Clearing barriers to incentive-based compensation in SOEs

04/08/2002

The reform of State-owned enterprises (SOEs) has come a long way in recent years. The modern corporate system is taking root, corporate governance is steadily improving and the way in which enterprises operate is changing -- albeit gradually -- for the better.

Nevertheless, many obstacles still lie on the path ahead, threatening to hinder the course of further advancement.

As Premier Zhu Rongji stressed in his report to the recent Fifth Session of the Ninth National People's Congress, continued efforts are needed to deepen enterprise reform. He specifically urged the government to clear the way for the use of stock option grants as an "incentive mechanism for enterprise managers."

In developed economies, stock option grants have become immensely popular, offering dynamic incentives to top managers and key employees. Among last year's Fortune Global 500, the majority of top companies had stock option plans.

Companies use stock option grants to attract and retain first-rate talents. Stock options serve as incentive-based compensation. A stock option is a contract that gives its holder the right (but not the obligation) to purchase company stock on or before a specified date, at a predetermined price. If the company grows and prospers, the market value of its stock will rise relatively to that predetermined price, creating value for the option holder.

In the United States, stock option grants have allowed companies to shift to more participative management structures, encouraging people to think and act like owners.

For many companies today, intellectual capital is an important asset. This capital, however, does not belong to companies -- it belongs to employees -- and unless anchored by strong incentives, it drifts elsewhere in search of a better return.

Brain drain is a major hindrance to enterprise reform in China. Highly qualified people who are relatively underpaid and have few opportunities for advancement in State-owned enterprises are easily lured away by more attractive offers from private firms.

Stock option grants are effective incentives, not only in enterprise management but in other areas as well, such as venture capital investment.

Last year's dramatic plunge in the NASDAQ, together with lesser declines in other world indices, led many people to believe that stock option grants would diminish in popularity. In fact, this has not been the case. Companies around the globe have preserved their grant systems with much success.

Although not widely used in China, stock option grants are not unfamiliar. Multinational firms have been promoting their use for many years. Recently, the government has been experimenting with them in Zhongguancun, the country's largest information technology industrial park, located in Beijing. In addition, in Guangzhou and Shenzhen, a group of medium and small-sized high-tech private enterprises introduced stock option grants two years ago, with encouraging results.

The widespread use of stock option grants in China, however, is problematic. China's Company Law and Income Tax Law impose significant barriers.

Exercising an option typically involves redeeming or newly issuing stock. Under the Company Law, stock may be redeemed only to reduce outstanding capital, and a corporation may not redeem its own stock. Issuing stock is equally problematic because it requires a lengthy and cumbersome process of governmental approval.

In addition, it is difficult for the directors, managers or supervisors of a listed company to realize a return on shares acquired by way of option grants. The Company Law prohibits them from transferring shares during their term in office.

The situation is quite different in other countries. In the United States, for example, the Securities Exchange Commission (SEC) in 1988 adopted Rule 701 under the Securities Act, which allows a listed company's affiliates and non-affiliates to more easily sell their stock according to certain requirements.

Taxation is anotherissue of concern. Other countries' tax codes facilitate the use of stock option grants as incentive-based compensation.

In the United States, for example, two types of options exist for taxation purposes. Incentive Stock Options (ISOs) are issued under formal plans qualified under Section 421 of the Internal Revenue Code (IRC). Their exercise price is deemed to be no less than their market value at the date when they were granted. This allows a company to avoid a taxable event upon granting the option. Upon exercise, the option spread is not treated as taxable income to an employee, nor is it deductible by the employer.

Incentive Stock Options, therefore, provide favorable tax treatment for incentive-based compensation and reduces its cost.

Non-qualified Options in the United States are taxed under rules generally applicable to the transfer of property in connection with the performance of services. Granting Non-qualified Options does not give rise to a taxable event, but exercising them has immediate tax consequences. The spread is taxed as ordinary income and is deductible by the company granting the options as an expense.

China's Law of Individual Income Tax, which has not seen a major revision since 1993, does not consider stock options. Related regulations stipulate that an employee who receives stock from an employer at a discounted price or by subsidy incurs a taxable event. The employee is taxed on the difference between the market value of the underlying shares and the discounted value at which they were granted. These regulations, of course, are too simplistic to be applied to the use of stock options grants as incentive-based compensation.