What are the impacts of grant option and conditional grant on determining the tax on the income of taxpayer working for local or offshore company incorporation?

In this blog we will have discussion on, what is the vesting period and its’ relation with the assessment year. We will also discuss the impacts of timing of grant option, conditional grant and non-Hong Kong employment on the assessable income of a taxpayer. These would be discussed with support from some examples and case study in order to clearly understand these phenomena. 

It was observed in a case D 10/10, an employee T while working in a company acquired got some shares of a company that was held by his employer at price of $4.54. He did so while exercising option to purchase share that were obtained by him during his employment. The unit price of these share was calculated at $21.67 at the date of acquisition. And it was calculated according to HLDC’s articles of association. In order to exercise the based on ($21.67 - $4.54) per share the T’s gain was calculated by Inland Revenue department. It was the stance of T that he cannot sell the above described shares according to the decision of board of directors and article of association of HLDC.

The stance of employee T was rejected among other things by board of revenue and argued that:

  • In order to calculate the gain that is to be realized by exercise of an option, the Section 9 (4) of Hong Kong tax law mandated a way. And this is totally non relevant to determine the realization of gain by knowing that T had actually been benefited by this exercise.
  • In the context of determining the realization of gain it was seen that Section 9 (4) (a) of Hong Kong tax law did not use the word ‘that person’ instead it used the word ‘a person’. So in order to determine the gain realized the restrictions to a specific person should not be taken into account. Therefore, as long as only determination of gain realized was concerned the fact that under HLDC’s articles of association and decision of board of directors’ T would not be allowed to sell the shares that would not be valid.

Grant of Options’ Timing

If the circumstances for the employment of taxpayer change between time when option was exercised and time when option was granted, there may arise some difficulties. These difficulties can also arise in the case if a taxpayer have employment in a company such as offshore incorporations HK limited.

The share option benefit is not exempted but taxable but only at the time of exercise not at the time when it was granted, as in Section 9 (1) (d) of Hong Kong tax law. But it is the stance of Inland Revenue department that, circumstances of employment of a person not at the time of exercise but at the time of grant decide that whether a person is taxable or not.

It is very rare that a share option is granted according to condition of employment of a person at the time of grant. The most common condition is that, if a person has provided the services for a specific period also known as ‘vesting period’ then only he would be entitled to that option. But according to the view of Inland Revenue department, these are the circumstances of employment of a person during the vesting period not the circumstances that exist during the time when option was exercised on which quantum of taxable benefits depend.

Employment in Hong Kong

It is the general consideration of Inland Revenue department that the share option benefit is assessable if at the time of grant the employee was in Hong Kong. And it would not be assessed if he/she render all of his/her services outside Hong Kong. According to DIPN 38 (revised), the assessment year in which option is exercised, the benefit is also assessable in that year only.

There are two different case. In first case a taxpayer after the cancellation of his employment exercises the option while in other case the taxpayer provides his services outside Hong Kong in a year assessment in which he/she also exercises his/her rights. In both cases discussed above, the benefits that a taxpayer would receive due to exercising of option would be taxable. But on the other hand the benefits would not be taxable if a taxpayer provides his/her services outside Hong Kong in a year assessment in which option is granted to him/her while provides his/her services outside Hong Kong in a year assessment in which that option is exercised by him/her. 

Grant based on Condition

The option may be taxable when it is granted to a taxpayer during a vesting period and that taxpayer has either Hong Kong employment at that time or has provided the services during that vesting period. In order to clarify our understanding here is an example.

Consider a vesting period was from 1 April 2013 to 31 March 2015. A taxpayer during his 60 days’ visit to Hong Kong provided his services in the year that ended at 31 March 2014. No services were provided by him in year ended 31 March 2015. Option was exercised by him on 1 July 2015. And also no services were provided by him in year ended 31 March 2016. Hence in the year assessment 2015 to 16 the full amount of option benefit was taxable. DIPN 38 (revised).

Employment outside of Hong Kong

It is accepted by Inland Revenue department of Hong Kong that if option is granted to a taxpayer on some unconditional basis, before a person providing his services overseas or to offshore incorporations HK limited then that option would not be taxable. This unconditional basis includes the end of vesting period in case of a conditional grant. Other than that option is also not taxable after a taxpayer starts to provide services in Hong Kong.  

The benefits will be divided according to equation given below, if grant is according to a vesting period. As provided in Section 9 (1) (d).

The midnight rule is applied in order to calculate the total number of days in vesting period. According to midnight rule, the day of arrival and day of departure of the taxpayer is calculated as one day.

If in other example vesting period is two years (730 days). During the vesting period a person provides services for a period of 292 days.  These days also include attributable leaves and calculated as below:

The taxable amount of share option gain = share option gain * 292/730

The period of stay of a person in Hong Kong during an assessment year would be excluded in computing the gain if a taxpayer provides his/her services in Hong Kong not more than 60 days during his/her visits in a year assessment.

If according to above scenario a taxpayer visits Hong Kong for 40 days in 2009 to 10 and spends 252 days in Hong Kong in 2010 to 11 then as during his visit on 2010 to 11 the days when he provided services to Hong Kong exceed than 60 days so the chargeable portion of gain for assessment year 2010 to 11 would be 252/730. One key point to note here is that as described earlier in previous articles the midnight rule does not apply for the purpose of 60 days’ rule. And no matter it is either day of arrival or day of departure it would be definitely counted as one complete day. DIPN 38 (revised)

The division of share option gain may consider the different time division from apportionment that was adopted for other income because this time division is not based on the day-in-day-out during the year of exercise but based on the day-in-day-out in the vesting period.

Vesting period wants to be divided between periods covered by two employments if, employment is changed by the taxpayer from Hong Kong employment to non-Hong Kong employment during a vesting period in a year assessment. The decision that whether the divided portion of vesting period for Hong Kong employment would be fully taxable or full exempted to tax would strictly depend upon whether during relevant portion of vesting period taxpayer has provided any services or not. The reference for this statement has been taken from DIPN 38 (revised).

In order to understand impact on taxable income of employee under such apportionment let’s have an example.

Miss White was employed by a corporation having setup offshore company in Hong KongFor two years (730 days), from 1 January 2012 to 31 December 2011 she was allocated to work in Hong Kong. She provided the services in Hong Kong for a total of 300 days during a vesting period as follow:

1 January 2010 to 31 March 2010 = 80 days

1 April 2010 to 31 March 2011 = 120 days

1 April 2011 to 31 December 2011 = 100 days

Total days = (80 + 120 + 100) = 300 days

The right was exercised by Miss White in May 2012. The year of exercise of right is same as year of assessment. So as a result of exercising the right, gain that would be assessable in assessment year 2012 to 13 is 41.09 % (i.e. 300/730).  The total chargeable portion of gain would be 34.24 % (i.e. 250/730).

It was observed in D 4/02 that, in order to subscribe for shares in 1992 to 93 and 1993 to 94 the options were granted to the taxpayer. Salaries tax was computed in full to his income. He was transferred from Hong Kong to London office of offshore company incorporation with effect from 7 April 1997. The options were exercised by that taxpayer on 3 April 1997. When services of taxpayer were subjected to tax it was his stance that, as he provided no services outside Hong Kong during 1997 to 98 so his share option benefit was not chargeable to tax.

As a counter argument the question that was asked by board from taxpayer under Section 9 (1) (d) was that, when the right to acquire the share option was obtain by a person the he/she was holder of an office in or an employee of that or some other company incorporation HK. So these questions that, what was the place where services were provided in the year of exercise of option and whether the taxpayer in the year of exercise of option has provided services were relevant. In the year of exercise of option in 1997 to 98, the income obtained from any services provided by appellant outside Hong Kong has nothing to do with option gain. Taxpayer is not assisted by any rule of Hong Kong tax law under Section 8 (1A) (b) (ii). So on the option gain the taxpayer was fully chargeable in that case.

In D 32/04, a taxpayer of Hong Kong was working with an offshore company C. There was another company B that was successor of company C. On 1 July 1996, started a new Hong Kong employment with that company B. An option was granted by company C on 27 September 1995 in which that taxpayer was allowed to obtain 200,000 shares in company B. The option from date of offering, would grant rate ably over a period of five years. A change in control of company was occurred in March 1997 and as a result the employment of taxpayer was terminated by company with effect from 31 August 1997. Under the option agreement between company incorporation HK and employee, the option granted fully upon termination of the employment and also it only be exercisable within one year of termination of employment. As employment of taxpayer was terminated by company C on 30 July 2017 so it was held by board of revenue that 20 % of option gain was assessable to his employment with company C. This was due to the reason that option was granted equally over five years. As the employment was offshore so this 20 % of gain was subjected to time division. And this was on the bases of following:

These number of days are calculated from date with effect to 27 September 1995 to 30 June 1996.  Among this 20 % option gain, the 8 % of option gain was assessable due to the employment of taxpayer with company B. while rest of 80 % was fully taxable due the reason that, employment was a Hong Kong employment.

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