Tax reform crucial for promoting innovation

Stock-based incentives should be encouraged to attract talent for startups and high-end firms

More preferential tax treatments should be granted to 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 staff retention in the long run. In particular, stock options and restricted shares can be used 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. 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 lifted. 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?

It does not have to be this way. The tax arrangement in the United States provides another option. For instance, the US tax benefit for stock options is that on exercising the option the individual does not have to pay ordinary income tax. Instead, if the shares are held for one year from the date of exercise and two years from the date of grant, then the profit made on the sale of the shares is taxed as long-term capital gains. Long-term capital gains are taxed in the United States at lower rates than ordinary income.

Last year, the long-term capital gains recognized were taxed at a maximum 15 percent or 0 percent if the individual was in the 10 percent or 15 percent income tax bracket. In comparison to ordinary income tax rates, which may be as high as 35 percent, it is the most favorable tax treatment.

With the increasing amount of Chinese companies rolling out equity incentive schemes for employees in the next decade, it is inevitable that this form of compensation will soon become the norm in all Chinese remuneration packages. High technology companies in China usually face more financial constraints. They need to enjoy tax advantages and access to more and better financing options. Thus, why not provide them with a better option: granting them more tax benefits in incentive stock schemes if their employees hold restricted shares or exercised stock options for a longer period?

Of course, to help Chinese companies achieve sustainable development, preferential tax treatment should also be offered to producers in the development of low carbon manufacturing as well as manufacturers that are accomplishing industry transformation and upgrading.

Therefore, further reform of China's tax system should be encouraged and implemented to provide a more effective solution for attaining domestic innovation and industrial upgrading. Policymakers should not be conservative in this.

The author is assistant professor in finance, Business School, University of Nottingham Ningbo China. The views do not necessarily reflect those of China Daily.

(China Daily Africa Weekly 04/25/2014 page18)