409a valuation in China
In this article, we explain what a 409A valuation is, and in which scenarios do you need a 409A valuation in China.
China has been one of the leading countries for businesses and entrepreneurs, especially when it comes to expanding and growing businesses. There’s no denying that China remains to be a powerhouse in the business world. Many US companies have set up business in China, but some may not be aware that they still need to comply with certain paperwork under the US tax laws. One important document is: a 409A valuation. Getting a 409A valuation in China may sound like a daunting task, but it’s really not that hard.
China Companies in the US
The Chinese business community in the United States has painted a bleak picture of Chinese enterprises operating in the United States, with companies increasingly anxious about navigating uncharted territory amid deteriorating bilateral relations between the world’s two largest economies. Growing uncertainty has pushed some Chinese enterprises to consider lowering or deferring investment in the US, or perhaps transferring to other markets as a result – a decoupling trend that industry watchers say could weigh on the US economy and weaken US companies’ competitiveness over time.
Overview of the China companies and business with the US
Chinese firms are increasingly considering establishing direct operations in the United States. For many people, forming a corporate entity in the United States makes sense. While a foreign corporation is not obligated to conduct business through a U.S. firm and can instead open a “branch office“, this is frequently not the best option for tax, liability, and other reasons.
For example, even if the company’s U.S. operations are conducted through a domestic entity, the officers of a Chinese company are less likely to be required to appear for a deposition in the United States, a U.S. entity may help facilitate the families of the company’s officers obtaining U.S. residency, and if the company seeks investors’ capital for its U.S. operations, such capital is often easier to obtain for a U.S. subsidy.
Important US tax issues to know
Before we explain further the importance of 409A valuations for companies in China, it’s important to understand the following US tax issues: 83(b) election, ASC 718, ISO 100k, and Form 3921 & 3922.
- 83(b) election – Under the Internal Revenue Code (IRC) 83(b), an employee or startup founder is allowed to pay taxes on the complete FMV of restricted shares at the time of grant. This is for equities with a vesting period, and it instructs the IRS to tax the elector for stock ownership at the time of gift rather than when the stock vests.
- ASC 718 – ASC 718 is a set of accounting regulations that corporations must adhere to. According to the regulation, employee stock-based compensation is expensed on an income statement. Equity awards are a type of compensation that is subject to ASC 718.
- ISO 100k – ISO 100k is a limitation on the amount of ISOs an employee can vest per year, and the limit is $100,000. This limit is a rule from the IRS that prevents ISO programs from being abused as a tax shelter since ISOs are still subject to Alternative Minimum Tax (AMT) to prevent wealthy individuals from sheltering their income.
- Form 3921 & 3922 – Form 3921 and 3922 are two forms used for reporting ISO exercises and ASPP share purchases respectively. Every time an exercise or purchase is made, a new form must be completed and filed.
409a Valuation & China Companies
There are various forms by the China companies that exist along with the 409a valuation. The taxation is based on the fact that it is imposed in China itself. Employees are taxed based on the value of the stock/options they are given. Because a large majority of executive pay is in the form of equity or rights, tax rules for this type of income are especially important when considering executive salary.
What exactly is 409a valuation/regulation?
The IRS regulation IRC 409A states that stock options cannot be issued for less than their fair market value. A 409A valuation is an impartial third-party valuation of your company’s common stock required to grant stock options to employees. The striking price for options granted to employees, contractors, advisors, and anyone else who receives common stock is determined by 409As.
When is a 409a valuation required for a China company?
A 409A valuation in China determines a company’s common stock, which is necessary when issuing stock options to employees. A 409A valuation in China is required for any corporation issuing stock options. The strike price for options granted to employees, contractors, advisors, and anyone else who receives common stock is determined by 409As.
Chinese tax consideration for US investors
In order to strengthen the system and stimulate foreign investment, the law has evolved quickly. Even at this early stage of growth, American investors interested in China must understand the fundamentals of Chinese corporate and tax law in order to structure transactions as efficiently as possible. Tax experts from the United States have been in contact with Chinese tax officials to aid in constructing a system comparable to those of other major countries.
US Holding company with the China subsidiaries
Investors in the United States have grown their exposure to companies based in China or with the majority of their activities there. The issuer of securities listed in the United States—the U.S.-listed firm—is often not the corporation established in or with activities in China, despite their operations being in China.
The US-listed firm is frequently a holding company founded outside of both the US and China, and it may or may not possess stock or other equity in the Chinese company. In some circumstances, the publicly traded corporation in the United States has contractual agreements with the Chinese firm. Although the U.S.-listed company does not hold any equity in the China-based firm, the contractual arrangements allow the U.S.-listed company to exert control over and gain economic rights from the China-based company.
China Holding company with US subsidiaries
The Chinese government has adopted a number of policies to encourage foreign investors to form holding corporations. These overseas investors are typically larger and have the financial means to make significant investments. Investors can find out if a U.S.-listed company with major Chinese operations utilizes this structure by looking at the firm’s annual reports and other SEC filings.
A corporation must file yearly reports with the Securities and Exchange Commission (SEC). The corporation has a Chinese subsidiary that was established to enter into commercial agreements with the China-based VIE. Powers of attorney, equity pledge agreements, and exclusive services or commercial cooperation agreements are all common examples of these arrangements. Multiple companies and individuals may be involved in actual constructions.
China companies with US employees (Offering ESOPs/Other Incentive Programs)
If your company has employees who are US citizens, then your company is required to conduct a 409A valuation. This is because the US employees are still subject to be taxed despite them being employed by a company in China. Even if you just have one US employee, your company still has to undergo a 409A valuation.
Other situations for 409a valuation
Aside from the above situations, a 409A valuation is also needed because of the following:
- ESOP in China – Through economic reform, China called for an “open-door policy” to encourage foreign direct investment and marketization. Employee ownership was introduced to many sorts of state-owned and collective firms in response to the new policy. At the time, 86% of China’s 3,200 pilot businesses had implemented employee stock ownership programs (ESOP). The process of restructuring and closing state-owned companies (SOE) began to speed up in the 1990s. The goal of the SOE ownership reform was to convert government agencies and controlled businesses into stockholders.
- Is ESOP Regulated in China? – Due to issues emerging from the applicable tax and securities rules, China enterprises will be offered participation in employee share programs. The Employee Retirement Income Security Act (ERISA), federal legislation establishing minimum standards for private-sector investment programs, governs ESOPs. Founders and major shareholders can sell all of their shares to ESOPs at once or sell portions of their shares over time.
- Transfer of Shares involving US shareholders – Any Shareholder may call a Shareholders’ Meeting at any time. The Secretary must give each Shareholder at least 21 days’ notice of each Shareholders’ meeting, with the mechanism for delivering such notice following the terms of Clause 19. The Secretary shall include the date, time, and location of the meeting, as well as the matter to be discussed in such notification. The Shareholders may agree in writing to a shorter notice period, in which case the meeting will be regarded properly called. All Shareholders’ meetings must be held in a site convenient to the Shareholders or the majority of their holdings unless the Shareholders agree otherwise.
Why is a 409a valuation important?
The 409a valuation is a third-party assessment of a firm’s common stock to estimate the cost of purchasing one company share. This appraisal is based on the current market value (FMV), which all private enterprises should use when analyzing their own stock.
- Determines the fair market value of shares – Getting a 409A valuation determines the fair market value of your company’s shares, and the FMV is needed when you are selling shares. The 409A valuation also determines the strike price for options granted to employees, advisors and anyone else who receives common stock.
- Determines the company’s financial standing – Management and investors can gauge where the company is at with regards to its financial standing. The 409A valuation can help you understand your company better and make better decisions on what to do with finances and funding.
- Safe harbor status – In order to obtain safe harbor status, you need to have a 409A valuation. This means that you protect your employees from any tax issues with the IRS. It also protects the company and owners from any lawsuits or tax liabilities.
Consequences for not complying with 409a while issuing equity
For nonqualified deferred compensation (NQDC) that contain stock appreciation rights and stock options, it is important to have an independent company valuation to determine the strike price at which the opportunities and SARs can be exercised.
By not complying with Section 409A, you risk penalizing your company and employees.
There are several tax penalties that can happen if there’s a failure to comply with section 409A:
- An income tax and 20% penalty could be imposed on any deferred vested amounts under the NQDC plan as of the last day of the vesting year.
- Employees will be asked to pay premium interest tax of 1% above the federal underpayment rate on failed compensation from the vesting date forward.
Common Valuation Methods
While conducting valuations, analysts use three valuation methods: asset approach, market approach, and income approach. Each method has a distinct way of getting the value of a company and the best method to use depends on every company.
- Asset Approach – In asset valuation method, the value of a company is based on its assets. It is obtained by subtracting the total liabilities from the total assets, which results in the net asset value. Tangible assets can include real estate and cars, while intangible assets include intellectual property.
- Market Approach – The market approach assigns a value to a company based on market forces in comparable situations. This method relies heavily on existing data in order to compare other companies in the industry. Under the market approach, there are two methods on how businesses are compared: public company comparables method and precedent transactions method.
- Income Approach – In the income approach, the company is valued at the present value of its future earnings or cash flows. This method does not use any past similar transactions in order to obtain the value of the company. The two main methods in the income approach are: capitalization of earning method, and discounted cash flow method.
Example of a 409A valuation for a China company
Manta Manufacturing, which manufactures and exports soaps and detergents, has subsidiaries in the US, as well as senior managers and executives who are expats and US citizens. These senior staff need to declare tax back in the US for their stock options they plan to exercise in the future. To determine the strike price on these options, Manta Manufacturing has a 409A valuation done to find the value and exerprice price for their ESOPs.
This is how their basic cap table looks like:
After getting the 409A valuation process, the resulting value was calculated as:
With the total valuation of the company at $8,750,00 after the DLOM, and capital structure with 27,750,000 shares, after processing the value through a waterfall analysis, the final share price was calculated as:
$0.22 price per share
After the valuation, Manta Manufacturing was able to issue its stock options according to its ESOP plan at a strike price of $0.22 to its US staff.
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