Editor's Note: With the development and improvement of company law and securities law, employee stock ownership plan and equity incentives have become an important tool for employees of listed companies to hold shares. In terms of tax policy, the Ministry of Finance and the State Administration of Taxation (SAT) have followed the pace of the capital market and formulated a more complete policy on equity incentives for listed companies, however, no clear regulations have been issued in respect of the employee shareholding plan, which has led to the listed companies in the implementation of the employee shareholding plan being caught up in the "maze" of how to apply the tax policy and encountering the "reef" of inconsistent understanding of the enforcement of the law. This has led listed companies to fall into the "fog" of how to apply tax policies and encounter the "reef" of different understanding of law enforcement. This article is intended to analyze the differences between equity incentives and employee stock ownership plan from a tax dispute case of employee stock ownership plan for listed companies, and provide suggestions for the implementation of employee stock ownership plan to prevent tax risks.

I. Introduction of the actual case: listed company's employee stock ownership plan declared low tax basis to be pursued for personal tax of more than 10 million yuan

(i) Basic facts of the case

In January 2023, Company A publicly discloses its Employee Stock Purchase Plan. The Employee Stock Purchase Plan proposes to repurchase price shares at $10/share and grant the shares to employees at $8/share. According to the plan, the repurchased shares will be held by the Board of Directors on behalf of the employees and will be released on March 1, 2024, after which the Board of Directors will change the registration of the shares into the employees' names through non-transaction transfers, and the employees can freely dispose of the shares. On the release date, the market price of the stock is $11 per share and the stock completes the non-trading transfer. In terms of personal income tax, Company A calculated the taxable income based on the "repurchase price - grant price" and declared and withheld personal income tax according to the tax item of "wages and salaries". For enterprise income tax, Company A used the "market price of the stock - grant price" as the pre-tax expense and declared and paid enterprise income tax.

In June 2024, due to the inconsistency in the caliber of salary declaration for individual income tax and enterprise income tax, which triggered an early warning in the tax system, the competent tax authority of Company A issued a Notice on Tax Matters in July, which determined that the tax basis of the individual income tax withheld and paid by Company A was on the low side, and the so-called Employee Share Ownership Plan was in essence an equity incentive, which should be calculated in accordance with the tax policy on restricted shares in equity incentives at the rate of According to the tax policy of restricted shares in equity incentives, the taxable income should be calculated based on the "market price of the shares - grant price", and Company A should be required to make additional withholding and payment of individual income tax amounting to more than RMB10 million in total.

(ii) Views of taxpayers and enterprises

The tax authorities considered that the employee stock ownership plan implemented by the enterprise was actually an equity incentive for the following reasons: In terms of enterprise income tax, the enterprise deducted wages and salaries before tax in accordance with the "Announcement of the State Administration of Taxation on the Issues Relating to the Handling of Enterprise Income Taxes on the Implementation of Equity Incentive Schemes by China's Resident Enterprises" (Announcement of the State Administration of Taxation No. 18 of 2012) in accordance with the difference between the fair value of the shares and the consideration received by the employees for acquiring the shares. Salary is deducted before tax, then, in terms of personal income tax, the enterprise should also withhold and pay personal income tax according to the tax policy of equity incentive.

Company A argued that the employee stock ownership plan implemented by Company A was not an equity incentive. First, in terms of incentive targets, the targets of the employee share ownership plan implemented included supervisors, while the equity incentive explicitly excluded supervisors. Second, in terms of performance conditions, the implementation of the employee stock ownership plan did not establish performance conditions, while the equity incentive requirements should be established performance appraisal system and assessment methods. Accordingly, in terms of individual income tax, the employee stock ownership plan implemented by Company A is not an equity incentive, and the tax authorities cannot force it to withhold and pay individual income tax in accordance with the tax policy of equity incentives, nor can they presume the substance of Company A's objective behavior based on the situation of the payment of the enterprise income tax declaration.

(iii) What are the root causes of disputes between taxpayers and enterprises?

In this case, the biggest point of contention between the two parties is whether the employee stock ownership plan implemented by Company A is an equity incentive? If it is an equity incentive, there is no doubt that the tax policy of listed company's equity incentive should be applied to withhold and pay individual income tax, if not, it is necessary to further discuss how Company A withholds and pays individual income tax. Therefore, it is necessary to clarify the difference between employee stock ownership plan and equity incentive.

Second, what is the difference between equity incentives and employee stock ownership plans? 

According to the principle of systemic interpretation, when the definition of a matter in a tax policy cites the provisions of other sectoral laws, the concepts of the sectoral laws should be respected. Similarly, when the tax policy does not define a matter, it should refer to the same concepts of other sectoral laws. As a matter of fact, the tax policy on equity incentives quotes the concept of equity incentives in the Administrative Measures for Equity Incentives of Listed Companies (for Trial Implementation) (No. 151 of the Securities and Regulatory Commission [2005], which has been upgraded to departmental regulations), while the current tax policy does not provide for the employee stock ownership plan, and therefore, it should differentiate between the two from the concepts of the sectoral laws.

(i) What are equity incentives?

According to the Measures for the Administration of Equity Incentives for Listed Companies, equity incentives refer to the long-term incentives provided by listed companies to their directors, senior management and other employees using the Company's shares as the underlying, which are intended to further promote the establishment of a sound incentive and restraint mechanism for listed companies. At the same time, the method has mandatory provisions on the target of equity incentives, performance assessment, incentive price and other aspects. The earliest application of equity incentive mechanism is the U.S. Pfizer Pharmaceuticals, its purpose is to effectively avoid the high personal income tax brought about by the high cash salary of executives, and then the executive compensation is split into "cash" + "equity". It can be seen that equity incentives are born with the attribute of "wages and salaries", which is actually a part of the employee's remuneration, and has the nature of motivating the employee's labor.

(ii) What is an Employee Stock Ownership Plan?

According to the Guidelines on the Implementation of Pilot Employee Stock Ownership Plans by Listed Companies (SEC Announcement (2014) No. 33) and the Drafting Instructions, an employee stock ownership plan refers to the institutional arrangement whereby a listed company, in accordance with the wishes of its employees, enables its employees to acquire the Company's shares in a lawful manner and hold them for a long period of time, with the interests in the shares to be distributed to the employees in accordance with the agreement, which is aimed at establishing and perfecting the mechanism for sharing the interests between the laborers and the owner, to Improve the level of corporate governance and enhance employee cohesion and company competitiveness. At the same time, the Opinion has made provisions on the objects, sources of funds and shares, and management of the employee stock ownership plan. As a matter of fact, employee stock ownership plan also originated from the U.S. In 1956, Louis Kelso proposed that wealth is created by labor and capital, so labor and capital should share the wealth, so that employees can participate in the distribution of the company's wealth through the holding of the company's internal shares, and share the success of the company with the capital owners. It can be seen that the employee stock ownership plan is born with the attribute of "bundled interests" and "capital", which has the nature of investment.

(iii) Summary

As mentioned above, the core difference between the two lies in the purpose of implementation, and if the main purpose is to incentivize employees, it is favored to equity incentives. Correspondingly, at the system design level, employees in equity incentives are always "laborers" and need to be subject to the mandatory constraints of the listed company's performance appraisal methods, which is why supervisors and independent directors are excluded from the target of equity incentives, otherwise it will be very easy to cause conflict of interest issues. Employees are also able to obtain company shares at a very low market price without having to bear the risk of share price fluctuations. If the main purpose is to increase the closeness between the company and its employees, the employee stock ownership plan is favored. Accordingly, at the system design level, the employees in the employee stock ownership plan become "owners", without the constraints of performance appraisal, to obtain a lower discount on the price of the stock, the need for profit and loss on their own, at their own risk. Because of this, the employee stock ownership plan does not have a limit on who can participate.

As for the present case, we believe that, according to the employee stock ownership plan disclosed by Company A, the participating objects do not include supervisors, there is no assessment of performance indicators for the participating objects, and the equity provisions are tightly bound with the interests of the company, etc., it can be concluded that the employee stock ownership plan implemented by Company A is of an investment nature, which needs to bear the risk of fluctuations in stock price and is not an equity incentive.

III. Sorting out tax policies for equity incentives and employee stock ownership plans

(i) The tax policy on equity incentives for listed companies is relatively clear, and the tax calculation method depends on the subject of the incentive.

According to the type of equity incentives, equity incentives can be categorized into stock options, restricted shares, stock appreciation rights and equity awards. Since equity incentives have the nature of "incentivizing employees' labor", the tax policy stipulates that individual income tax shall be declared in accordance with the tax item of "Salary Income", and at the same time, different taxing methods shall be applied respectively, specifically:

1. Stock option refers to a right granted by a listed company to the employees of the Company and its holding companies, which allows the authorized employees to purchase a certain number of shares of the Company at a specific price in the future time. According to the Circular of the Ministry of Finance and the State Administration of Taxation on Individual Income Tax on Income from Stock Options (Cai Shui [2005] No. 35), no tax is levied on the granting of stock options to employees, and the taxable income is calculated on the basis of the "market price of the stock on the date of exercise of stock options - the granting price" upon exercise of stock options. When the options are exercised, the taxable income is calculated based on the "market price of the stock on the date of exercise - grant price".

2. Restricted shares refer to a certain number of the Company's shares granted to the employees of a listed company in accordance with the conditions agreed in the equity incentive plan. According to the Notice of the Ministry of Finance and the State Administration of Taxation on Issues Relating to Individual Income Tax on Income from Stock Appreciation Rights and Income from Restricted Shares (Cai Shui [2009] No. 5) and the Notice of the State Administration of Taxation on Issues Relating to Individual Income Tax on Equity Incentives (Guoshuifan [2009] No. 461), the employees will not be subjected to any tax when accepting the grants, and the ownership of the restricted shares shall be attributable to the employees in terms of the "The average of the market price of the shares on the stock registration date and the market price of the shares in the current batch of restricted shares on the same day - the authorization price" is used as the basis for tax calculation of the taxable income of the shares in the current batch of restricted shares.

3. Stock appreciation right refers to the right granted by a listed company to the employees of the company to obtain a specified number of proceeds from the increase of stock price in a certain period of time in the future and under the agreed conditions, and the difference with stock options is that the future employees will obtain the cash, not the stock. According to the provisions of Cai Shui [2009] No. 5 and Guo Shui Han [2009] No. 461, no tax is levied when the employees accept the grant, and when the options are exercised, the taxable income is calculated on the basis of "the market price of the stock on the date of exercising the option - the grant price".

4. Equity awards refer to the gratuitous granting of a certain share of equity or a certain number of shares by an enterprise to the relevant technical personnel. According to the Circular of the Ministry of Finance and the State Administration of Taxation on Extending the Pilot Tax Policies Relating to the National Independent Innovation Demonstration Zone for Nationwide Implementation (Cai Shui [2015] No. 116) and the Announcement of the State Administration of Taxation on the Administration of Taxation on the Issues of Individual Income Taxation on Equity Awards and Conversion of Equity Shares to Shares (Announcement of the State Administration of Taxation No. 80 of 2015), the employees, when accepting the grants, will calculate taxable income on the basis of the current day's The "market price of shares" on the date of grant is used as the tax basis for calculating the taxable income.

(ii) Employee stock ownership plans are currently not expressly provided for and are handled differently in practice

Covering the current tax policy does not make clear provisions for employee stock ownership plan, in practice, the implementation of employee stock ownership plan by listed companies, the form is complex and varied, some through the listed company on behalf of the employees management, such as this case; some through the trust company, securities companies and other asset management institutions on behalf of the management. In terms of personal income tax treatment also comes in all shapes and sizes. For example:

1, the listed company to employee self-funded stock repurchase, employees to obtain the stock price is lower than the repurchase price, "repurchase price - grant price" as the basis for tax, according to the income from wages and salaries, the calculation of personal taxable income, such as this case;

2. When a listed company repurchases shares with an incentive fund and the price at which the employee acquires the shares is equal to the repurchase price, there are cases in which the market price at the time of actual acquisition of the shares is used as the basis for calculating taxable income in accordance with the income from salaries and wages, cases in which the market price of the shares at the time of the establishment of the special plan is used as the basis for calculating taxable income in accordance with the income from salaries and wages and cases in which taxable income is calculated by reference to the rules for restricted shares;

3. When a listed company repurchases shares with employees' self-financing and incentive funds, and the price of the shares acquired by the employees is lower than the repurchase price, there are rules for calculating taxable income with reference to stock options; there are rules for calculating taxable income with reference to restricted shares; and there are rules for calculating taxable income with reference to the "repurchase price - grant price" as the basis of tax calculation. There are also cases where the taxable income is calculated on the basis of "repurchase price - grant price" as the basis for calculating the taxable income according to the income from salaries and wages.

IV. How should the employee stock ownership plan in this case be reported for tax purposes?

(i) Is it necessary to refer to the equity incentive tax policy?

According to the principle of statutory taxation, it requires the tax authorities to strictly comply with the substantive and procedural elements of taxation when levying taxes on taxpayers, not to make expanded interpretation, and to give the taxpayers' economic and legal life the stability of the law and the possibility of prediction. At present, the current tax policy does not stipulate how the employee stock ownership plan should be declared and paid for individual income tax. We are of the view that the tax authorities' request for enterprises to implement the employee stock ownership plan with reference to the tax policy on equity incentives for tax purposes is not justified by the law and violates the principle of statutory taxation.

(ii) Returning to the "investment" attribute of the employee stock ownership plan

As mentioned above, we believe that, according to the employee stock ownership plan disclosed by Company A, it is not an equity incentive, so it should return to the attribute of "investment" of the employee stock ownership plan to apply tax policy. In this case, the employee stock ownership plan is actually a project jointly operated by the employees, the success of the project, we benefit; project failure, we lose money, the nature of the same with the investment, the expected future earnings are uncertain, therefore, the employees invested in the funds to operate the plan, the employees do not generate any tax obligations. At the time of termination, the employees terminated the jointly operated program, from which they obtained the shares, gained economic benefits and realized the recovery of investment, which can be based on the Announcement of the State Administration of Taxation on the Collection of Individual Income Tax on the Recovered Amounts from Individuals Terminating the Investment and Operation (Announcement of the State Administration of Taxation No. 41 of 2011), "Individuals who terminate the investment, joint venture, operation, cooperation and other acts for various reasons, from the invested enterprise, will have no tax obligations. The amount of money recovered from the invested enterprise or cooperative project, other investors of the invested enterprise and business partners of the cooperative project under other names is taxable income for individual income tax and shall be calculated and paid as individual income tax in accordance with the provisions applicable to the items of income from transfer of property". "In accordance with the provisions of the Law of the People's Republic of China, individual income tax shall be withheld and paid on behalf of the investor under the tax item "Income from transfer of property" at a tax rate of 20%.