ESOP (Employee Stock Ownership Plan) in China

In this article, we will discuss ESOP in China along with its benefits and working mechanisms.

In recent years, the adoption of ESOP or Employee Stock Ownership Plans has been increasing in China as well as throughout the world. Similar to stock options in private companies, ESOP gives employees the right to purchase shares for the company they work for after a set period of time and at a predetermined price. In this way, ESOP is considered as a way of attracting and retaining employees by offering a portion of ownership. Since its introduction in China, ESOP has been growing and becoming an increasingly favourable option for companies and employees. In this article, we will discuss ESOP in China along with its benefits and working mechanisms.

ESOP in China

ESOP in China has emerged as a result of China’s reform and changing policy, as well as the reform of state-owned enterprises (SOEs). In 1984, a state-owned department store hosted the first ESOP with the permission of the Chinese government. Since then, ESOPs have gradually become a popular stock-based compensation tool in China. Basically, the purpose of employee stock ownership plan is to attract and retain experienced employees by offering them a share of the company’s ownership, thus ensuring a good bond between the company and its employees. It is also a method to motivate employees and contribute towards long-term value.

Understanding ESOP in China

ESOP in China is a typical example of a stock-based or equity compensation. ESOP programs are relatively common in privately held companies whereby a fixed number of shares is given to selected employees at a particular price after a certain period of time. In essence, these shares are given to the employees as a part of their stock-based compensation package. However, the process of granting ESOPs requires certain considerations, including terms of ESOPs, vesting policy, and pricing. Thus, it is crucial to be well-versed in ESOPs in order to understand the working mechanism of such plans.

How does ESOP work in China

Well, the principle and working of ESOP are typically similar throughout the world. ESOP schemes in China work on the same principle as stock options. In an ESOP, a certain number of shares are given to an employee after a certain period at a price set by the company. The period of time during which the employee must hold the ESOP is known as the vesting period, the price at which the ESOP is exercised or purchased is the strike or exercise price, and exercising of ESOP refers to a process of buying the shares under ESOP after all the conditions are fulfilled.

Benefits of having an ESOP in China

ESOPs may be a great way to motivate and encourage employees towards long-term value as well as provide a sense of responsibility. ESOP can help an employee feel that they are part of the company, thus earning their respect and trust. Here are a few benefits of ESOP in China:

Benefits of having an ESOP in China

  • Flexible compensation arrangement – ESOPs have proven to be more effective compared with other forms of stock-based compensation such as restricted stock, performance-based awards, and other forms. They are more flexible and fair with respect to both management and employee needs.
  • Increase employee commitment to the company – With the growth of China’s economy, many companies are trying to be more innovative, proactive in the development process, and considerate of their employees. ESOPs are useful in this regard as they promote growth through increased employee commitment.
  • Cheaper method of compensation – For early-stage companies, cash compensation can be a little expensive. However, with ESOPs, and providing a portion of ownership stake, employers can achieve a good balance between cost and rewards.

How to set up an ESOP in China

Generally, the concept and foundation of ESOPs are the same all over the world, however, they may differ in terms of taxation and reporting. In China, the working mechanism of ESOPs is typically similar to the stock options of private companies. Below mentioned are some of the main steps involved in ESOPs:

  • It is essential to construct an ESOP agreement that outlines the terms of ESOPs including the number of shares, vesting schedule, grant date, expiry date, strike or exercise price, and other related clauses. The agreement is then signed by the company and the employee in order for them to be bound by their respective agreements.
  • Start the ESOP program by granting a certain number of shares (commonly known as stock units) to selected employees. The vesting period and pricing are usually determined on a case-to-case basis depending on the company and the ESOP agreement. It is advisable to consult an expert in this respect.
  • As stated in the agreement, after a certain vesting period and before the expiry date, which is usually determined by company policies, the employee is able to exercise their rights over ESOPs. Typically, it is the point of time during which the employee has the right to purchase shares at the predetermined price.

Legal considerations for setup ESOP in China

Probably you might be thinking what are the legal considerations for ESOP in China? Currently, Chinese employees cannot buy foreign currency for an overseas investment or send more than about $10,000 USD outside of China without the State Administration of Foreign Exchange’s permission. The exercise price of an ESOP may theoretically be paid by employees using funds held outside of China, but this is not a practical option since the majority of employees do not have bank accounts outside. Therefore, consideration must be given to the manner in which employees exercise rights to the ESOPs such that it does not violate Chinese law.

Challenges of setting up and managing an ESOP in China

ESOPs have proven to be great incentives for employees and a valuable tool for companies in terms of employee retention, motivation, and building long-term value. However, there are certain challenges in setting up an ESOP program in China. As a matter of fact, ESOP requires various calculations or valuations for pricing ESOPs, several terms for setting the vesting periods, taxation, reporting and other factors such as board resolutions, shareholder approvals and other legal restrictions in implementation.

This can be a daunting task for small and mid-sized companies to handle on their own. Thus, it is essential to hire an expert or professional service provider like Eqvista having a good knowledge of ESOPs in China as well as the concerned laws. Hence, it is highly recommended to hire an expert when planning or setting up an ESOP program.

How does ESOPs tax work in China?

Now that you have understood the concept of ESOP in China, let us look at ESOP taxation in China. According to U.S. tax law, an option issued to an employee in China will be regarded as a nonqualified stock option. A nonqualified stock option, however, is not taxable to the employee in the year of exercise. Rather, it is taxable when the option is exercised and the shares are acquired at a lower price than their fair market value on that date. In addition to this, if the shares are sold at a higher price than the purchase price, capital gains tax will be payable. Overall, it is essential to have a good understanding of the tax implications in China in order to avoid any possible penalties.

Addition tax reporting requirements for ESOP in China

By proposing 15 new measures related to tax collection and administration, the State Taxation Administration released guidelines that aim to streamline and simplify the tax administration process. With regard to employee share ownership plans, guidelines (a circular) notably contain a clause imposing new tax reporting obligations and enforcing current tax reporting requirements. The administration, collection, and enforcement of individual income tax compliance have been a higher concern for the tax authorities in recent years.

The latest circular adds an extra tax reporting obligation and upholds current tax reporting obligations for ESOPs in China in order to tighten administration, enhance taxpayer experience, and go along with the widespread usage of ESOPs as tools to retain and attract talent. For companies that have an ESOP, the circular outlines the following tax reporting requirements:

  • Within 15 days of a new ESOP’s approval, complete and submit an equity incentive details disclosure form to the relevant tax authorities.
  • By December 31, 2021, complete and submit a disclosure form to the responsible tax authorities, along with the necessary supporting documentation for ESOPs that have already been put into effect.
  • Continue providing information on employee stock ownership plan to the responsible tax authorities within the deadline specified by the applicable legislation and regulations.

Tax benefits for ESOP in China

The China Securities Regulatory Commission (CSRC) finally approved the voluntary piloting of ESOP in listed companies as long as the total number of shares owned by employees does not exceed 10% of the company’s share capital. Such proportion must not exceed one percent for each employee who participates in the plans. The agreement also specifies the length of time that an employee must own stock, as well as rules for information disclosure. Therefore, the implementation of employee stock ownership plans can help to boost employee retention and motivation at work, and likewise in terms of taxation, ESOP can bring double benefits to the employee and the company.

Tax consequences for ESOP in China

As mentioned earlier, under US tax law, an ESOP granted to an employee in China is treated as a nonqualified stock option. In accordance with Chinese law, the employee will be taxed when exercising. When an option is exercised, the company’s Chinese subsidiary will be responsible for withholding and remitting the applicable income tax as well as for meeting any necessary reporting obligations.

For a business to gain more advantageous tax treatment for its Chinese employees, U.S. employees must qualify as “incentive stock options” In the case of a privately held company, there would be no liquidity, for instance, if an employee left the business and had 30-90 days to exercise their option. As a result, employees would have no incentive to stay with the business and this would potentially have a negative impact on the business.

Efficiently manage your ESOPs with Eqvista!

During the course of this article, we have discussed all the important aspects related to ESOP in China. Now that you are familiar with all the necessary legal and financial considerations, you may be thinking about how to implement an ESOP program for your business in China. Why not hire Eqvista to set up, implement, and manage an ESOP for your company in China? At Eqvista, we have a highly-qualified team who are well-versed in both the Chinese and US federal tax laws, as well as ESOP setup, governance, management, and administration. Contact us today to learn more!

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