A different version of this was first published in World Tax Daily.

China tax aspects of stock options were further clarified by a circular issued by the State Administration of Taxation. The circular, Guoshuihan [2006] No. 902 ("Circular 902"), issued on September 30, 2006, serves a supplement and amendment to the Caishui [2005] No.35 ("Circular 35") of the SAT and the Ministry of Finance.  Circular 902 clarifies various issues, confirming the attractiveness of phantom options, clarifying that only publicly listed shares will enjoy full tax preferences, narrating the allocation of option income between work inside and outside China, and addressing the taxation of publicly tradable options as well as the consequences of multiple option exercise(s) and/or multiple option plans. 

Options on Listed Shares v.s. Private Shares 

The new issued Circular 902 preserves the requirement that the underlying shares must be publicly listed in order for the option-holder to enjoy the tax preferences specified by Circular 35 (although a few preferences dating from 1998 appear to remain available in respect of options on non-listed shares). And it confirms that the shares may be publicly listed either inside or outside China, and that the shares need not be issued by the employer, and appears to confirm that the share-issuing company may be unrelated to the employer.

Deduction of Purchase Price of Stock Option

Circular 35 assumes stock options are granted freely to the employees and thus is silent on the treatment of purchase of stock option.  Circular 902 amend this unclear issue by prescribing that purchase price of stock option can be deducted for determination of the taxable income when the stock option is transferred (before exercising), or exercised.

Phantom Stock Options 

The new issued Circular 902 confirmed the availability of tax preference for phantom options.  It is provided in Circular 902 that the relevant individual income tax ("IIT") can be calculated using the method provided by Circular 35 even if the employee does not actually purchase the share but receives compensation equivalent to the difference between the fair market value and the exercise price when exercising the stock option. 

Phantom options avoid the cross-border currency procedures, controls and other barriers to China employees’ purchase of foreign shares through exercise of stock options, and thus can serve a useful vehicle for stock option plans related to Chinese employees. Attention is needed to documentation of the grant and implementation of phantom options, in order to track the Circular 902’s relevant provision, which specifies that remuneration is eligible when it is calculated by subtracting an agreed ‘exercise price’ from the market value of a listed share.

Sourcing of Income and Time Apportionment 

When the employment services to which a stock option relates have been provided in more than one tax jurisdictions, an allocation rule is necessary for purposes of determining the amount of tax should paid to each jurisdiction.  Circular 35 use a logical allocation method, to have the China-source stock option income determined by the proportion of the number of months during which employment services has been provided within China to the total number of months during which the employment services from which the stock option is derived has been provided.  But Circular 35 does not clarify how to determine the exact numbers of months related to the stock option income. 

Circular 902 further defined the number of months of employment services required from the employee as a condition of exercising an option will be deemed as the number of months related to the entitlement to stock option income, which may be generally interpreted as the sum of the months included in the vesting period, i.e., from the date of granting to the date of vesting, but the actual situation may depend on the provisions of the stock option plan.. 

Taxation of Tradable Options 

A notable development of Circular 902 is the taxation of tradable stock options.  A tradable stock option is defined as a stock option that is transferable, as agreed upon at the date of the initial grant, with quoted prices on an open market (inside or outside China).  Compared with non-tradable stock options which is not taxable at grant, the taxation of tradable options differs in the following ways: 

• Tradable stock options should be taxable at the grant date since the employee received a benefit in kind already at the granting because the tradable option formed a disposable asset with a determinate value. Circular 902 defines the taxable income as the spread between the market price and the purchase price (if any) of the option concerned.
• Gains from the transfer of such options are stated to be taxed identically to gains from the sale of shares originated from exercise of non-tradable options, which are presently exempt from tax if the shares/options are publicly listed in China, while all other share/option gains are taxed at 20%.  
• The exercise of tradable stock options will not be taxed. The exact meaning of this provision is not clear.  It may mean that exercise will not be taxed, or will not be taxed as salary income but capital gain. 

Taxation of Multiple Exercises or Multiple Option Plans 

A major tax benefit of Circular 35 is that stock option income can be spread over a period up to 12 months for calculation of tax liability. Circular 35 does not impose any limitation on the number of times that the spread method may be used (if there are multiple exercises in a tax year) but Circular 902 amended this loophole.  Under Circular 902, if an employee exercises share options more than once in a calendar year, tax will be payable during each month of exercise, and will subsequently be adjusted to the extent that all the option income derived in a year can only be spread (within up to 12 months) once in a year.  The adjustment is achieved through the following measures: 

• For the first tax month where an employee receives stock option income, his/her individual income tax payable will be determined by spreading the income over stipulated number of months, as provided in Circular 35.
• Starting the second tax month, tax payable will be calculated based on the accumulated stock option income, deducting by the tax paid in the previous tax months.  The following formula will be used for determining tax payable for each subsequent tax month:

Tax payable for the current month = (Aggregate taxable stock option income in the current tax year including the current month /stipulated number of months × applicable tax rate – quick deduction) × stipulated number of months – sum of tax paid for stock option income before the current month

This is the first adoption by China of annual (rather than monthly) calculation of individual income tax.  Though it is still based on the monthly reporting regime, the spirit behind reflect the trend of China's tax development.

If the employee's incomes involves multiple stock option plans, his taxability will be determined by 1) combine all the stock option income in the month concerned, and 2) spread the income over the weighted average months to compute the exact tax payables.

Conclusions 

As China's salaries continue to increase, enforcement efforts and penalties stiffen, and retention difficulties continue to stimulate employers' interest in deferring employee's compensation and fine-tuning employee's incentives, employee stock options and other equity-based compensations are becoming useful for more and more employers in China.  The clarification of Circular 902 makes China's tax rules on stock option more and more clear and flexible, which is likely to cement the role of real and phantom options as central pillars of many employers’ China human resource strategies. 

When investing in real estate sector, the investor will definitely consider the tax cost involved.  Land Value Appreciation Tax (LVAT) is on significant tax factor should be carefully considered.  Though not enforced strictly, LVAT, with the 30%-60% progressive tax rate, is really a critical transaction cost (at least an exposure) for property transactions.  This is to analyze the deductions for calculating LVAT when the tax payer transfer a used property.

National Regulations

Article 6 of the Provisional Regulation of LVAT clearly stated that the deduction for used real estate is the appraised price of the building. And the Implementing Rules for the Provisional Regulation further stipulates that the appraised value should be based on the assessed value (replacement value discounted by the using rate.). The two major circular governing LVAT do not use purchase price as deductions for LVAT.

A recent circular, however, allowed the use of purchase price as an alternative for deduction. Circular [2006] No. 21, issued by the MOF and the SAT on March 2, 2006, allows the purchase price to be used as deductions as substitute of land-use right and development cost if the tax payer can not provide an appraisal report. What's more, an annual appreciation of 5% is allowed for the basis of deduction. Note that valid official invoice for purchasing the property should be presented to local tax bureau for their confirmation.

Shanghai

As early as 1995, Shanghai local tax bureau issue HuDiShuiDi[1995]No. 40 allow tax payer to use purchase price as deduction (Article 10). Shanghai local tax bureau further confirm this in its HuDiShuiDi [1997] No. 25 (Article 5). However, Article 2 of Hudishuidi [1997] No. 25 and HuDiShuiDi [1998] No. 1 provide another treatment, requiring appraised value to be used for transferring real estate in stock.

It appears that only tax payers with investing in real estate as major business scope can use purchase price as deductions and ordinal tax payer will still need t use appraised value.

Beijing

Beijing does not have such local regulations as Shanghai and requires appraised value to be used for transferring used properties. (JingDiShuiEr [1996] No.251)

Shenzhen

The most reasonable regulation may be that of Shenzhen. ShenDiShuiFa [2005] No. 609 requires purchase price to be used as the preferred choice for deduction while the appraised value is only used as substitute (only allowed when the property has been used for over 5 years). Shenzhen use the price indicated on the certificate of property instead of invoice as evidence of purchased price.

Comment

The rationale of Circular [2006] No. 21 allowing the purchase price to be used as substitute for deduction maybe that purchasing price should be consistent with replacement value. Otherwise the buyer may choose to build a new building instead of buying the old one.

Circular [2006] partially establish the step-up basis for LVAT since it allows tax payers to use purchase price as an alternative, though not preferred choice for determining the deductions. Investors purchasing property via asset deal will have more chance to claim the step-up basis. But it does not mean investors purchasing property via equity deal will lose the step-up basis . That's because the appraised value is still preferred choice (besides Shenzhen) under national regulation, and the appraised value may be in line with the purchase price, based on the rationale of Circular [2006] No. 21.

An important factor for structuring property transaction is tax cost, which can affect the consideration of the transaction.  Generally the buyer will demand a discount under equity deal since it will lose the step-up basis.  For property transactions, however, discount of consideration for equity deal should not be too large since every future investor can dispose the property through equity deal and the liability for LVAT can be deferred without much limitation.  And most importantly, the buyer may not lose the step-up basis, as discussed above.