plan compensation offered by listed companies to nonresident individuals based on employment is assessed separately based on the following formula:

IIT on current month equity incentive plan compensation = [(year-to-date accumulated amount of equity incentive plan compensation ÷ 6) × applicable tax rate – quick deduction] × 6 – year-to-date accumulated tax paid on equity incentive plan compensation

Nonresident individuals are nondomiciled individuals that spend less than 183 days in aggregate in China in a tax year. In practice, the tax authorities generally require enterprises with equity incentive plans to perform registration and reporting in a timely manner for this treatment to apply.

Equity incentive instruments

With domestic and foreign capital markets flourishing in recent years, equity incentive instruments are diversifying. In addition to stock options and restricted shares, the use of various types of equity instruments in incentive plans has been widely adopted, including the use of restricted share units, phantom shares, and employee-owned shares. Asset management plans or trust arrangements also may be involved in the equity incentive plans, which further increases the complexity. The tax treatment of these complex and diverse equity incentive plans is not explicitly stipulated in the prevailing tax laws. Instead of directly applying the preferential treatment, enterprises with such equity incentive plans should be aware that there could be uncertainty in tax treatment and risks. Enterprises should undertake a comprehensive analysis of their operations and transactions to determine potential tax treatment and have adequate communications with the tax authorities. 

Unlisted companies

As an important tool for talent motivation and retention, equity incentive plans also have been widely adopted by many unlisted high-growth enterprises. Enterprises should carefully plan the scope of participants, volume of shares granted, grant price, vesting schedule and conditions, and exit mechanisms, among others. In addition, the tax implications also should be considered when designing the framework of an equity incentive plan. In view of the flexibility of equity incentive plans operated by unlisted companies, multiple types of shareholding structures and trust arrangements are commonly involved, which further increases the complexity of the tax treatment. Enterprises intending to operate equity incentive plans should conduct a comprehensive analysis of the tax implications of different equity instruments under different shareholding structures and to adopt the arrangement aligned with their position and strategic plan, to ensure the effectiveness of the equity incentive plan and successful business operations.