With share prices in China rising again, the economy booming, and the Shanghai Stock Exchange Index hitting five-year highs repeatedly this month, an exotic form of executive compensation is coming back into vogue in Corporate China: the stock option.

Earlier this decade, options generated considerable interest in China, and indeed some were issued. Then, the Chinese market tumbled and the idea took root that options might not be an entirely legitimate way of compensating employees; cash became king, and the incentive option was almost never discussed and rarely used.

But now Chinese executives and other high-level employees are contemplating the notion that linking their pay to stock performance may not be a bad idea. And companies are seeing that they need more than just Chinese currency to convince highly experienced executives to stick with them. Meanwhile, the government is becoming more receptive to the concept of the incentive stock option. It sees it as a way to make—and keep—Chinese companies competitive and is at least tolerating options, if not outright promoting them.

Options are, of course, a type of derivative, so they have long been regarded with some suspicion by Beijing; the government fears anything that attracts speculation. That options are tough to regulate doesn’t help, and for years options in China had the weakest of legal underpinnings. Several rules related to the tax treatment of stock options were issued in the late 1990s, but not nearly enough law was published to handle such a complex financial product.

Then came Circular 35. Last year, the State Administration of Taxation issued this statute to clarify certain remaining issues regarding how the bureaucracy would view incentive options as personal income. Most notably, the tax authority clearly said incentive options would be taxed upon execution rather than on issuance. For some observers, this was all too obvious of a regulatory decision.

Naim

“It was simply the rational way to go, almost ‘Duh,’” says Tahir Joel Naim, a stock options attorney at the law firm Fenwick & West.

Nevertheless, that the always-opaque Chinese bureaucracy chose such a straightforward route—indeed, that it chose to issue a regulation at all—sends a signal that it supports stock options. Circular 35 may not have answered all of the questions companies may have about issuing options, but it does telegraph the government’s intention to improve the regulatory environment for them.

Optimism was further fueled by the recent announcement that state-controlled companies with foreign-traded shares will be able to offer options to their executives. Again, it was not really a major decision for Beijing, but it shows a certain level of acceptance of stock options.

Scope Of Circular 35 Expanded

Circular 35 also has been tweaked. Late in November, the tax authority issued Guo Shui Han 902, a supplementary note to the original statute. In it, the government clarifies that Circular 35 applies to local and foreign companies; the taxable income from the disposition of discounted options is the difference between the cost of the options and the actual amount received; and income from synthetic options (where no real option actually exists) will be treated like normal Circular 35 income.

Naim adds that the government has chosen to parcel out gains received from options territorially. That is, employees will pay tax on options in China depending on how much of the life of the option is spent working in China. If the option is granted when the recipient is living in China, but exercised when the person is in another country, the Chinese government will claim a percentage of the option’s value proportional to the amount of time he or she was in China. For example, if the option’s life is three years, and the employee spent one of those three years in China, the government will tax the employee on one third of the gain from the option.

Andy Chen, a partner at Ernst & Young in Beijing, says that stock option tax law is fairly clear and quite strong for individuals; the remaining problems are largely those of implementation, use, and enforcement. For example, when Circular 35 came out, the regulators published a definite effective date—but the supplementary notes do not have such a declaration. According to Chen, accountants in Beijing are scrambling to figure out when to use the clarifications and whether they are retroactive.

“902 is helpful and most of the points have been clarified, but it did not mention when it would be effective,” he says. “Things are confusing right now.”

Chen adds that while Circular 35 and GSH 902 are fine guidance unto themselves, he wonders how the message will be received at the local level. Typically, companies must deal first with county tax officers. They can escalate to Beijing, but before they do they will have to spend a lot of time with local bureaucrats whose interpretation of the statutes can reach impressive heights of creativity.

Chen

Chen also is concerned about the corporate side of stock option regulations. It is not clear exactly, for example, how options granted by a foreign company should be expensed at a Chinese subsidiary. The government has yet to determine what method must be used in calculating the cost of the options granted and how exactly this should be booked.

Aside from tax issues, other regulatory problems remain. The most serious perhaps is the lack of guidance from the China Securities Regulatory Commission. In the United States, the Securities and Exchange Commission made the decision not to view stock issued in stock options programs as a public offering—an invaluable policy to keep option legalities relatively simple. While the CSRC is expected to follow the same course and has promised to issue regulations “soon,” its long silence on the question increases regulatory risk.

Technically speaking, a non-Chinese company issuing stock options to its local employees needs to get its shares approved for public offering by the CSRC. In other words, the foreign company needs to place itself under the watch of the Chinese regulator, a situation most companies would want to avoid vigorously.

Furthermore, a foreign company will need to register its stock option program with the tax authority of every province in which it has employees enrolled in the program. That logistical ordeal only grows worse by the possibility that inconsistent local rulings may be applied, and, in some cases, local tax offices may be corrupt.

The way around these problems is to offer local employees cashless sell-all options. These instruments are not options in the sense that they do not allow the employees to buy shares at a predetermined price; they simply offer the employees the same amount of money that they would have received had they owned that instrument. It is not really an option plan; it is more of an option-linked bonus plan and the reward is cash, which attracts very little regulatory scrutiny.

Chen says the law says nothing about this practice, and it has been used by many multinationals: “It’s neither legal nor illegal.”