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Re-cap of 2006 Regulatory Changes
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Equity-Based Compensation
Significant changes took place in China’s regulatory landscape for equity-based compensation in 2006. Various authorities published long awaited policies and guidelines. After the guidelines on the share-trading reform were issued in the fall of 2005, numerous domestic companies announced equity-based incentive plans to “test the water”. On the very last day of 2005, the China Securities Regulatory Commission (“CSRC”) issued a circular promulgating the measures governing equity-based incentive plans for listed companies. Although the circular is for trial implementation only, it has become the major detailed policy on equity-based employee incentive plans in Mainland China.
In March 2006, the CSRC published Circular No. 38 (Zheng Jian Gong Si Zi [2006] No. 38) revising the Guidance for the Articles of a Listed Company. Directors, supervisors and senior managers are now allowed to sell a portion of their share holdings every year, although the amount is capped at 25%. Additionally they are prohibited from selling their holdings within six months from the date of termination of the employment.
Following the CSRC’s new measures, the State-owned Assets Supervision and Administration Commission (“SASAC”) announced two separate trial measures for foreign and domestically listed SOEs in January and September 2006. Despite of nuances among these two measures, the framework and most of the text are the same:
- Share options and restricted shares are both allowed;
- Participation in the plans is limited to specific position levels;
- Shares that can be used for incentive plans are capped at 10% of total shares outstanding; and
- Two-year lock-up period plus three-year vesting period.
These circulars and regulatory updates were much needed given that both State Owned Enterprises (“SOEs”) and companies of other types were anxiously searching for alternative compensation arrangements to retain and incentivise executives, senior management and key employees in the midst of fierce competition.
PRC Accounting Standards
The Ministry of Finance (“MoF”) issued on 15 February 2006 new accounting standards for Business Enterprises - Chinese Accounting Standards (“CAS”). The MoF has now brought Chinese accounting standards closer in-line with international practice. The revised standards will be first applied to listed companies starting from 1 January 2007 and then gradually to other types of entities. The revised standards for Chinese enterprises have now largely converged with International Financial Reporting Standards (“IFRS”).
In relation to executive compensation, the new accounting standards require that the fair value of equity-based awards be measured and expensed (Accounting Standard for Business Enterprises 11 [“ASBE 11”]). Similar requirements were already implemented in the western countries in 2005 and 2006. In the past under the old PRC GAAP, equity-based compensation did not have any impact on company accounting. ASBE 11 sets out methods for companies to measure and recognize share-based payment. Disclosure requirements are stated as well:
- Equity-based compensation is divided into equity-settled transactions and cash-settled transactions;
- An entity is required to recognize an equity-based payment when the services are received;
- An entity is required to recognize equity-based payment in its financial statements, using a fair value measurement and expensing such costs in the income statement.
ASBE 11 is similar to IFRS 2 “Share-based Payment”, except that the standard does not address:
- The different treatment for market and non-market conditions regarding equity-settled transactions;
- Modifications to the terms and conditions on which equity instruments are granted; and
- Share-based payment transactions with cash alternatives.
In December 2006, MoF revised the 1993 version of the General Finance Rules for Business Enterprises. Section 41 of the revised version allows companies to have different compensation treatments for management and key technical personnel whilst the previous version did not explicitly mention this. Section 37 of the revised General Finance Rules for Financial Enterprises (which was published in the same year) offered the same provisions. It goes further to state that with the approval of shareholders or the board of directors, a certain portion of the company’s budgeted salaries can be allocated to the employees who have made significant contribution in research of core technology, safety of operation and development of the market.
Taxation
In March 2005, MoF and the State Administration of Taxation (“SAT”) jointly issued Cai Shui [2005] No. 35 with regard to stock option plans. The circular defined various terms and concepts relating to stock options and set out the applicable methods for calculating the PRC Individual Income Tax ("IIT") payable on income related to stock option plans. In summary:
- IIT will be levied upon option exercise rather than on the day of grant;
- The difference between the exercise price and the fair market price (i.e. the closing price) on the day of exercise is deemed as taxable “salary income”;
- When calculating IIT, the income can be spread over a 12-month period;
- The dividend received and the gain from subsequent sale of shares should be considered for IIT with reference to the prevailing regulations.
On 30 September 2006, SAT issued a supplementary notice (Guo Shui Han [2006] No. 902) to further clarify the application of the aforesaid circular. The notice:
- Pointed out that if employees are granted publicly tradable options, the IIT liability occurs upon vesting instead of exercise;
- Modifed the previous individual income tax calculation formula for options in the scenario of multiple exercises within one year.
Up to the current date, the two circulars (Cai Shui [2005] No. 35 and Guo Shui Han [2006] No. 902) are the main PRC IIT regulations on equity based incentives.
Database of Directors’ Remuneration Report 2006/07
The Executive Compensation team at Watson Wyatt has been publishing a Directors’ Remuneration Report annually over the past few years. The report provides in-depth analysis of compensation arrangements among companies listed in Hong Kong. The 2006/2007 edition, published in September 2006, provides research findings on the executive compensation packages at 97 China Enterprises (Red Chips) and China-Affiliated Corporations (H-Share Companies) that are listed on the Hong Kong Stock Exchange.
CEO compensation for China Enterprises is low compared to that of the China-Affiliated Enterprises, primarily due to the fact that compensation in SOEs is highly supervised and managed. The gap may become narrower, however, given the flexibility allowed in the new MoF's rules in 2007.
Hong Kong listed companies with Mainland background are typically early adopters of equity-based incentive plans because they are closer to the international market place. Our study of the current constituents of Hang Seng China-Affiliated Corporations Index (HSCCI) indicates that almost all of the companies in the index adopted option plans (as shown in the first chart).
On the other hand, analysis on Hang Seng China Enterprises Index (HSCEI) constituents reveals that only one company (3%) adopted a stock option plan and almost 2/3 of the companies do not have any stock plan, which, is due to the fact that these companies are governed by PRC company and security law. Among the long-term incentives plans adopted, Share Appreciation Rights (or SARs) with settlement in cash are most common among China enterprises (H-Shares). Whilst SARs plans are in compliance with Chinese regulations, they have a downside. When SARs are settled in cash, variable expense is incurred and a liability has to be recognized at the same time in the company balance sheet.
Equity-based Compensation in PRC – A Look at Shanghai Stock Exchange
We also conducted research on the announcements made by the companies listed on the Shanghai Stock Exchange (“SSE”) from 1 June 2005 to 30 December 2006. We found that more than 30 companies promised to adopt equity-based incentive plans within 12 to 18 months upon completion of their share-trading reform. In addition, around 20 companies announced equity-based incentive plans but most of the plans are pending approval from relevant authorities and shareholders.
A close reading of these published plans suggests that a majority companies are adopting option plans with performance criteria attached to granting or vesting. Clear influence of the recent regulations can be observed as various terms in the plans are copied from the regulations. In most of the companies, the shares required will come from new issuance. It remains unclear whether companies are allowed to buy back shares or even purchase shares through a third-party trust for equity-based compensation.
A close reading of these published plans suggests that majority companies are adopting option plans with performance criteria attached to granting or vesting. Clear influence of the recent regulations can be observed as various terms in the plans are copied from the regulations. In most of the companies, the shares required will come from new issuance. It remains unclear whether companies are allowed to buy back shares or even purchase shares through a third-party trust for equity-based compensation.
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