EQUITY-BASED COMPENSATION IN PRC

A Look at Companies Listed on Shanghai and Shenzhen Stock Exchange

The employee share purchase plans (“ESPPs”) adopted by several city commercial banks stirred much controversy on equity incentive plan design after two city commercial banks went public on China domestic stock market in the second half of 2007. The discussion was ignited by the huge wealth accumulation discrepancy between executives and lower level employees after the banks were listed. It is expected that new regulations on equity incentive plans in city commercial banks will be released later this year.

After almost half year of silence due to the self-inspection requirement imposed by the China Securities Regulatory Commission (“CSRC”) as discussed in the last section of this issue of China Watch, there has been a surge of announcing equity incentive plans since 20 December 2007. We identified 13 new plans in the company announcements published in the three-week period starting from 20 December. All except one plan are performance option plans, which might reflect the authorities’ preference of option plans as we will discuss later on with regard to the tax regulations.

Moreover, three out of the four plans which require approval from the State-owned Assets Supervision and Administration Commission (“SASAC”) limit participants’ realizable gain from exercising options at 50% of participants’ respective individual total compensation. This practice is clearly influenced by the draft notice SASAC issued for comments in October 2007 which we will also further discuss below in this issue of China Watch. However, no such requirement is found in plans that do not require SASAC approval.

Number of Equity Incentive Plans

We continued our efforts of tracking equity incentive plans adopted by companies listed in China since last issue of China Watch ( English / 中文版 ). Our research covers the Shenzhen Stock Exchange (“SZSE”) in addition to the SSE (“Shanghai Stock Exchange”). We analyzed company announcements published up till 31 December 2007 in both stock exchanges and identified approximately 160 companies as having equity incentive related announcements.

Plan Vehicles and Source of Shares

SSE Listed Companies

The majority plans use options with performance conditions attached to grant or vesting. No vanilla option plan is found in the study, which implies a clear emphasis on the linkage between pay and performance. For the plans utilizing full value shares, most of them have a purchase mechanism built in.

SZSE Listed Companies

Issuing new shares to participants (“private placement”) is the most common source of shares. Shares reserved from the share trading reform come in second place in terms of the share sources. There are also a few companies which purchase shares from the market or use parent / subsidiary companies’ equity to grant to plan participants.

Performance Metrics

In both SSE and SZSE, most of the performance plans use 2 performance metrics as vesting conditions. Similar to the performance conditions that are used by SASAC to evaluate state-owned enterprises’ executives, net profit and return on equity are most commonly used among the plans which have performance conditions attached.

DATABASE OF DIRECTORS’ REMUNERATION REPORT 2007/08

Watson Wyatt’s latest Directors’ Remuneration Report was published in early September 2007. This year we have extended our analysis to over 3,500 directors and 500 senior managers in more than 260 companies across 11 major industries and 8 main board indices in Hong Kong and China. We also included A/H-Share dual listing companies and Hong Kong Growth Enterprise Market companies in addition to Hong Kong Main Board companies.

From our analysis, CEO compensation for Red-Chip companies has been increased over the last year at a rate of 11%.

Directors of Boards are typically remunerated through fees. China Red-Chip companies pay the highest fees to directors.

2007 REGULATORY UPDATE

Foreign Exchange

ANNUAL INDIVIDUAL FOREIGN EXCHANGE QUOTA INCREASED AND PROCEDURAL RULE FOR PARTICIPATING EQUITY PLANS IN FOREIGN COMPANIES ISSUED

On 5 January, 2007, the State Administration of Foreign Exchange (“SAFE”) issued Hui Fa [2007] No. 1 which increased the quota of individual annual foreign exchange purchase to the equivalent of USD50,000. The detailed rules also addressed some of the practical issues related to Chinese nationals participating in ESPPs or option plans in foreign companies. According to the circular, local participants of such plans should file applications through their employer or domestic agent to seek approval from the SAFE. A special foreign exchange account should also be set up to facilitate the remittance of local participants’ foreign currency income from the plans.

In addition, the SAFE further issued an internal circular - Hui Zong Fa [2007] No. 78 in April to clarify some of the procedural aspects of Hui Fa [2007] No. 1. Individuals are prohibited from paying the option exercise price straight from overseas accounts and must use a domestic account for such purpose. The initial foreign exchange quota and application for opening the special account for ESPPs needs to be filed with the central SAFE through a local SAFE while the subsequent annual quota will be approved by the local SAFE directly.

Individual Income Tax (“IIT”)

NET ASSETS PER SHARE CAN BE USED AS BENCHMARK PRICE FOR UNLISTED COMPANIES

On 9 October 2007, the State Administration of Taxation (“SAT”) formally replied Zhejiang Local Tax Bureau’s inquiry on IIT derived from Alibaba’s employees receiving share options of an unlisted company. In Guo Shui Han [2007] No. 1030, the SAT clarifies that Cai Shui [2005] No. 35 does not apply to such situation since it deals with stock options of listed companies only. Nevertheless, Guo Shui Han [2007] No. 1030 allows the gains from exercising options of an unlisted company to be taxed in the same way as “annual bonus” (i.e. spread into 12 months), which is similar to the rationale behind Cai Shui [2005] No. 35 and Guo Shui Han [2006] No. 902.

The real difference that sets Guo Shui Han [2007] No. 1030 apart from the other two taxation regulations lies in the method of calculating the gains from exercising options of an unlisted company. Since there is no readily available share price upon exercise to use, the reply of the SAT allows companies to use audited net assets per share as the benchmark if no actual transaction price or comparable price exists.

Looking at all three tax-related regulations (Cai Shui [2005] No. 35, Guo Shui Han [2006] No. 902, and Guo Shui Han [2007] No. 1030) as a whole, it is worth noting that these regulations deal with share options only. Such focus might reflect a preference of share option plans over other plans. Although it is mentioned in several previous regulations that vehicles other than options shall be studied and explored as well, the exclusive reference for share options in tax regulations may result in an unintended bias towards option plans rather than full-value share plans, as companies want to avoid regulatory uncertainties when considering plan design.

Other Regulatory Remarks

LISTED COMPANIES TO COMPLETE SELF INSPECTION BEFORE IMPLEMENTING EQUITY INCENTIVE PLANS

On 29 March 2007, the CSRC issued Zheng Jian Gong Si Zi [2007] No. 28, which requires listed companies to conduct self inspection, ask for public comments, and improve corporate governance by October. The notice specifically linked the completion of such campaign to the implementation of equity incentive plans - companies cannot implement or obtain approval for their equity incentive plans unless they finish the campaign first. In this regard, only a few equity incentive plans were announced in the second half of 2007 prior to 20 December, which is clearly a reflection of the impact of such campaign.

25% ANNUAL SHARE TRANSFER LIMIT CLARIFIED

In the previous issue of this news update, we discussed the 25% annual share transfer limit mentioned in the Company Law and Zheng Jian Gong Si Zi [2006] No. 38. On 5 April 2007, the CSRC further clarified in Zheng Jian Gong Si Zi [2007] No. 56 that such limit should be calculated based on each individual’s share holdings at the end of the previous year.

POTENTIAL NEW APPROVAL PROCEDURE TO EQUITY INCENTIVE PLANS

The new Labor Contract Law was announced on 29 June 2007 and has come into effect on 1 January 2008. This may bring another complication to the process of implementing equity incentive plans as the law requires that significant matters in direct relation to remuneration shall be discussed at the workers' congress or by all the workers. Moreover, equity incentive plans, if deemed as collective contracts with the employer in terms of remuneration, shall be presented to the workers' congress or all the workers for discussion and approval, which effectively adds another approval procedure before the equity incentive plan can be implemented.

CAP ON REALIZABLE GAIN FROM EQUITY INCENTIVE PLANS SUGGESTED

In October 2007, the SASAC issued a draft notice on the implementation of equity incentive plans for comments. The draft notice explicitly suggests attaching certain types of performance metrics to both the grant and the vesting of the equity in addition to specifying the performance level. It mandates a cap in the amount of 50% of total compensation on the realizable gain that executives may have from participating equity incentive plans. Although the notice is still in its draft stage, as mentioned earlier, its influence can already been seen from the equity incentive plans announced around 2007 year end.