Hogan Lovells' Steve Robinson and Kurt Tiam explain the new rules for employee share plans in China

The granting of employee stock options and shares as a form of remuneration is an increasing trend in the People's Republic of China (PRC). This comes as no surprise, considering retention of talented employees is critical for any corporation to expand in the Chinese market – a market most companies can ill afford to ignore. With the influx and expansion of foreign multinational corporations, the demand for high-level management employees, in particular, is greater than ever.

Given that no foreign multinationals are allowed to list their shares yet in China, the ability of such companies to grant rights to their foreign-listed shares to employees in China as part of their employee share and option plans (ESPs) is important to their human resource and recruitment strategy.

sharesDespite the commercial needs, however, legal restrictions and uncertainties have until now limited the rolling out of ESPs in China. Recent legislative changes in China may, however, change this situation.

On 20 February 2012, the State Administration of Foreign Exchange (SAFE) issued the Circular on the Foreign Exchange Administration of Domestic Individuals Participating in Foreign Listed Companies' Employee Share Incentive Plans [2012] No. 7 (Circular 7), which took effect on the same day. Circular 7 replaces the Circular on the Foreign Exchange Administration of the Participation of Domestic Individuals in Foreign Listed Companies' Employee Share Ownership Plans and Share Option Plans [2007] No. 78 (Circular 78).

A number of key changes have been introduced by Circular 7 which expand the scope of application. Representative offices and partnerships are now considered 'domestic companies' and so employees of these entities are now able to participate in ESPs. There is also an express reference to shareholding control and actual control under Circular 7, possibly allowing employees of indirect subsidiaries or affiliates to participate as well. Another key change is that under Circular 7, phantom shares and share appreciation rights are specifically included as 'types of plans' in the registration form appended to Circular 7.

Thus, Circular 7 may require plans that mirror the economic benefits of ESPs to be registered, even though no shares or options are actually issued to the participants. Under Circular 78, there was no express reference to phantom shares, which led some to conclude that phantom share plans did not fall within the scope of Circular 78. Furthermore, Circular 7 now expressly defines 'domestic individuals' as participants who are PRC, Hong Kong, Taiwan and Macau nationals. Other foreign nationals who have resided within China for one full year on a continuous basis are also now covered, although there is an exception for foreign diplomats and representatives of international organisations in China.

Circular 7 has reduced and simplified the requirements regarding the role of intermediaries and agencies compared to Circular 78. A domestic agent and foreign management entity must be engaged, but it is no longer a requirement to appoint a foreign custody bank. Circular 7 has also reduced the documents that must be submitted to the local SAFE authority for approval. There is no longer any requirement to provide agreements entered into with the various agents and intermediaries, board resolutions and documentation regarding internal control systems on risk control and information disclosure of the domestic agent. Under Circular 7, however, SAFE requires that all submitted documents be notarised and legalised, which was not previously required under Circular 78.

Under both Circulars 7 and 78, there is a requirement that a special purpose domestic foreign exchange account (special purpose account) be opened with a bank by the domestic agent. Remittance and conversion of proceeds and payments are mainly done through the special purpose account. Furthermore, the reporting requirements are slightly more onerous under Circular 7 than they were under Circular 78.

Under Circular 7, the relevant bank engaged by the domestic agent for the opening of the special purpose account is required to submit two forms to the local SAFE authority within three business days of the end of each month reporting on the operation of the special purpose account.

A key question is whether existing ESPs registered under Circular 78 need to be registered again under Circular 7. Unfortunately, Circular 7 does not address this issue, so we suggest consulting with the local SAFE authorities where the registration has been made to determine if indeed another application needs to be made under Circular 7. Presumably, the process will be more straightforward, since the authorities will already be aware of the applicant's circumstances.

A common problem faced by many of the applicants under Circular 78 was that a lot of time and resources were spent explaining to the authorities the terms of the ESPs. It is important to bear in mind that because the local SAFE authority is the main approval authority, interpretation of Circular 7 may differ from jurisdiction to jurisdiction. Due to these uncertainties, until there are clear and specific guidelines and a uniform approach is promulgated by SAFE, it is still too early to determine whether Circular 7 will open a new chapter for implementation of ESPs in China.

Nonetheless, it is clear that Circular 7 has significantly expanded the types of plans that are subject to SAFE's oversight. This is welcome news, since it will allow more foreign multinationals to implement their global ESPs in China, where they face a challenging hiring environment.

Despite the uncertainties and cumbersome requirements that still remain under Circular 7, foreign multinationals should certainly consider whether to apply for registration to implement their ESPs in China.

Steve Robinson (pictured) is a partner and Kurt Tiam a senior associate at Hogan Lovells.