Equity incentives, the seemingly standard component of any
compensation package in Silicon Valley, are being rapidly
adopted by companies based in Asia. These popular plans seek to
motivate, retain, recognize and reward the best available
personnel by providing additional incentives to employees,
directors and consultants, which align the recipients'
interests with those of the company, thereby promoting the
success of the business. In today's tight labour market,
competition for quality personnel is stiff. Without the promise
of equity incentives many companies, internet start-ups and
established old economy firms alike, would have difficulty
attracting top quality staff. In adopting equity compensation
schemes, many companies in Asia look to US stock option plans,
particularly "Silicon Valley" style plans, as a model. However,
differing legal, tax and accounting rules in Asian countries
mean that modifications must be made to the US model.
The US Background
In the US, share or stock options have traditionally been
the most common form of equity incentive. Simply put, an option
bestows the right to purchase shares in the granting company at
a fixed price (the exercise or "strike" price) for a specified
period of time (the term or exercise period). Stock options are
favoured by companies, in part, because they are understood to
create a direct link between the participant and the company.
Because the exercise price is typically set at the actual value
of the stock at the time of grant, the employee will profit
from the option only if the company's stock increases in price.
The terms of equity incentives vary based on strategic goals,
corporate culture and other considerations applicable to the
particular company, including the need to be competitive in
recruiting and retaining key employees.
Beneficial accounting treatment, as well as favourable tax
and securities law treatment, have greatly expanded the
popularity of stock options in the US. While the recipient of
the option (grantee) receives an uncapped upside potential
equal to any increase in the price of the stock, the company is
not required to deduct the value of the grant from company
earnings (despite a potentially negative impact on earnings per
share), and the company typically experiences positive cash
flow when the grantee exercises the option. To tie the grantee
to the company, most options vest over a period of time and
require the forfeiture of some or all of the options if the
recipient's employment with the company terminates before the
end of the vesting period.
The US Internal Revenue Code requires stock options to be
classified in one of two categories for tax purposes: either as
incentive stock options (ISOs), or as non-qualified stock
options. If the options qualify for ISO treatment, the taxpayer
will be allowed to account for appreciation over the exercise
price as capital gains. While countries such as Singapore and
Hong Kong do not impose capital gain taxes, this is significant
for US tax purposes, as this reduces the holder's US tax burden
on the appreciated amount from almost 40% to 20%. The taxpayer
can also defer payment of this tax liability until the eventual
sale of the stock. In exchange for this preferential tax
treatment, the Internal Revenue Code places specific
restrictions on ISOs regarding eligible recipients (employees
only), exercise price, term, exercise flexibility, holding
periods before a subsequent disposition of shares, and other
requirements. For the majority of US companies, the regulatory
restrictions and the most significant disadvantage of ISOs
– the inability of the issuing company to take an
offsetting tax deduction equal to the participants' gains
(except in the case of a disqualifying disposition) –
are tolerable in light of the tax savings and deferral
opportunities afforded by US law.
Non-qualified stock option treatment allows the company to
deduct the participants' gains as a compensation expense, but
does not provide the attractive tax rate differential and
deferral opportunities for the grantees. Non-qualified option
participants pay tax at the higher ordinary tax rates on the
difference between the exercise price and the fair market value
of the shares when the option is exercised. Capital gains tax
on any additional increase in value applies upon subsequent
sale. On the plus side, non-qualified plans are not as heavily
restricted by legislation in the US and so allow for much
greater design flexibility. In either case, US companies have
grown very comfortable with structuring plans and integrating
the tax and accounting implications into their compensation
structure.
Equity incentives in Asia
This sort of comfort level in structuring option plans has
yet to be reached by companies doing business in Asia. Asian
companies, as well as foreign multinational corporations doing
business in Asia, are rushing to implement incentive plans in
accordance with their own internal goals and policies and to be
competitive with the perceived Silicon Valley standard. Since
accounting, tax, securities laws and other regulatory factors
play a very important role in the design of equity incentive
plans, the specific legal and regulatory climate in each
country in which a company operates and employs personnel must
be examined to craft an equity incentive plan which promotes
the goals of the company in that country in the most productive
manner. Additionally, many companies in Asia hire US tax-paying
employees who would like ISO treatment for their options.
Successful companies will need to understand the implications
of their local operating environment as well as their
employees' needs, before adopting a Silicon Valley plan that
may or may not address all of their goals.
Foreign exchange and other restrictions
A typical US plan does not contend with foreign exchange
regulations; however, Asian plans may need to address these
restrictions. For example, citizens of the People's Republic of
China (PRC) may own options or shares of a foreign company, but
exercise of the option or sale of the shares will trigger
foreign exchange control issues. Foreign exchange laws also
generally prohibit compensation of Chinese citizens in any
foreign currency. Further complications arise for domestic
companies in the PRC, as PRC law does not recognize the concept
of authorized but unissued capital, and all registered capital
must be paid up. These factors, combined with state-owned
assets issues, make the notion of a US-style option plan
difficult to apply there.
Companies are exploring trust vehicles, derivative
securities such as stock appreciation or dividend rights,
performance units and phantom stock, or a system providing for
same-day sale upon vesting of exercise rights, as possibilities
for the granting of direct share options in the PRC and other
markets. Unfortunately, such alternative structures may not
accomplish all of a company's goals in adopting an incentive
plan, and may raise additional issues for the company adopting
them that were not foreseen. For example, use of a trust
vehicle may complicate registration of the underlying shares
for US securities law purposes. Further, for US taxpayers, ISO
qualification may be sacrificed, as ISOs cannot be granted to a
trustee of a trust, and other mechanisms may fail to meet the
ISO-required holding periods. Additionally, the adoption of a
trust or re-sale system may result in additional administrative
costs, regardless of whether the rights are ultimately
exercised.
Tax considerations
One reason that the US stock option model is so successful
is that tax for grantees on the optioned shares is not due
until the time of ultimate disposition in the case of ISOs, or
the time of exercise in the case of non-qualified stock
options. This important tax provision ensures that option
holders will have the means to pay the taxes due, even if some
of the exercised shares must be sold to satisfy the tax
obligation. Similarly, most Asian countries tax options at the
time of exercise or purchase. However, when operating in a
jurisdiction that imposes tax at the time of option grant,
consideration may be given to a tax loan, bonus programme, or
other mechanism designed to ensure that grantees have the
ability to pay any associated taxes.
Local tax laws in general, and with respect to options in
particular, are subject to rapid change. Many countries are
examining taxation of options and making changes. Earlier this
year Singapore announced its new Entrepreneurial Employee Stock
Option Scheme which provides extensive tax deferral and savings
opportunities to employees of certain Singapore-based companies
which meet the requirements of the government-announced
framework. One reason cited for this change was the need for
Singapore companies to compete effectively for top talent. More
countries may enact similar proposals in an effort to remain
competitive.
Taxes owed by the option holder are on one side of the tax
equation, while corporate taxes of the granting company are on
the other. Before adopting a plan, a granting company must
determine whether it will be able to deduct the grant as a
compensation expense and at what point the deduction can be
taken. As noted above, American companies generally are not
entitled to a compensation deduction for ISOs, but are
permitted to take a deduction when grantees exercise
non-qualified stock options. Because tax and regulatory laws
differ so dramatically from country to country, it is essential
to obtain tax and legal counsel in each jurisdiction in which
employees or other participants reside, before including them
in any particular option plan.
Securities laws
Companies offering options in multiple countries must comply
with the securities regulations in each jurisdiction. Foreign
companies issuing options to people resident in the US must
comply with federal law as well as state securities regulations
or "blue sky laws." US federal securities laws require that the
offer and sale of securities (an option is considered to be a
security) must either be registered with the Securities and
Exchange Commission (SEC) or be exempt from registration. A
legal analysis of the plan and the pool of grantees is required
to ensure SEC compliance. To ensure compliance with blue sky
laws, the company should note the particular states of the US
in which grantees reside. For example, when granting options to
an employee in California, in addition to complying with all
federal securities laws, certain filings at the state level may
be required in order to qualify for necessary state securities
exemptions. Failure to comply with such laws can have negative
and potentially costly consequences, as the grantees may be
able to rescind the options or take back the exercise price if
the shares have lost value.
Accounting issues
Any company listing shares on a US stock exchange will have
to deal with US accounting laws, as listing rules require that
companies present their accounts in accordance (or reconciled)
with US generally accepted accounting principles (US GAAP).
Under US GAAP, most companies grant options at current fair
market value, with a fixed vesting term, and do not record any
compensation expense. The idea is that if the options are
granted at fair market value, the company does not incur any
expense at the time of the grant. However, when the share price
increases and the option is ultimately exercised, the company
would, in theory, have a large compensation expense because it
must sell the option shares at a price significantly lower than
the market price at the time of exercise.
US GAAP allows companies to note this difference in a
footnote to the financial statements, rather than requiring the
company to record an expense.
Under US GAAP, if the exercise price and vesting dates are
not fixed at the time of the grant, companies must employ a
method of variable plan accounting, whereby quarterly
compensation charges, usually equal to the difference between
the grant price and the current market price, are recorded and
reflected in the income statement. Repricing and other
modifications of fixed option terms can also trigger variable
plan accounting. In such cases, vacillating stock prices will
cause wide swings in corporate profits, making the job of
predicting profits almost impossible. For a publicly traded
company, this is likely to cause unmanageable volatility in the
price of the company's shares. Therefore, option plan features
that could result in variable plan accounting treatment should
be avoided whenever possible by companies that keep their books
under US GAAP.
Plans in which option vesting is dependent on the attainment
of certain financial or other performance benchmarks typically
require the application of variable plan accounting under US
GAAP because the vesting dates of such grants are uncertain.
So-called cheap-stock issues (a term used by the SEC to
describe options granted to employees with an exercise price
considerably lower than the fair market value of the shares at
the time of grant) can also have negative accounting
consequences under US GAAP rules. Local accountants and
attorneys can often minimize exposure in these areas with
proper consultation before option grants are made.
Listing rules
In private companies, demand for stock options is fuelled by
a hope that the company will make an initial public offering
(IPO) of its shares on a stock exchange. In drafting their
option plans, companies should consider where such a listing
might ultimately take place. Most exchanges have rules for
option plans. Many, including Nasdaq, Singapore and both Hong
Kong boards, require shareholder approval. Singapore and Hong
Kong go further and have set up substantive rules governing,
among other things, eligible participants, exercise price,
maximum number of shares eligible, and exercise term. Many
exchanges provide for the grandfathering of existing option
grants under the pre-IPO plan without disturbing their terms.
In such cases, the terms of both must be disclosed. While
Nasdaq does not impose rules covering the terms of an option
plan, companies planning a Nasdaq listing are advised to
consider US GAAP accounting issues and US securities law issues
well in advance of starting the listing process.
Other concerns
Many Asian companies employ US taxpayers who want
ISO-qualified stock options, and many decide that it is worth
the added administrative burden to establish ISO plans. As the
US provisions are very technical and generally not required for
non-US purposes, companies may choose to maintain one plan for
US employees and one plan for non-US employees. If more than
one plan is maintained it is important to note that share limit
restrictions generally apply to all plans in operation, not to
each individual plan.
Summary
Equity compensation is just beginning to take off in Asia.
Market trends show that increasing numbers of firms will join
in, turning employees into interested owners. Companies have
many, often conflicting, alternatives when looking to institute
equity compensation plans and should look to legal and
accounting professionals to ensure compliance with the complex
tax, securities, accounting, labour and other laws in each
jurisdiction to structure plans that meet the company's
particular goals.
Morrison & Foerster
21/F, Entertainment Building
30 Queen's Road
Central
Hong Kong
Tel: 852 2585 0888
Fax: 852 2525 0800
www.mofo.com