March 23 2005
The issue of how to deal with stock options from labour, tax and accounting perspectives has proved problematic. Is the stock option considered a wage? What is the nature of the profit where a stock option is exercised? How should stock options be dealt with for accounting purposes?
In 1997 the Ministry of Labour (now the Ministry of Health, Labour and Welfare) and the Labour Standards Inspection Office (LSIO) took the position that stock options and profits earned by exercising stock options are not wages as per the Labour Standards Laws. Since then, companies and employees dealing with stock options and profits have classified them as 'occasional' profit or loss. This approach benefited employees in particular, who could exercise stock options as occasional income and enjoy preferential tax rates.
The tax authorities appeared to accept the position of the Ministry of Labour and the LSIO. However, in about 2000, the tax authorities began treating profits from the exercise of stock options as wages, and retroactively imposed a tax as the difference between income tax for occasional income and income tax for wages.
Many individuals challenged the legality of the tax authority's actions and sued for judgment. Various disparate judgments were rendered by the district courts. Finally, on January 25 2005 the Supreme Court issued its first ruling on the matter.
A US parent company issued stock options to the representative director of a Japanese company under the US company's stock option plan. The Japanese company was a wholly owned subsidiary, and the stock option plan applied to certain officers and key employees of the US company's group. The director exercised his entitlement to the stock options and earned a profit equivalent to over Y350 million between 1996 and 1998. The director reported these profits as occasional income and paid income tax at the corresponding rate. However, in 2000 the tax authorities determined that such profit was actually wages and retroactively imposed the difference between the 'wage' and 'occasional' income taxes. The director challenged the validity of the tax authority's actions.
The Supreme Court found that profit from the exercise of stock options was to be regarded as a provision from the US company as consideration for non-independent work under an employment agreement or similar arrangement. The reasoning behind this was twofold. First, the director acquired profits from the US company because the entitlement to stock options was not transferable or assignable, and therefore he alone could exercise his entitlement; and he acquired shares for a cheaper price from the US company by exercising his stock options. Second, the director worked as a representative director of the Japanese company under the control of the US company because the Japanese company was the wholly owned subsidiary of the US company. Accordingly, the director was provided with the stock options as an incentive to work as an officer or key employee of the US company group.
The ruling is not directly contrary to the position of the Ministry of Health, Labour and Welfare and the LSIO, although it may arguably be at odds with this. The key difference is that the Supreme Court found that profit earned by exercising a stock option is regarded as wages from a tax perspective, and the substantive arguments of the judgment will apply to taxes. However, the ministry and the LSIO's stance is that such profits are not wages under the Labour Standards Law. This reasoning helps meet certain rules to bring the payments into conformity with the Labour Standards Laws. For example, the laws require the payment of wages in cash, so a different classification for profits from stock options makes more sense. Thus, the application to different bodies of law may be different.
Another questionable interpretation is with respect to applicable employees. In this case the stock options were provided to a representative director of the wholly owned Japanese subsidiary, who performed substantive work for the parent company controlling the Japanese company. Thus, it is unclear whether profits from stock options provided to regular employees of a Japanese subsidiary will be treated as wages. A key factor is that these employees would be working for the subsidiary only, even though their work may bring profit to the parent company.
The judgment is likely to impact on the manner in which companies structure their practices for stock options from a tax and accounting perspective.
From a labour law perspective, the LSIO has already announced that, although provision of stock options is not regarded as a provision of wages or salary, it is still considered part of the terms and conditions of employment. Therefore, companies desiring to provide stock options to all employees must provide for them in their respective work rules under the Labour Standards Law.
For further information on this topic please contact Yasuhiro Fujii at Tokyo Aoyama Aoki Law Office/Baker & McKenzie by telephone (+81 3 5157 2700) or by fax (+81 3 5157 2900) or by email (email@example.com).
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