In this blog we will discuss on the taxable perquisites and the two different approaches known as ‘upfront’ and ‘back end’ that are required to determine that when perquisite has accrued to an employee. Then we will have a brief comparison between these procedures.
Exercising the option of share after termination of Employment from Hong Kong
In Subhash Chander D 34/05, during employment a taxpayer of Hong Kong incorporation company, he was granted an option. After sometime he left that job in Hong Kong and returned back to India. In India he exercised that option. As employment of that person had already terminated from Hong Kong so it was considered by the board of revenue department that the benefits from option that were exercised by him in India were not taxable. But during the hearing of this case in High Court, it was its stance that these option benefits were fully taxable otherwise the purpose of Inland Revenue ordinance would be defeated according to Section 11C of Hong Kong tax law.
Tax implementation policy on Share Award Benefits
The approach for assessment of benefits:
If shares are acquired from share-based remuneration, then these are taxable perquisites. These perquisites forming part of employment income of a taxpayer. It is necessary to verify some items for purpose of salaries tax and these are given below:
When does employee accrue the perquisite?
When a person becomes eligible to claim the payment when income accrues to that person. According to Section 11D (b), the saying ‘entitled to claim right the payment’ is taken to mean ‘entitlement of a person to ownership of the shares’ in the situation of the share awards. If an income is not received by a person yet but it is accrued to him then it should not be included in his assessable income and it could only be included in the assessable income as long as it is received by that concerned person as described in Section 11D (a). That income only would be regarded as received by him which has been available to employee whom it has been dealt with or it has accrued, according to his directions or on his behalf, in DIPN 38 (revised). In order to determine the time at which shares were accrued to an employee, the reference to the terms of award plan need to be considered. In order to assess such awards there are two options:
The full entitlement of employee to ownership of share is use to determine that, which approach is to be adopted among above described approaches. The full entitlement of employee to ownership of share mean that whether, employee has right to attain full economic benefits of shares and when that taxpayer has all the rights of normal shareholder as in DIPN 38 (revised).
What type of value would attached to perquisite when it is given to employee?
The value that should be ascertained at the time of accrual is fair value or FV, in DIPN 38 (revised). The fair value specifically refers to the closing value of quotation on the stock market for quoted shares. It is up to the taxpayer to select the most favorable price if the share is listed to two non-Hong Kong exchanges according to context DIPN 38 (revised). The other methods such as net asset value are to be adopted by Inland Revenue department for the shares that are unquoted. The objective of this approach is to verify that to obtain the subject shares on the date of exercise of option, what price a purchaser that is not anxious but hypothetical willing would need to pay to the not anxious but hypothetical seller, in DIPN 38 (revised). It will sometime beneficial for officers of inland revenue department to meet the representative of company. These representatives may subject to allocated authority being given by concerned employees. These meetings are useful with a view to agree both parties for valuation on exercising of these benefits.
In D 37/10, a person T was employed in a company setup Hong Kong. Under the equity of Incentive Compensation plan of his employer T was granted with various unit stocks. Immediately after the allocation of units to him under that incentive plan there was a black out period for 10 days. During that black out period employee was not allowed to sell that units. It was contended by T that, the date at which shares were free of every conditions they should be valued on that date. It was stated by board of revenue that, the actual amount that was realized upon disposal in order to ascertain the value of shares to be assessed was a consideration that was not relevant. And according to the law, the shares are only acquired by taxpayers when these are allocated to him/her. In order to compute the salaries tax, the value of share at that of allocation or vesting is income that is assessable. And it is totally non relevant consideration to impose the restrictions on the shares or any subsequent event. This would also be an irrelevant consideration if there is non-disposal condition or black out period is imposed on the employee T. as long as shares become allotted to T, he would be a legal owner of the shares. Furthermore, the character cannot be altered by the sale restriction that is imposed on the shareholders. So these shares are no longer something which can be turned into financial account. This statement of price fluctuation during period of 10 days was irrelevant. The difficulties in the market are of no importance. If there is discount offered in accordance with the black-out period even though no discount would be warranted having regard to circumstances of case or having regard to short period of time. So by taking into account all the scenarios the appeal of the employee T was dismissed.
Determination of when perquisite has accrued to Employee
‘Back end Approach’
Under influence of this approach some critical conditions need to be verified before vesting of shares in the employee. These conditions include
There can be a trustee to contain and allocate the shares but if employer resigns from Hong Kong incorporation company or dismissed due to misbehavior or predefined conditions are not met then these shares should be liable to become lost. During normal conditions, the employee is not allowed to vote, he is not allowed to receive the dividend, he is not registered as owner of shares and also he have no rights of shareholder. The employee will receive all the shares such as dividend or dividend shares or bonus shares together that were distributed during vesting period. These would be receiving by him at the expiry of vesting period not before that. It is duty of Inland Revenue department to take the views at the time of grant, under such conditions that only promise amount are received by employee with respect to shares. The employee is only entitled to reception of perquisite if shares are vested to employee without any restriction. As described earlier, in only this case employee would be consider as entitled to ownership of shares. And this would be the case when the shares that are awarded to the taxpayer would be subjected to the tax, given in DIPN 38 (revised).
The time when after being free from all the conditions the employee is entitled to ownership of the shares of company doing business in Hong Kong would be referred to as ‘vesting’. And the vesting period is the period that is difference between two dates. First date is the date when share award is granted to an employee. And the second date is the date immediately before when employee was entitled to ownership of all the shares without effect of any condition. The case in which back end approach would be the more appropriate in order to assess the shares would be when due to some future events or termination of employment the shares granted are subject to some penalty. There can be many tough scenarios while assessing the shares obtain by a taxpayer. So in order to ascertain the point of time when share accrue to employee for purpose of salaries tax the most appropriate method is to examine the term of award. That’s why this share was allocated to a taxpayer and there would be implementation of different rules of Inland Revenue ordinance on different cases, is seen DIPN 38 (revised).
According to this approach the award should be presented for assessment purpose when it was granted to an employee or taxpayer by the employer. The certain restrictions may or may not imposed on the award granted. Among other restrictions the most common restriction to sell that usually apply on the taxpayer that provide services to a set up company in HK is that, ‘within a certain period of time an employee is not allowed to sell the shares’. There are some benefits that he/she would get other than these restrictions. These benefits include that, employee would be able to attend the general meeting, would receive the dividend, name would be added into the register of shareholder, would be able to pledge the shares to banks for loans etc. In short, other than having the right of selling the shares within the restriction period employee have all the rights of a normal shareholder. As long as the restriction period is end then there may normally little needs to be done to vest the shares in the employee according to this approach. Under such situation it would be considered by the Inland Revenue department that at the time of grant employee has taken a perquisite in the method of share so he would be chargeable to tax. And this situation is called upfront, as taken from DIPN 38 (revised).
Now we will summarize both of these approaches by having their comparison in the tabular form as given below:
‘Back end’ approach
Application of vesting period?
At the time of grant hence upfront.
At the fulfillment of conditions hence back end.
Market value applied at the time of grant of shares.
Market value at the time of success of conditions.
Discount in evaluation
Yes. In the light of fact of a particular case the discount is to be determined. For each year of sale restriction 5 % discount would be given. D 120/02 to observe the allowance of 25 % discount for a restriction period of 5 years. This is also in line with handling of share options.
Allocations (e.g. additional benefit share, dividends)
Not taxable; as employee is entitled to the share at time of award hence regarded as investment income. Shares received during period of restriction.
As employee is only entitled to the shares at the end of vesting period hence taxable. To be received during vesting period.
Employment in a company doing business in Hong Kong
During the year of assessment, the price of shares accruing will be:
That would be in case if taxpayer:
Then according to Section 8 (1A) (b) (ii) and 8 (1B) of Hong Kong tax law the shares of taxpayer along with income of his employment will not be assessable. Shares that are vested after termination of the employment are seemed to accrue on the last day of employment of a person.