Authored by Ivy Yang

With the expansion of the registration-based IPO regime on China’s ChiNext and STAR Market, technology-driven enterprises have gained increasingly efficient access to the capital markets. In the pre-IPO stage, equity incentive arrangements for key technical personnel have become a common tool to enhance employee loyalty and align long-term interests with corporate growth.

In practice, equity incentives are generally implemented in two forms.

The first involves incentives based on actual equity interests, under which the company grants incentive recipients the right, within a specified period, to acquire the company’s equity at a pre-agreed price. This model is commonly implemented through three structures:

(i) direct shareholding by employees;

(ii) employee shareholding through a corporate holding vehicle; and

(iii) employee shareholding through a limited partnership holding platform.

The second consists of so-called “virtual equity” incentives, which do not alter the company’s actual shareholding structure. Instead, the company records notional equity interests internally and grants incentive recipients a specified number of virtual shares, entitling them—based on such notional holdings—to profit distributions or gains linked to asset appreciation.

As “virtual equity” arrangements may pose substantive obstacles to a subsequent listing, in practice, Chinese companies preparing for an IPO more commonly adopt equity incentive structures under which employees hold equity through a limited partnership holding platform.

At the early stage of corporate development, equity incentives are often designed by reference to market practices or online templates, with primary attention paid to the incentive effect itself. Compliance with listing requirements and potential tax risks are frequently overlooked. As a result, when IPO intermediaries later become involved, companies may discover that earlier equity incentives require substantial restructuring. Such restructuring not only raises compliance concerns but may also result in significant tax costs. In addition, individual income tax (“IIT”) issues arising from equity incentives—particularly where partnership-based holding platforms are involved—remain controversial in practice, and these controversies tend to intensify during the IPO process.

I. Individual Income Tax Implications of Equity Incentives

Key stages of equity incentives include grant, exercise, and transfer. Generally, no tax liability arises at the grant stage, while IIT obligations may arise at the exercise and transfer stages.

1. Grant Stage

As a general rule, no taxable income arises upon the grant of stock options, unless otherwise specified. However, under Article 10 of the Notice of the State Taxation Administration on Further Deepening the “Delegation, Streamlining and Service” Reform in the Tax Sector to Cultivate and Stimulate Market Vitality (STA [2021] No. 69), enterprises implementing equity incentives are required to file an Equity Incentive Report Form with the competent tax authority by the 15th day of the month following the decision to implement the incentive plan, together with supporting documentation in accordance with prevailing tax regulations, including (among others) Notice of the Ministry of Finance and the State Taxation Administration on Individual Income Tax Treatment of Income from Stock Options (Caishui [2005] No. 35, “Caishui 35”) and Notice on Improving Tax Policies on Equity Incentives and Technology Contributions for Equity (Caishui [2016] No. 101, “Caishui 101”).

2. Exercise Stage

Based on a review of relevant cases, in pre-IPO practice, companies adopt varying approaches to exercise pricing, with no unified standard. Exercise prices may range from nominal consideration (including zero consideration) to prices benchmarked against the most recent financing valuation or asset appraisal. To preserve the incentive effect, equity is typically granted at a price below fair market value.

It should be noted that, at the time of exercise, the difference between the amount actually paid by the employee and the fair market value of the equity is generally treated, for PRC tax purposes, as income derived from employment. Accordingly, such income is subject to IIT under the category of “wages and salaries,” with marginal tax rates of up to 45%.

Under Article 2 of Caishui 35, employees’ receipt of stock options under an equity incentive does not generally give rise to taxable income; however, upon exercise, where the exercise price is lower than the fair market value of the equity, the price difference constitutes income derived from employment and is subject to IIT under the “wages and salaries” category.

Although Caishui 35 formally applies to listed companies, policies applicable to non-listed companies—namely the Notice on Extending Certain Tax Pilot Policies of National Independent Innovation Demonstration Zones Nationwide (Caishui [2015] No. 116, “Caishui 116”) and Caishui 101—both provide that Caishui 35 should be applied by reference. Specifically, Article 4 of Caishui 116 provides that equity awards obtained by individuals shall be taxed as “wages and salaries” by reference to Caishui 35, and the taxable basis is determined by reference to fair market value at the time the equity is obtained. Article 4(1) of Caishui 101 provides that where an individual obtains equity from the employing enterprise at below fair market value and does not satisfy the deferred taxation conditions, the price difference shall be taxed as “wages and salaries” by reference to Caishui 35.

3. Transfer Stage

Upon subsequent transfer of the equity by the employee, IIT shall be levied as income from the transfer of property. Where a non-listed company is listed domestically, the disposal of such equity shall be subject to the prevailing PRC tax rules applicable to restricted shares.

4. Tax Incentives — Deferred Taxation Policy

To mitigate the financial burden and economic uncertainty at the exercise stage—when employees have not yet realized actual economic gains—China introduced a deferred taxation regime under Caishui 101. Where statutory conditions are met, taxation may be deferred until the equity is ultimately transferred, at which point IIT is levied at a flat rate of 20% under the “income from the transfer of property” category. This policy significantly reduces the overall tax burden across the equity incentive lifecycle.

II. Applicability of Deferred Taxation to Partnership Holding Platforms

From a textual perspective, the foregoing PRC tax policies (including the deferred taxation regime) are primarily designed for scenarios in which employees directly hold equity in the company. In practice, however, direct employee shareholding is rare. For reasons including separation of control rights and economic interests, as well as internal transfer and administrative convenience, most non-listed companies adopt a limited partnership as an equity incentive platform, whereby employees hold partnership interests rather than company shares directly.

Under Caishui 101, deferred taxation is available only if seven statutory conditions are satisfied simultaneously, one of which provides that “the equity subject to an incentive shall be a domestic resident enterprise’s own equity. The equity awarded may also include equity interests obtained through capital contributions in the forms of technological achievements to other domestic resident enterprises. The equity (or stock) may be granted through the issuance of new shares, direct transfer by major shareholders, or other lawful and reasonable methods.”

In a Q&A issued by responsible officials of the Tax Policy Department of the Ministry of Finance and the Income Tax Department of the State Taxation Administration on Improving Tax Policies on Equity Incentives and Technology Contributions as Capital (“Q&A”), the officials explained that “to ensure alignment of interests and encourage entrepreneurship, the equity granted under an incentive should be a company’s own equity, and equity of affiliated companies is excluded from the scope of the preferential treatment.” As a result, this interpretation excludes holding platform structures from the scope of the deferred taxation policy.

In practice, Chinese tax authorities mostly accept deferred tax filings only where employees directly hold company equity. However, a limited number of pre-IPO companies have disclosed successful deferred tax filings involving partnership-based structures.

Reference Case 1: Changchun Zhiyuan New Energy (listed on ChiNext on 19 April 2021) — First-Round Inquiry

In the first-round inquiry (Question 10.2), the company was requested to disclose and explain the reasons and rationality for a May 2019 share transfer at a symbolic price of RMB 1 to Zhongzhi Huiyuan, versus a transfer at RMB 6.00 million to Wu Weigang, whether relevant parties timely fulfilled tax obligations, and whether the transfers involved tax risks.

The company responded that, to ensure stable development and align the interests of core employees with the company’s long-term growth, it decided to grant shares to core employees; Zhongzhi Huiyuan served as the employee holding platform. The transfer at RMB 1 was treated as an equity incentive based on employees’ roles and contributions, and the company recognized share-based payment and expensed it as administrative expenses. The company further cited Caishui 101 and stated that, on 12 March 2020, it completed the deferred taxation filing with the competent tax authority and obtained a filing confirmation issued by the Chaoyang District Tax Service of Changchun, confirming that the relevant individuals could defer IIT on a temporary basis.

Reference Case 2: Zhejiang Runyang Technology (listed on ChiNext on 15 December 2020) — Implementation Letter on Listing Committee Review Comments

In the implementation letter (Question 2), it was noted that the issuer implemented equity incentives through employee holding platforms and requested disclosure of the deferred taxation filing status with the competent tax authority and whether there were tax risks; the sponsor was also requested to provide a clear opinion.

The company responded that some employees obtained equity incentives through employee holding platforms (Anyang Investment and Mingmao Investment). As of the signing date of the prospectus, it had completed deferred taxation filing with the competent tax authority for all employees who received equity incentives (including those receiving incentives through holding platforms). It further disclosed that, on 14 September 2020, the Changxing County Tax Service issued a confirmation stating that the company had completed the filing registration with complete procedures, that the deferred taxation filings complied with relevant rules, and that no tax violations were identified. Based on this, the company concluded that the filing registration was lawful and compliant and that no related tax risks were identified.

III. Practical Dilemmas and Possible Approaches

Based on the foregoing analysis, partnership holding platforms do not clearly fall within the scope of the deferred taxation regime under Caishui 101. However, inconsistent enforcement practices among local tax authorities have created uncertainty for pre-IPO companies. Where no deferred tax filing has been made due to the perceived inapplicability, does this create tax risk, and how should companies respond if regulators raise inquiries on taxation during IPO review?

In the author’s view, employees’ acquisition of partnership interests as partners differs from employees’ direct acquisition of equity in the company. In such circumstances, the price difference between the employee’s actual contribution and the fair market value should not automatically be characterised, by reference to Caishui 35, as “wages and salaries” for IIT purposes. Where no IIT liability arises at this stage, the question of whether deferred taxation filing under Caishui 101 applies would not arise.

This reasoning may be supported from several angles:

First, from the perspective of consistency and fairness, since the Q&A issued by officials of the Tax Policy Department of the Ministry of Finance and the Income Tax Department of the State Taxation Administration interprets the “equity subject to the incentive” in a strictly literal sense as referring to a company’s own equity, the relevant language in Caishui 35 should be understood in a correspondingly consistent manner.

In Caishui 35, the price difference between the actual purchase price (i.e., the exercise price) of shares obtained by an employee from an enterprise and the fair market value on the purchase date is characterised as income related to employment on the basis that such income is derived from the employee’s performance and work achievements in the enterprise. On this basis, the reference to “the enterprise” in both contexts should be understood as referring to the same enterprise—namely, the enterprise by which the employee is employed.

Accordingly, where an employee acquires partnership interests from a partnership holding platform, such acquisition constitutes an investment activity rather than employment-related income, as the employee is not employed by the partnership and does not obtain the partnership interests by virtue of services rendered to it.

Second, from the perspective of whether equity incentives can be treated as wages and salaries for deduction purposes, equity incentives implemented through a partnership holding platform differ fundamentally from equity incentives granted directly by a company. Where a partnership is not entitled to claim the difference between the exercise price and the fair market value as a deductible wages and salaries expense for tax purposes, it would likewise be inappropriate to characterise such price difference at the partner level as wages and salaries income.

In May 2020, the Dalian Municipal Tax Service of the State Taxation Administration (“Dalian Tax Service”) issued a public response to the following inquiry¹:

Question:  

Pursuant to the Announcement of the State Taxation Administration on the Enterprise Income Tax Treatment of Equity Incentives Implemented by PRC Resident Enterprises (STA Announcement [2012] No. 18), where equity incentives become exercisable, a listed company may calculate the amount by reference to the difference between the fair market value of the shares at the time of exercise and the exercise price paid by the employees. Based on the number of shares exercised, such amount may be treated as wages and salaries expenses of the listed company for the relevant year and deducted for enterprise income tax purposes in accordance with applicable tax laws.

This announcement addresses long-term equity incentives granted to directors, supervisors, senior management, and other employees (collectively, the “Participants”), under which the relevant benefit arising from the exercise of equity incentives, if the prescribed conditions are satisfied, may give rise to wages and salaries expenses and deducted for enterprise income tax purposes.

In practice, however, many companies have established partnerships as employee shareholding platforms, with employees acting as partners and the partnership holding shares of the company. Where equity incentives are implemented through such a partnership platform and granted to the partners (i.e., the employees), may the benefit arising from such equity incentives be deducted as wages and salaries by reference to the above approach? If not, how should the expenses arising from such equity incentives be treated for tax deduction purposes?

Response by the 12366 Taxpayer Service Center of the Dalian Tax Service:

Dear Taxpayer,  

Your online inquiry has been received. Our response is as follows:

1. The above announcement does not apply. STA Announcement [2012] No. 18 applies exclusively to listed companies.  

2. Pursuant to Article 3 of the Notice of the Ministry of Finance and the State Taxation Administration on Individual Income Tax Issues Concerning Partners of Partnerships (Caishui [2008] No. 159), income derived from a partnership’s business operations, as well as other income, is subject to the principle of “taxation after allocation.”  

The calculation of taxable income shall be carried out in accordance with the Provisions on the Levy of Individual Income Tax on Investors of Sole Proprietorships and Partnerships (Caishui [2000] No. 91) and the Notice of the Ministry of Finance and the State Taxation Administration on Issues Concerning the Adjustment of Pre-Tax Deduction Standards for Individual Income Tax Applicable to Individual Industrial and Commercial Households, Sole Proprietorships, and Partnerships (Caishui [2008] No. 65).  

For these purposes, income from business operations and other income include income allocated to all partners by the partnership, as well as income (profits) retained by the partnership for the year.

Third, from the perspective of the tax treatment applicable upon a future transfer of equity, equity incentives implemented through a partnership holding platform also differ from equity incentives granted directly by a company.

Under Caishui 35, Caishui 116 and Caishui 101, where equity granted under an equity incentive is subsequently transferred, the resulting income is generally subject to individual income tax at a rate of 20% under the category of “income from the transfer of property.” However, where equity is held through a partnership holding platform, and the exit is effected by way of transferring the incentive equity (or shares), the transfer is first carried out by the partnership itself, followed by a distribution of the transfer proceeds to the participants.

In such circumstances, when a natural person partner receives income derived from the partnership’s transfer of equity (or shares), such income is taxed under the category of “income from the business operations of individual industrial and commercial households,” to which tax rates ranging from 5% to 35% apply. This tax treatment differs materially from that prescribed under Caishui 35, Caishui 116 and Caishui 101.

In Issue No. 3 (December 2019) of the “Hot Topics” released by the Inner Mongolia Tax Service of the State Taxation Administration, the first question addressed the following:

Question:

Where an enterprise establishes a partnership as a shareholding platform and indirectly grants stock options of the enterprise to its employees, with the employees becoming partners of the shareholding platform, and where the platform distributes profits or transfers the shares it holds, may the relevant income be calculated by reference to Article 2 of Caishui [2018] No. 164²? If not, how should such income be calculated?

Answer:

Where employees indirectly hold stock options of their employer through a shareholding platform, Article 2 of Caishui [2018] No. 164 does not apply.

Pursuant to Article 2, Paragraph 3, Item (2) of STA [2011] No. 50, income derived by sole proprietorships and partnerships from transactions involving equity (or shares), futures, funds, bonds, foreign exchange, precious metals, mining rights, and other investment products shall be fully classified as income from business operations and subject to individual income tax in accordance with law.

Accordingly, income derived from the transfer of shares by a shareholding platform shall be treated in accordance with Article 2, Paragraph 3, Item (2) of STA [2011] No. 50.

Finally, from the perspective of the latest equity incentive reporting requirements introduced in 2021—namely STA [2021] No. 69, as well as the relevant implementation practices, the State Taxation Administration has taken a relatively limited approach to equity incentive reporting where the incentive is not based on the company’s own equity.

Specifically, STA [2021] No. 69 only provides that where a domestic enterprise grants equity incentives to employees using the equity of an overseas enterprise, such arrangements are subject to reporting requirements and individual income tax withholding under the “wages and salaries” category. STA [2021] No. 69 does not include employee shareholding platforms within the scope of equity incentive reporting. This absence may also be seen as reflecting the State Taxation Administration’s regulatory stance toward employee shareholding platform arrangements.

Accordingly, the author is of the view that, in responding to regulatory inquiries during the IPO process, companies may consider reframing the analysis away from whether deferred taxation filings under Caishui 101 are available, and instead focus on whether any IIT liability arises at the exercise stage in the first place. This perspective may offer a more viable path through the current regulatory and practical complexities surrounding partnership-based equity incentives in China.

Disclaimer: The English translation of the laws, regulations, policies and related materials referenced in this article is for reference only. In case of any discrepancy, the original Chinese text shall prevail.

【1】https://12366.chinatax.gov.cn/nszx/onlinemessage/detail?id=b491e707c67847a1a8b19a7f9ddaa8c6 

【2】 Article 2 of Caishui [2018] No. 164

Policies on Equity Incentives for Listed Companies (I) Where PRC resident individuals obtain equity incentives—such as stock options, stock appreciation rights, restricted shares, or equity awards (collectively, “Equity Incentives”)—and the relevant conditions set out in the following regulations are satisfied:

• the Notice of the Ministry of Finance and the State Taxation Administration on Individual Income Tax Treatment of Income from Stock Options (Caishui [2005] No. 35);

• the Notice of the Ministry of Finance and the State Taxation Administration on Individual Income Tax Treatment of Income from Stock Appreciation Rights and Restricted Shares (Caishui [2009] No. 5);

• Article 4 of the Notice on Extending Certain Tax Pilot Policies of National Independent Innovation Demonstration Zones Nationwide (Caishui [2015] No. 116); and

• Article 4(1) of the Notice on Improving Tax Policies on Equity Incentives and Technology Contributions for Equity (Caishui [2016] No. 101),

the income derived from such Equity Incentives, if obtained on or before 31 December 2021, shall not be aggregated into the individual’s annual comprehensive income. Instead, the full amount shall be taxed separately by applying the tax rate table for comprehensive income, and the individual income tax payable shall be calculated in accordance with the following formula:

Individual Income Tax Payable = Income from Equity Incentives × Applicable Tax Rate − Quick Deduction