Using Stock Options to Attract and Retain Key Employees in China

May 12, 2011 Posted by China Briefing Reading Time: 8 minutes

By Cory Lam

SHANGHAI, May 12 – Increasing labor costs and the related issues associated with it are probably not something of a novelty for businesses operating in China. While many foreign companies have traditionally preferred to stick with expatriate staff at the expense of providing lucrative reward packages for their employees, many are now switching their focus instead to attract equally suitable Chinese staff in order to cut employment costs.

These same companies are now looking for new ways to retain the crème of the crop of “Generation Y” – China’s emerging domestic workforce made up of young, capable, educated, bilingual individuals. Although a relatively unexplored area in typical remuneration packages currently provided by FIEs, offering stock options for employees working in China could be a tax effective strategy in ensuring successful staff retention in the long run.

Overview of stock options
A stock option is a right that is granted to employees which allows the employee to subscribe to a certain amount of shares of the company at a specific price within a specified period. The purchase price for employees is referred to as the strike price (usually much lower than the market price of the share) and the date before which an employee must exercise their right to buy the granted shares is known as the vesting date. Once the allocated shares have been purchased, the employee will have normal voting rights, just like any other shareholder of the company.

As a type of equity-based compensation approach frequently adopted by employers in the West, apart from being a good source of cashless monetary reward for the workers, recent research has confirmed that, more importantly, being allocated company shares actually has significant positive psychological effects on employees.

“The reciprocity effect we found is really bigger than the incentive effect,” explained management professor Peter Cappelli on the findings of a report published by the University of Pennsylvania earlier this year. “We found that when the company does well and the share price goes up and people make more money, their performance in the next period goes up as well.”

There are also other benefits of setting up a stock option plan, as it can provide employees with a sense of ownership, while cultivating loyalty and commitment at the same time.

Are stock option plans often adopted in China?
Although generally seen more as a Western initiative, many may argue that the Chinese culture is actually more compatible with such practices, considering the typical thriftiness in Chinese characteristics to save for the long-term and that much emphasis is usually placed on feeling valued or having a sense of “belonging” in the community.

However, the reality is that this idea has not really taken off in China, with only an estimated 16 percent of companies offering some type of equity compensation scheme for employees and only 8 percent specifically offering stock options. There are many possible reasons for this: firstly, Chinese society continues to see a stronger preference for cash compensation; secondly, the current employment market is extremely fluctuant, especially for younger staff, and therefore long-term incentives may not be fully appreciated; and finally, there is also the time and cost involved in educating staff about these types of rewards, and without adequate training on how to exercise the stock options, its intended motivational effect could easily be lost in the process.

Many foreign employers also tend to avoid offering shares to their Chinese-based employees, especially when it comes to providing cross-border stock options which are likely to yield additional complications. Using U.S. companies with subsidiaries based in China as an example, it is estimated that around 70 percent of the few companies offering stock options have only done so under their normal U.S. scheme, rather than setting up a separate scheme for their Chinese counterparts.

Legal requirements
Perhaps the biggest deterrent to implementing a stock option plan for FIEs is the ambiguity in its associated legal and tax implications. In the past five years alone, the Chinese government has released a total of six new circulars affecting equity incentives for income received by individuals (the latest of which was released in 2009), and even then those who had successfully applied for a plan with the local authorities would testify that much of the process has still not been fully developed yet in the midst of constantly changing regulations.

One important point to clarify is that, contrary to popular belief, it is legally possible for a Chinese individual to own overseas listed shares under the current legislations. This right, however, is restricted by the government and will need to be approved on a case by case basis by the China Securities Regulatory Commission (CSRC). At the time of writing, the rules do not explicitly specify whether the same goes for foreign unlisted shares, but historically it seems that CSRC has not granted many approvals for the holding of unlisted shares purely due to the lack of official guidelines in regulating this type of foreign currency exchange.

For companies looking to roll out stock option plans for employees in their PRC subsidiaries, some of the current legal requirements to be considered are as follows:

The foreign company offering shares must be publicly listed on a foreign stock exchange;
The PRC subsidiary through which these shares are offered must be a legal entity in China, excluding representative offices and branch offices;
The PRC entity will only be considered a subsidiary of the foreign parent company if more than 50 percent of its shares are owned by the foreign parent company;
Foreign exchange transactions of individuals within these plans should only be handled by a qualified security broker registered with the CSRC;
The foreign account status and exercise share purchases under the plan are subjected to regular reporting requirements to the State Administration of Foreign Exchange (SAFE) on a quarterly basis;
All equity plans offered to employees within Mainland China should obtain prior approval from both SAFE as well as from the local tax authorities.

Foreign exchange controls
Strict foreign exchange controls remain to be the biggest barrier to foreign equity compensation schemes in the country. For a Chinese employee, whether buying or selling the granted foreign stocks, the exchange of funds between the mainland and an offshore country would need to be processed through a dedicated foreign exchange bank account and the amount transferred would also be capped by annual quotas obtained from the government.

Other local foreign exchange regulations are also applicable, but differ from city to city, so the district in which one submits an application should be carefully chosen. For example, the SAFE in Shanghai will permit only one quarterly conversion of funds from a dedicated foreign exchange account, and some SAFE offices have been known to require funds from the stock options to be distributed directly to employees and not through payroll – a requirement which could complicate issues from a tax withholding perspective. Therefore, employers are advised to check with legal professionals in terms of the best approach in setting up and administrating a stock option plan, based on each company’s individual requirements.

At present, many employers will choose to sidestep the above complications, and may either offer stock options only for foreign employees using offshore transactions, or offer them in the form of a “phantom shares plan,” which is basically a bonus scheme where employees never really hold the shares themselves but will receive a cash bonus instead from the appreciation of the “granted” company shares. A common alternative method is by way of a cashless exercise option, where employees must immediately sell all shares acquired, therefore benefiting from a cash gain (usually) on the difference between the strike price and the market price. While both of the above workarounds are feasible, in the absence of physically owning the company shares, employees may not really understand the true value of being in a stock option plan.

Tax implications
Since 2005, the Chinese government has introduced preferential individual income tax (IIT) treatments on stock option incomes if the following two criteria are met: firstly, the employee in question must be part of a listed company, and secondly, the equity incentive plan must have been set up after the company was listed.

More specifically, income from stock options are taxed separately from normal income and enjoy lower tax rates overall, as regulations allow stock option incomes to be spread over the period between grant date and vesting date, up to a maximum 12 months. Any IIT levied must be withheld by the domestic employer enterprise.

For Chinese residents, their global income is taxable and therefore taxes would incur on the sales of foreign stock both in China and in the foreign country involved, unless the employee can successfully apply for double taxation treatment between the two countries, if available. For an expatriate, if the proceeds are obtained from an overseas company and this expense is not allocated to PRC subsidiary, then the tax liability could be exempt.

From the employer’s point of view, the start-up costs for providing share options are low, since this form of compensation begins as a “right” only, and may not be taken up by all employees in the end. Moreover, offering stock options will not affect the social security payments for employees, as for this purpose stock option incomes are deemed as a bonus received and therefore can be excluded from calculations.

Is it worth the hassle?
For a foreign company looking to start up a stock option plan for its employees in China, at first glance it may seem that the effort required to overcome the legal hurdles involved hugely overshadows the benefits. However, tax benefits aside, companies should keep in mind the real reasons behind considering such schemes in the first place – to attract and retain key personnel at a low cost.

With the increasing amount of both foreign and PRC companies rolling out equity incentive schemes for their Chinese-based employees in the last few years, it is inevitable that this form of compensation will soon become the norm in all Chinese remuneration packages. Companies planning on setting up stock options for their employees would be well advised to consider building flexibility into the terms and conditions of the scheme in anticipation of the constantly changing legislation, especially in areas such as foreign exchange controls. Until such controls become more open for cross-border stock option activities, it may also be sensible to limit the beneficiaries to only include key foreign employees, while continuing to consider alternative forms of cash awards paid, funded and offered locally for PRC nationals.

Whichever the form, it should be noted that companies are no longer taking a “wait and see” approach, so in terms of devising an effective equity incentive scheme, every company needs to develop a compliance plan in China as soon as possible.

Richard Cant and Candy Fu from Dezan Shira & Associates and Michael Maeder from Direct HR contributed to this article.

Dezan Shira & Associates is a boutique professional services firm providing foreign direct investment business advisory, tax, accounting, payroll and due diligence services for multinational clients in China. For more information on employee stock options, and the associated tax and legal responsibilities, you can contact the firm at info@dezshira.com or visit www.dezshira.com. The firm’s brochure can also be downloaded here.

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