Over recent years increasingly more businesses have used incentive shares to retain key employees. They may hold shares in the subject company directly (hereinafter referred to as “holding shares directly”) or indirectly through a limited partnership i.e., a platform for employees to hold shares (hereinafter referred to as “holding shares indirectly”). What are the advantages and disadvantages of holding shares directly or indirectly? This article deals with this issue in the areas of business control and tax burden.

I. Holding shares indirectly can avoid annoying intervention of minor shareholders

In the case of holding shares directly, the person holding incentive shares directly holds shares in the target company. Although the shareholder will be highly motivated in this way, its disadvantages are obvious. In Chinese company law, shareholders of limited companies have the right to information. In other words, shareholders are entitled to get access to the company’s financial reports and accounting books and documents. Most Chinese private businesses, especially small and medium-sized ones lack appropriate corporate governance, financial and tax arrangements. The inappropriateness may cause conflicts between major and minor shareholders in withdrawal from a share incentive program.

In the case of holding shares indirectly, can the person holding incentive shares, i.e., limited partner of a limited partnership penetrates the partnership and exercise the right to information of the target company? Let’s look at two precedent cases, one decided by Shanghai No.2 Intermediate Court and the other by Jiangsu High Court.

In the opposition to the enforcement of the shareholder’s right to information case between Guo Jinlin and Jinpu Group decided by Jiangsu High People’s Court (Case No. [2017]SZJ648), the court found that the shareholder’s right to information of an investment company in general included the right to information of the subsidiary under its control and that the subsidiary was not obligated to provide financial documents that should be provided by the parent company.

In the shareholder’s right to information case between Netac and Shanghai Hefeng decided by Shanghai No.2 Intermediate Court (Case No. [2013]H2ZM4(S)ZZS1264), the court found that the shareholder had the right to information about the company’s subsidiary to an appropriate extent, in which the company should hold 100% shares, without damaging other shareholder rights of the subsidiary, an independent legal entity with civil rights and liabilities.

In these cases, legal authorities at high levels held that shareholders had access to financial documents of subsidiaries of the target company. However, they are based on some characteristics inherent in the case like the company’s articles of association or an agreement between the parties involved and limited to 1. the holding subsidiary (Jiangsu High Court); 2. the 100% holding subsidiary (Shanghai No.2 Intermediate Court); 3. access to the target company, so that its subsidiary is not a party to the legal action.

As a limited partnership of a share incentive platform, it held a small part, usually no more than 30% of shares in the target company which was not its controlling subsidiary. If LP claimed that it had the right to information of the target company, the court would not support it. Therefore, if the LP of the shareholding platform wants to claim the right to know with reference to the provisions of the Company Law, it can only claim it to the limited partnership. Therefore, the indirect shareholding mode through the establishment of limited partnership as a shareholding platform can better protect the interests of the controlling shareholders. People holding incentive shares only have rights to dividends and make suggestions.

II. Tax burden on holding shares directly is relatively light

Tax on holding shares directly is fixed, while tax on holding shares indirectly paid by a limited partnership is flexible, usually higher upon withdrawal at a high premium.

In the case of holding shares directly, personal income tax is paid at 20% of the share transfer premium, while limited partnerships pay personal income tax at 5%-35% of “revenue”. In the Circular on Improvement of Income Tax Policies Connected with Share Incentive and Shares Obtained by Technology Transfer (CS[2016]101) published by the State Administration of Taxation in 2016, in the case of holding shares of directly, qualified non-listed companies can apply for recordation to the competent tax authority and be entitled to deferred payment of personal income tax policies, under which the employee is entitled not to pay any personal income tax on incentive shares acquired until they transfer the share and should pay personal income tax at 20% according to the difference between earnings from the share transfer minus the costs and reasonable taxes connected with acquisition of such shares.

If conditions for deferred payment of tax are not met, upon acquisition of the incentive shares, 3%-45%personal income tax on the difference between the actual paid-in capital and the fair market price of the shares should be paid at the rate decided in the same way as “wages and salaries” after deduction of the cost of paying for the incentive shares. In case of transfer of the shares, 20% personal income tax should be paid on the difference between earnings from the share transfer and costs and taxes connected with acquisition of the shares.

If they could be filed for recordation with tax authorities, tax would be reduced dramatically.

Incentive shares held indirectly cannot be filed for recordation with tax authorities at the moment. Pursuant to Article 1 of No.101 Document, incentive shares mean shares in the target company. One of the prerequisites for deferred payment of tax on incentive shares is directly holding the shares in the target company. Incentive shares held through a limited partnership are incentive shares in nature, but subject to No. 101 Document, tax authorities generally refuse to accept requests for recordation of incentive shares held indirectly so that the deferred payment of tax policies are not applicable to this type of incentive shares.

For tax authorities, incentive shares held through a partnership platform should be taxed as follows. Upon acquisition of incentive shares, 3%-45%personal income tax on the difference between the actual paid-in capital and the fair market price of the shares should be paid at the rate decided in the same way as “wages and salaries” after deduction of the cost of paying for the incentive shares. In case of transfer of the shares, 5%-35% personal income tax on the difference between earnings from the share transfer and costs and taxes connected with acquisition of the shares should be paid at the rate decided in the same way as “revenue” of a partnership.

In conclusion, within the current legal framework, incentive shares held indirectly can motivate staff, reduce unnecessary invention in the company’s development and help with its stability, but impose heavy burden of tax; and incentive shares held directly incur stable tax and act as good motivation, but could adversely affect the company’s development if used inappropriately. A company can decide which type of incentive shares to choose by considering characteristics of persons given incentive shares, the stage of its development, compliance, etc.