Advanced Issues in Tax-Qualified Stock Options: Exercise Price, Tax Reform, Overseas Residents and M&A

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

As discussed in the basic guide, the formal requirements for tax-qualified stock options can be summarized in a list. In actual practice, however, what takes time is applying them to specific facts. Questions such as how far the exercise price can be lowered, which special rule can be used given the company's years since incorporation, how to handle options already issued when the tax rules change, what happens when a member living overseas joins, and how these rights should be handled when the company receives an M&A approach come up frequently in practice.

In this article, I explain, as an advanced guide, issues on which I have actually confirmed facts and given advice in real matters, abstracted with due regard to confidentiality. I have written separately about the specific issuance procedure itself in The Practice of Issuing Stock Options: From the Shareholders' Meeting Resolution to Registration and Statutory Reports.

The tax-related statements in this article are based on a review of the Act on Special Measures Concerning Taxation as of September 12, 2026, and the National Tax Agency's "Taxation of Stock Options (Q&A)" as revised in November 2024, among other sources. When actually issuing or exercising options, it is a prerequisite to confirm the rules in effect at that time with a tax accountant or other adviser.

Fair Value Rules for the Exercise Price and the Practice After the Circular Amendment

Among the tax-qualified requirements, the one directly tied to the economic terms is the exercise price. The exercise price per share must be at least the value per share at the time the grant agreement is concluded, in other words the fair value (Article 29-2, Paragraph 1, Item 3 of the Act on Special Measures Concerning Taxation). The lower the exercise price, the greater the benefit to the member who receives the grant, but if it falls below the fair value at the time of the agreement, the tax-qualified requirements will not be met. In practice, therefore, the focus is on how to calculate the fair value of unlisted shares.

Before July 2023, there were standards for calculating fair value under the Basic Circular on the Income Tax Act (23-35 Kyo-9) and other sources, but practical concerns remained about how special valuation methods should be applied to tax-qualified stock options. In particular, at companies that had raised money through preferred shares, even where there was room to value common shares lower than preferred shares carrying rights such as preferential dividends and liquidation preferences, companies were sometimes cautious about using the special valuation method. As a result, practice leaned toward conservative judgments, and exercise prices tended to be set at a higher level with the price of the most recent round in mind. This created a frustrating situation in which, the more successful a company's fundraising and the higher its valuation, the harder it became to offer an attractive exercise price.

What changed this situation significantly was the National Tax Agency's amendment in July 2023 of the circular relating to the Act on Special Measures Concerning Taxation (29-2-1), together with the explanation provided in the Q&A. It was made clear that, for shares with no quoted market price, a value calculated by the methods in the Basic Circular on Property Valuation (typically the net asset value method) can, subject to certain requirements, be treated as the "value per share at the time of the agreement" (a so-called safe harbor). In effect, among multiple valuation methods, an option was presented that can be used after confirming the conditions for its application. At the same time, for companies that have issued class shares, a method was shown for calculating the value of common shares taking into account rights such as preferential distributions. Because the number of shares to which the remaining amount after deducting the preferential distribution amount is allocated differs depending on whether the preferred shares are participating or non-participating, the same deduction or denominator cannot necessarily be used for all preferred shares.

The practical meaning of this circular amendment is clear. At a loss-making startup shortly after its founding, net assets are often smaller than the value of the business, and a path was established for further reducing the net asset value per common share by deducting the preferential distribution amount of the preferred shares. However, the result of the calculation varies depending on the state of the net assets, the timing of the most recent capital increase and the terms of the class shares, so it will not always produce a low value. This tax-qualified requirement is determined by whether the price is at least the fair value calculated by the method applied. The procedure under the Companies Act for determining the exercise price is also separately required.

In actual matters, a well-established flow is for a tax accountant to perform the calculation in line with the circular and for the exercise price to be determined on the basis of that valuation report. The role of the legal side is to confirm that the exercise price stated in the terms of issuance matches that in the allotment agreement, that it is at least the fair value at the time of the agreement calculated by the applicable valuation method, and that there is no gap between the valuation reference date and the date on which the allotment agreement is concluded. In addition, because the basis for "why that exercise price was chosen" will be questioned in due diligence for future M&A or investment, properly keeping the tax accountant's valuation report and the internal deliberation materials from the time will help later on.

Determining the Exercise Period and Annual Limit Based on Years Since Incorporation

The general rule for the exercise period is "from the day on which two years have elapsed after the date of the grant resolution until the day on which ten years have elapsed." As a special rule, an unlisted company that was less than five years from incorporation on the date of the grant resolution can extend this to a maximum of 15 years (FY2023 tax reform). The reference date for determining the number of years since incorporation is the date of the grant resolution, and the treatment of this specific date is set out in the circular on the Act on Special Measures Concerning Taxation. The starting point is to count accurately from the date of incorporation in the commercial register, rather than mechanically fixing the date to the allotment date or the date of the shareholders' meeting. In actual matters, too, there have been cases where, after confirming the number of years since incorporation, the company avoided the 15-year special rule and redesigned the clause with a 10-year period.

The annual limit on the aggregate exercise price is likewise divided into categories according to the number of years since incorporation. The general statutory limit is JPY 12 million per year. Under the 2024 reform, the structure became as follows: for a company less than five years from incorporation on the date of the grant resolution, the determination is made by dividing the exercise price by two (effectively a JPY 24 million limit), and for a company at least five but less than 20 years from incorporation that is unlisted or less than five years from listing, the determination is made by dividing by three (effectively a JPY 36 million limit). Where stock options granted at different times are mixed, the determination is made by aggregating the amounts converted according to each category.

This limit is determined by the "aggregate exercise price" paid in at the time of exercise. It is not a mechanism under which the limit changes depending on the share price at the time of exercise. This limit also applies to exercises before listing. The key point to note is that the entire acquisition of shares through the exercise that causes the limit to be exceeded falls outside the scope of tax qualification, and taxation is not limited to the portion exceeding the limit. If, at the stage of deciding the exercise price and the number of options granted, you estimate whether the annual limit would be exceeded if the grantee later exercised all at once, you can prevent confusion down the line.

This limit rule needs to be stated expressly in the allotment agreement. In actual allotment agreements, clauses are included setting out the method for calculating the coefficient, such as "in calculating the annual aggregate amount, the exercise price shall be divided by two," and stating that exercises exceeding JPY 12 million per year cannot be made (the law is not understood to mandate that single phrase in fixed form). Grantees sometimes ask about the purpose of the limit, and explaining that the statement is prescribed by law as a tax-qualified requirement can ease unnecessary concerns.

The Scope of Eligible Grantees and Management Requirements After Tax Reform

As a rule, eligible grantees are directors, executive officers and employees of the granting company and of related corporations prescribed by law. However, when you review an actual list of grant candidates, cases arise in which eligibility is unclear.

Founders may be excluded depending on their shareholding ratio. This is because, at an unlisted company, major shareholders holding more than one-third of the issued shares and persons specially related to them are excluded from tax qualification. Not every founder is automatically excluded, but if a founder qualifies as a major shareholder, another method, such as paid stock options, will be considered.

The position of company auditor or accounting advisor alone does not bring a person within the scope of eligible grantees. Because their legal treatment differs from that of directors and employees, thorough checks should be made based on titles so that, after proceeding with a design of "granting to all officers at once," you do not discover that some are ineligible.

Outside collaborators such as independent contractors are excluded as a rule, but for certain outside highly skilled personnel covered by a plan certified under the Industrial Competitiveness Enhancement Act, there is a path to including them in tax qualification if the prescribed requirements are met. However, this involves several prerequisites, such as a requirement of continuous residence in Japan, and overseas residents in general cannot simply be included. It is important to take care not to casually issue options to outside advisers on the same terms as for internal personnel.

Managing options already issued and responding to tax reform are also practical challenges. Under the 2024 tax reform, as a method of managing shares acquired through exercise, in place of entrusting their custody to a securities company or similar institution, it became possible to choose an arrangement under which, for shares with transfer restrictions, the issuing company itself prepares a ledger for each holder and carries out segregated management as prescribed by law.

With this reform, a transitional measure was provided under which contracts for options issued before the reform could be amended by December 31, 2024, and companies had to conclude amendment agreements. The deadline for this transitional measure has already passed, and options that are currently non-qualified cannot now be freely converted into qualified ones. Even after issuance, stock options may require a review of options already issued in response to future tax reform. Keeping the register of holders and version control of the agreements in order on a day-to-day basis leads to a calm response to changes in the rules.

Dealing With Members Living Overseas and Designing Rights on Departure

Where the grantees include overseas residents, being an overseas resident alone does not necessarily mean immediately falling outside Japanese tax qualification. However, it involves individually checking the period of work in Japan, residency status for tax purposes, the application of tax treaties, and the tax and securities regulations in the relevant country. If you simply reuse documents designed for residents of Japan, there is a risk of violating local laws.

In actual matters, there have been cases where separate terms of issuance were prepared for residents of Japan and for overseas residents. In particular, where U.S. residents are included, there may be situations requiring consideration of compliance with tax valuation under Section 409A of the U.S. Internal Revenue Code (a 409A valuation), and the Japanese valuation method cannot necessarily be used as is. Identifying the grantees' places of residence at an early stage helps you determine early on where the design needs to branch.

The treatment on departure and vesting are conditions that the company designs by contract. They are decided separately from the tax-qualified requirements. In addition to the standard four-year vesting with a one-year cliff, in an actual matter there was a case that adopted reverse vesting under which, "rather than lapsing uniformly on departure, the number of exercisable options, based on the number vested as of departure, decreases monthly over 24 months after departure." This is an intermediate option that rewards contributions made while employed while preventing rights from remaining outside the company indefinitely (this is one design example from my own matters and is not an obligation prescribed by law).

Attention must also be paid to consistency between the allotment agreement and the terms of issuance. In some structures, the agreement contains wording that can be read as "exercisable even after departure," while the terms of issuance make continued service a condition of exercise and allow exercise only exceptionally with the company's approval. If the precedence or conditions between the two documents are unclear, disputes may arise over whether exercise after departure is permitted, so align the requirements for exceptional approval and the approving body (such as the board of directors or the shareholders' meeting, depending on the articles of incorporation and governance structure) without inconsistency in both documents. Because any adverse change after the grant requires confirming the contractual basis, the holder's consent, the necessary resolutions and the tax impact, it is important to envisage specific departure scenarios at the advance design stage. We handle the design of terms of issuance and allotment agreements that take the tax-qualified requirements into account under Startup Legal and Fundraising Support.

Handling Rights in M&A and Advance Preparation

Tax-qualified stock options require care in coordinating with an exit through a share transfer.

Having the buyer purchase the stock acquisition rights themselves falls outside a tax-qualified exercise, so the tax deferral from a tax-qualified exercise does not apply. The taxation of the transfer is confirmed by income category according to the substance of the transaction. To take advantage of the tax-qualified framework, the basic sequence is to exercise the rights, acquire shares and then transfer them, but there are constraints here too. Because tax-qualified options cannot be exercised until two years have elapsed after the date of the grant resolution, if an M&A deal materializes shortly after issuance, the options may not yet have reached the exercisable period. Some terms of issuance at unlisted companies provide that options cannot be exercised before listing, while permitting exercise only during the period from approval of the acquisition until immediately before it takes effect; whether such an exercise is tax-qualified depends on whether all the requirements are met, including the two-year requirement, the annual limit and the share management method. Simply lifting the pre-listing restriction does not automatically satisfy the tax-qualified requirements.

Note that, even while an M&A deal is in progress, room to change the conditions is not understood to be completely excluded. The National Tax Agency's Q&A examples (such as Question 10 of the Q&A) show an example in which an amendment to the agreement lifting the pre-listing exercise restriction in connection with an acquisition or similar transaction does not affect qualification. When making an amendment, confirm the holders' consent and the internal resolution procedures, and carefully determine whether qualification can be maintained.

In due diligence for M&A or investment, whether waivers of rights have been obtained from former employees and others is also checked. If you have the waivers on hand, they serve as material objectively supporting the state of the rights, but if they remain uncollected, they can lead the buyer to doubt "whether any rights as potential shareholders remain." While having a waiver does not necessarily mean that all defects are automatically eliminated, it is one of the important pieces of documentary evidence proving how the rights were handled. Designing the options from the issuance stage with an eye to the possibility that the exit may be an M&A deal and not only an IPO is a form of preparation for later. Our support for the selling side, including the handling of stock acquisition rights at exit, is described under M&A Support.