- What are Stock Options?
- How Stock Option Plans Work
- Kinds of Stock Options
- Tax treatment of stock options (tax levied on the individual acquiring stocks)
- Accounting treatment of stock options (for the issuing company)
Stock options have gained attention in Japan recently as a means to motivate employees, as they are expected to generate capital gains linked to the company’s performance. In this article, we will take a look at the outline, structure, types, accounting and tax treatment of stock options.
A type of stock acquisition right; a stock option is a right to acquire shares of a company at a predetermined price (grant price) within a certain period of time (exercising period).
The reason why stock option plans are considered to be incentive schemes (compensation) for employees is that by acquiring shares at a predetermined (grant) price and selling the shares when the stock price rises, the difference between the grant price and the stock price at the time of sale would be considered a capital gain. Therefore, it is often used by companies preparing for an IPO with a large potential for future growth in earnings, as well as companies that can increase their business performance in the future.
We mentioned above why stock option plans are considered to be incentive plans for employees. Here, we will provide some simple values to give you an idea of how stock options work.
Suppose a company with a current stock price of 1,000 yen grants stock options to its directors and employees that allow them to purchase up to 1,000 shares of the company’s stock at 1,000 yen per share at any time for the next five years. After that, thanks to the hard work of the directors and employees, the company’s performance improves, and the stock price rises to 2,000 yen three years later.
By exercising their rights, directors and employees who are granted stock options can purchase up to 1,000 shares of the company’s stock for 1,000 yen, regardless of the stock price at the time. Therefore, stocks currently worth 2,000,000 yen (= @ 2,000 yen x 1,000 shares) at market price can be purchased for 1,000,000 yen (= @ 1,000 yen x 1,000 shares), and when these stocks are sold, the seller can realize a capital gain of 1,000,000 yen.
As you can see here, stock options are not beneficial if the shareholder cannot freely sell the shares when they want to, because the shareholder will not be able to earn capital gains. That is why stock option plans are used by venture companies aiming for IPO in the future or companies that are already listed.
The tax treatment of stock options depends on the type of stock option, so before we discuss tax treatments, we will first introduce what types there are.
Stock options can be classified into to types, depending on whether they have been issued with or without compensation: “paid stock options” (with compensation) and “free stock options” (without compensation).
Free stock options can be further divided into “tax-qualified stock options”, which are those that meet certain tax qualification requirements, and “tax-exempt stock options”, which are stock options that don’t meet those requirements. Tax-qualified requirements are eligible for tax benefits.
The main tax-qualification requirements are as follows:
(Primary) Tax Eligibility Requirements
|Eligible Target||① Directors, executive officers and employees of the issuing company and its subsidiaries, and their inheritors.
② Major shareholders and their dependents and other specially related partners are not eligible. Major shareholders are defined as shareholders holding more than 1/10th of the outstanding shares in the case of listed companies, and shareholders that holding more that 1/3rd of the outstanding shares in the case of unlisted companies.
|Exercise Price||① Amount must at least be equivalent to the price per share at the time of issuance.
② Annual exercise amounts us less than 12 million yen.
|Exercise Period||Any 8 year period from 2 o 10 years after the granting of shares.|
|Transfer of Exercise Right||Not possible. Exercise rights must be exercised by the grantor.|
The taxation on stock option acquirers depends on the type of stock option, as described above. The following table summarizes the “when” and “what” types of taxes are levied for each type of stock option.
Taxes on Stock Options (SO)
|Type of SO||Tax|
|When SO rights are exercised||Upon sale of shares|
|Paid SO||None||Capital gains tax|
|Free Sos||Tax-qualified||None||Capital gains tax|
|Tax-exempt||Income amount, etc.||Capital gains tax|
As shown in the table above, the main difference is that tax is imposed upon the exercise of stock options only in the case of tax-exempt stock options. In other words, tax-exempt stock options are taxed twice: first, the “market value of the stock at the time of right exercise less the exercise price” is taxed as employment income, and then “sale price of the stock less market value of the stock at the time rights are exercised” is taxed as transfer income when the stock is sold.
When exercising stock options, you will be taxed at a rate of up to 45% (55% if you include the 10% inhabitant tax) if the amount is large enough. In addition, since the exercise of stock options only involves the purchase of shares and not the receipt of cash, it is necessary to prepare funds to pay the tax. Therefore, tax-exempt stock options have the highest tax burden among all stock options.
On the other hand, tax-qualified stock options are not taxed at the time of the exercise ― only at the time of sale of the stock, when the amount of stock sale price less exercise price is taxed as transfer income. This is advantageous not only because the taxation timing is one time, but also because the tax rate of the transfer income is approximately 20%, which is likely to be lower than that of tax-exempt stock options, which are subject to tax on pay upon exercise. As with tax-qualified stock options, paid stock options are taxed only as income from the transfer of assets when shares are sold.
Next, let us see how the accounting treatment of stock options for the side of the company that has issued the shares in chronological order based on simplified assumptions.
Recording Stock Options
① Number of stock options: 10
② Issued shares per stock option: 1 share
③ Estimated value at the time of granting of stock option: 1,000 JPY
④ Exercise price of stock options (per share): 2,000 JPY
[Upon granting of stock options]
|(Share-based compensation expense)||10,000||*1||(Stock acquisition right)||10,000|
(*1) ③ 10 stock options = 10,000 JPY
[Upon exercising of rights (use 7 stock options)]
|(Stock acquisition right)||7,000||*2||(Capital)||21,000|
(*2) ③ 1,000 JPY x 7 stock options = 7,000 JPY
(*3) ④ 2,000 JPY x 7 stock options x ① 1 share = 14,000 JPY
[Upon expiry of the exercise period (remaining 3 stock options expire)]
|(Stock acquisition right)||3,000||*4||(Gain on reversal of stock acquisition right)||3,000|
(*4) ③ 1,000 JPY x 3 share options = 3,000 JPY
The key points in accounting for stock options are the amount and timing of the recording of the “share-based compensation expense” and the fact that it is booked against a net asset account called “stock acquisition rights”.
When stock options are granted, the fair value of the stock options is recorded as “share-based compensation expense” over the applicable service period (which refers to the period during which the rights cannot be exercised). In the above example, the total fair value of the stock options is recorded as an expense at a point in time, using one accounting period as the target service period. It should also be noted that, in practice, the calculation should exclude employees who are scheduled to retire.
In this article, we took a look at stock options, which are becoming more popular in Japan, from their overview, to tax and accounting treatment. Stock options have many advantages, such as increasing employee motivation, attracting individuals with a larger skillset, and raising a variety of funds. However, depending on the company’s performance after introducing a stock option scheme, the benefits may not be utilized. Therefore, when considering the introduction of such a scheme, it is necessary to take into account not only the short-term financial benefits, but also the company’s strategy and business prospects from a long-term perspective.
Among the many different types and conditions of stock options, in this article we focused on the basic tax and accounting aspects. We hope that this article has helped you understand the tax and accounting treatment of stock options.