Employee Stock Ownership Plan (ESOP): How does it function?

Employee Stock Ownership Plans (ESOPs) are programs offered by companies that enable employees to invest a particular number of shares or their portion of the company.

This is a good way for both business and employee because this establishes a long-term development and investment for both sides.

This article takes the reader through the concept of ESOPs in Hong Kong, the tax implications of an ESOP, and how to set up an ESOP in a business.

What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is a program initiated by either listed or private companies in which their workers purchase share stocks at a fixed price. This price is known as the exercise price.

The employee can decide to exercise the option, and the period of validity is usually many years following the grant date. This will be based on the employee’s desire and not something imposed on them.

Why use an ESOP?

For employees, it is an unmatched capital gain difference when the company’s future valuation is higher than the exercise price of the stock. This motivates workers to work much harder and make sure that the company triumphs.

The company regards ESOPs as an effective instrument of remuneration and retention of key employees because of the right of equity ownership.

These can be especially beneficial for start-ups or early-stage companies that are financially constrained among other limitations, as ESOPS can be used as a medium to incentivize the key performers and talent without implementing other monetary remuneration methods.

ESOPs as a mechanism to establish ownership and loyalty of the employees in the organization can as a result lead to increased productivity and a stronger and more successful company.

How does ESOP function in Hong Kong?

Companies may decide to implement the employee stock ownership plan (ESOP) as a way to compensate employees according to how long they work in the company or their performance at work, going beyond existing employee contract benefits. This is especially helpful in fields with high demand for quality human resources.

It’s worth noting that ESOPs are not limited to employees only and can also be granted to:

• Directors
• Officers
• Consultants

An ESOP presents a close parallel to taking the case of the sale of a company’s security, an activity that comes within the sphere of regulation under the Companies (Winding up and Miscellaneous) Ordinance (Cap.32).

Nonetheless, the ESOPs are subject to an exemption and regulation does not prescript or restrict these issues given they are made to the 4 categories of beneficiaries (employees, directors, officers, and/or consultants).

Hong Kong ESOP tax system

One of the biggest benefits of ESOP is that if you are in Hong Kong there is no tax imposed on the award of a stock option plan.

While an employee does so, the company is also required to prepare a tax form and submit the relevant details to IRD.

The taxable amount usually will be the market value of the shares at the date of exercising the option, then the grant of the options, less the considerations that are given for the shares (e.g. the option exercising price). It will be deemed income and will be taxed in the year in which options are exercised.

If the employment is not a Hong Kong-sourced employment or if the employment changes from Hong Kong to non-Hong Kong-sourced employment or vice versa during the vesting period, it is quite complicated to calculate the taxable income.

While salary tax will only be paid once the employee exercises the option, it is also worth mentioning that employees who stay outside of Hong Kong and who choose to exercise their ESOP option may also face salary tax in their home country (after which relief will then become applicable through the appropriate double taxation treaty).

Consequently, the ESOP does not form part of the exemptions that may arise in Mandatory Provident Fund (MPF) taxation.

How do I establish an ESOP for my business?

The procedure of establishing an ESOP in Hong Kong is simple and it is a cheap process.

The ESOP adoption should happen at the shareholder level when the shareholders meet for the annual general meeting(AGM), and the company will be required to issue an ‘Option Certificate’ when the ESOP plan is being adopted. This certificate is the one that needs to set the rules and regulations for the ESOP, including the vesting period, the number of shares granted, the selling price of the shares, and other similar information.

In this context, the company can also append an explanatory note containing the details needed for the employee to be able to exercise the options.

When an employee exercises the option the total share capital of the company is increased and new shares are given to the new owners. It is critical to log in all the transactions and also stay in line with regulatory filings such as with the Companies Registry.

The periods for the vesting of ESOPs can be divided into several vesting option periods and a 1-year cliff that restrains the exercising of that option is a common practice. The purpose of this is to provide a period to both the company and the employee-owners so that they know if they want to proceed longer with the relationship.

For example, the ESOP designed as the shares can be exercised are not entitled in the first year, and the employee is entitled to 50% of the shares in the second year, and the employee can exercise the option in the third year which is the remaining 50%.

The ‘exercise option’ may be operated with additional restrictions on performances, conditions, and/or targets. ESOPs are generally formed in the first or second round of investment where the investors tend to expect a high level of commitment with appropriate resources for the executive team.

The size of the option pool varies with each situation, and it is normally between 8% to 20%.

How can FastLane help you?

An ESOP can be a great tool for companies wanting to reward and retain their key employees as well as for employees who have an opportunity to claim part of the company’s success. While it does not seem that establishing an ESOP in Hong Kong is a complicated and relatively expensive process, it does require strict observance of all legislative requirements to avoid violations.

FastLane Group offers financial services like taxation, accounting, and audit services to help walk you through the process. If you want to get more knowledge about ESOPs or have some tax questions, contact us and all of the tax experts on our team are there for you.