Tax reform for innovation

Stock-based incentives should be encouraged to attract and retain talent for startups and high-tech companies

More preferential tax treatments should be granted to the equity-based compensation plans of high-tech companies. This is a crucial step for promoting technology innovations in China.

High-tech companies in China are now looking for new ways to attract and retain young, educated, talented and creative employees. To survive in the fierce global research and development competition, they need to motivate talented employees to design or produce high-quality, knowledge-intensive products. But many companies in China find it hard to attract top-notch talent.

The classic objectives of equity-based compensation plans are attracting and retaining talent and aligning employees' and shareholders' interests with the long-term success of the company. It is an approach frequently adopted by employers in the West, but many have argued that China is actually more compatible with such practices, simply because Chinese people are more likely to save for the long-term and usually place more emphasis on feeling valued or having a sense of "belonging" in the community.

Although a relatively unexplored area in typical remuneration packages currently provided by Chinese high-tech companies, offering equity-based compensation for employees could be an effective strategy to ensure successful staff retention in the long run. In particular, stock options and restricted shares can be employed to attract talented employees, and these are crucial tools for startups and small or medium sized companies, which usually cannot offer very competitive salaries.

However, equity-based compensation has not really taken off in China, as yet. Only a small percentage of Chinese companies offer some type of equity compensation scheme for employees and the most common vehicles in China now include restricted stock units and stock options.

Since 2005, the government has offered preferential individual income tax treatment on income from stock options and restricted shares. More specifically, such incomes are taxed separately from normal income and enjoy lower tax rates overall, as regulations allow such incomes to be spread over the period between grant date and vesting date, up to a maximum of 12 months.

On the surface, there seems to be nothing wrong with this tax arrangement. The problem is that Chinese individuals have to pay income tax on the difference between the exercise price and the fair market value of the shares issued in the equity compensation scheme within one month. In other words, no matter how long they are willing to hold the newly purchased shares, they have to pay income tax just after the stock options are exercised or the restrictions on selling company stocks are released. To pay the income tax, some employees of listed companies rewarded with the equity-based compensation have taken great pains to sell at least some of their newly purchased stocks, which increases the volatility of short-term stock price fluctuations at the expense of long-term growth.

From the employers' point of view, this tax arrangement contradicts their primary goal of equity-based compensation. If this tax legislation no longer helps to motivate key employees to keep their stock incentives, what purpose does it serve?