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Mark Footer

Stock options, the offer of discounted shares in lieu of cash, were all the rage 18 months ago, when Internet start-ups and their high-technology brethren were desperate for talent but could promise only future riches.

As far as local taxation of an employee's stock options goes, it is mostly straightforward.

An employee who obtains a share-option as part of a remuneration package for employment is taxable on the difference between the option price offered and the market value of the shares at the time the option is exercised and the shares are obtained.

For example, if an employee has an option to buy a share for HK$10 and that option is exercised when the share price stands at HK$25, the HK$15 difference, or the benefit, is subject to tax.

The price of the share when it is actually sold, whether it falls or rises, is irrelevant.

If options are assigned or released for consideration instead of being exercised, a tax liability can also arise. Such transactions are effectively taxed as being exercises of the transaction.

Unless there are any complicating circumstances, that is the end of the matter.

However, complications do occur if employment circumstances change between the time the share option is granted and the time it is exercised. For example, if an employee of a multinational were granted an option overseas but decided to exercise that option while on secondment in Hong Kong, would that employee be liable for tax on the benefit?

Until recently, tax provisions lacked clarity on this and, as a result, the Commissioner of Inland Revenue issued new guidelines.

Under these guidelines, employees are split into two categories - those deemed to have Hong Kong employment and those with non-Hong Kong employment.

The majority of employees in the SAR have Hong Kong employment and the tax position of these people does not give rise to many problems. They will almost invariably be taxed on the full benefit amount.

The only exception occurs when the employee (or former employee) does not visit Hong Kong for more than 60 days in any of the tax years during the vesting period - the period between an employee commencing employment and the time, stipulated in the employment contract, when all the options can be exercised. In this rare instance, the benefit will not be taxable. (This exemption also applies to those with non-Hong Kong employment).

Non-Hong Kong employment is fairly common among senior executives in multinational corporations who are seconded to work in, or from, Hong Kong. This is because these executives tend to be employed by overseas companies and their contracts have usually been negotiated, concluded and are enforceable outside Hong Kong.

As a rule, taxation of the benefit of employees with non-Hong Kong employment will be calculated on the number of days spent in the SAR during the vesting period.

'Under the new revenue practice they are really looking at the period from granting to vesting,' said Agnes Chan, tax partner at Ernst & Young.

If the option vests, or becomes unconditional before the employee's arrival in Hong Kong, no tax is liable on the benefit.

'If it is exercised in Hong Kong, providing the granting and vesting are all done outside Hong Kong, there is no Hong Kong tax implication,' Ms Chan said.

Where the option vests after an employee comes to the SAR, the benefit liable for taxation will be calculated on a pro-rata basis, according to the proportion of the vesting period spent in service in Hong Kong.

The pro-rata calculation is also used if an option is exercised after an employee leaves Hong Kong permanently, having rendered services in Hong Kong during the vesting period.

This poses significant enforcement problems for the Inland Revenue Department (IRD), as it is burdened with the collection of tax directly from a departed employee.

Recognising the potential problem and acknowledging that employers do not have any secondary liability to pay tax in the event of default by an employee, the IRD will permit, but cannot compel, an employee to pay tax on the benefit before leaving, calculated as if the option had been exercised on the day immediately before departure.

No discount for any restrictions on disposal of stock, imposed under the terms of a share option, is permitted.

If such prohibition exists, the employee will still pay tax on the benefit even though it is not realisable.

If, in this situation, the value of a share falls, tax could conceivably be paid in circumstances where no benefit was received.



Tax stance on stock offers straightforward