This GMS Flash Alert reports on opinions released by the Hainan Local Tax Bureau in the People’s Republic of China relating to the individual income tax treatment of equity incentive income derived from unlisted companies.
The Hainan Local Tax Bureau in the People’s Republic of China (PRC) recently released its opinions relating to the individual income tax (IIT) treatment of equity incentive income derived from unlisted companies.
Since 2011, this is the first time the PRC tax authorities have issued operational guidelines on IIT issues for equity incentive income derived from unlisted companies.
It could have the effect of encouraging unlisted companies (including companies preparing for public listing) to implement employee equity incentive plans.
It should be noted that the Hainan Local Tax Bureau’s opinions, as stated in Circular No. 1151, play a guiding role in the taxation treatment of share-based incentive income derived by employees who participate in unlisted companies’ equity incentive plans in Hainan Province, but it is not binding in other locations.
After the Reply of State Administration of Taxation in Circular 10301 became invalid in 2011, this opinion from the Hainan Tax Bureau is the first time operational guidelines on IIT issues for equity incentive income derived from unlisted companies have been issued.
On 10 December 2015, the Hainan Local Tax Bureau replied to a query raised by the Haikou Local Tax Bureau regarding employees’ IIT implications for stock option income derived from unlisted companies.2 This response, in the form of Circular No. 1151, clarifies the specific taxation practice, including the taxation point, share valuation method, and tax calculation formula relating to shares and options granted to employees of unlisted companies.
Circular No. 1151 states that employees’ equity incentive income derived from unlisted companies shall be regarded as "wages and salaries income," and the taxation point is at purchase date.
The taxable income equals (value per exercised share minus exercise price paid by employee) multiplied by the number of shares exercised, in which the value per exercised share can be determined based on the net book value of the unlisted company as stated in the preceding year’s annual report, which has been audited by an audit firm.
The IIT payable on the equity-related income of the month shall be calculated according to the following formula:
IIT Payable = (income derived from equity incentive ÷ respective number of months × applicable tax rate – quick deduction) × respective number of months
Wherein the respective number of months shall refer to the number of months during which an employee derived the taxable income from equity incentive in the PRC; where the period is more than 12 months, it shall be taken as 12 months.
The release of Circular No. 1151 fills the gaps in the operational taxation guidelines on equity incentive income derived from unlisted companies.
Clarification of Taxable Value Per Share of Unlisted Companies
Circular No. 1151 draws from Circular No. 1030, and suggests that the taxable value per share can be determined based on the net book value per share of the unlisted company as stated in the preceding year’s annual report, which has been audited by an audit firm.
Circular No. 1030 was abolished and became invalid on 4 January 2011. At present, there is no official guidance issued by the Chinese tax authority in respect of the determination of the taxable value of shares which are not publicly traded. It is complicated to calculate the fair market value of share-based compensation of unlisted companies given the absence of a public market to ascertain the volatility of the share options amongst other relevant parameters. Circular No. 1151 confirms that determination method of the taxable value of unlisted companies’ shares, which fills the gaps in this area.
Clarification of Applicability of IIT Preferential Treatment Method
Currently, the only official guidance available on the taxation treatment of share-based incentive awards granted to employees of unlisted companies is Circular No. 9 from 1998.3 This circular points out that in calculating the IIT, the taxable value of a share-based incentive award can be amortized over a period of no more than six months, and the amortized amount is then aggregated to the employee’s regular wages and salaries income for IIT withholding purposes, subject to the local tax authorities’ approval. The expired Circular No. 1030 stated that the preferential tax treatment method applicable to annual bonuses can be applied to employees’ wages and salaries income in the form of share options derived from unlisted companies.
The IIT calculation method stated in Circular 1151 makes reference to the IIT calculation method which is applicable to income derived from share-based incentives by employees of listed companies as it is stated in Circular No. 35 issued in 2005.4 This IIT calculation method is more preferential than the method stipulated in Circular No. 9 and the expired Circular No. 1030. However, the requirement for tax registration of the equity incentive plan of the listed company with the local tax authorities, as one of the prerequisites for applying the preferential tax treatment stated in Circular No. 35, was not mentioned in Circular No. 1151.
Circular No. 1151 plays a guiding role in the taxation treatment of the share-based incentive income derived by employees who participate in the unlisted companies’ equity incentive plans in Hainan Province. As Circular No. 1151 is a reply to a query raised in the province of Hainan, it is technically not binding in other locations. Unlisted companies with share-based incentive plans may consider using Circular No. 1151 as a reference for consultation with the respective local tax authority to reach an agreement on the appropriate tax treatment.
1 Reply of SAT on Alibaba (China) Network Technology Co., Ltd.’s Employees’ Individual Income Tax Issues for Stock Option Income Derived from Unlisted Companies, Guo Shui Han  No. 1030 (Circular No. 1030).
2 Letter of Hainan Local Tax Bureau on Opinions relating to Individual Income Tax Issues for Equity Incentive Income Derived from Unlisted Companies, Qiong Di Shui Han  No.1151 (Circular No. 1151).
3 Notice of the State Administration of Taxation on the Issue of Individual Income Tax Treatment of Discounts or Subsidies Derived from Subscription of Marketable Securities from Employer, Guo Shui Fa  No. 9 (Circular No. 9).
4 Notice of Ministry of Finance and State Administration of Taxation on Issues relating to Collection of Individual Income Tax on Personal Income from Stock Options, Cai Shui  No. 35 (Circular No. 35).
This article is excerpted, with permission, from “Hainan Local Tax Bureau Released the Individual Income Tax (IIT) Policy on Equity Incentive Income Derived from Unlisted Companies, Filling Local Operation Guidelines Gaps,” in China Tax Alert (Issue 4, January 2016).
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