Trust-Type vs. Paid Stock Options: Taxation and Issuance Procedures

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

When the question "Should we choose trust-type or paid stock options?" comes up, the first thing to check is the axis of classification. The two are in fact classified along different axes. Trust-type refers to a "method of delivery" by which stock acquisition rights reach the holder, whereas paid refers to a "method of payment" under which payment is required at issuance. Some structures combine both, and others take entirely separate forms. When choosing a scheme, what matters is not how the name sounds but the substance: to whom, when, and on what terms economic benefits are granted; at which stage (grant, exercise or sale) tax is imposed; and what procedures the company must follow under the Companies Act, accounting rules and tax law.

Stock Option Choices and the Three Basic Forms

The stock option choices a startup considers come down to three basic forms: non-tax-qualified stock options (free type), tax-qualified stock options, and paid stock options. Trust-type is positioned as a delivery method used to place options into one of these basic forms. The main points of comparison are as follows.

Point of comparison	Non-tax-qualified free SO	Tax-qualified SO	Paid SO
Eligible grantees	No tax-qualification restriction on grantees. Income classification etc. to be checked by grantee type	Directors, executive officers, employees, etc. Excludes major shareholders etc.; certain outside highly skilled professionals are also eligible	No tax-qualification restriction on grantees. Contracts, securities regulations etc. to be checked separately
Determination of grantees	Determined through application and allotment, or a total-subscription procedure	Same as left. The grant resolution date for tax purposes is also checked	Same as left
Taxation at exercise	If consideration for services by officers/employees, salary income as a rule. Depends on income amount etc.	No tax (deferred until sale of shares)	No tax (if acquired at fair market value)
Taxation at sale	20.315% on capital gains from shares as a rule (Japanese residents)	20.315% on capital gains from shares as a rule (Japanese residents)	20.315% on capital gains from shares as a rule (Japanese residents)
Cash burden at acquisition	None	None	Yes (payment of an amount equal to the fair value of the stock acquisition rights)

Here I focus on cases where officers and employees who are Japanese residents acquire the options, following the National Tax Agency's Q&A on Taxation of Stock Options (revised November 2024) (Japanese). Individual income classification and the application of special provisions should be checked separately.

For non-tax-qualified free SOs with transfer restrictions, if they are consideration for services by officers or employees, they are as a rule taxed as salary income at the time of exercise (for grants to outside collaborators and the like, classification as business income or miscellaneous income is considered). Because salary taxation is imposed on the economic benefit at exercise, the progressive rates of aggregate taxation may apply. By contrast, for tax-qualified SOs, taxation at exercise is deferred, and the gain is taxed as capital gains when the shares are sold. For paid SOs, where the holder purchased them at fair market value, the gain at exercise is not taxed, and no tax arises until sale. At the time of sale, for Japanese residents, all three are as a rule subject to separate self-assessment taxation of 20.315% on the capital gains from shares. However, the amount deductible from the sale price differs by scheme. To calculate the capital gain, the market value at exercise is deducted for non-tax-qualified free SOs, the exercise price for tax-qualified SOs, and the total of the purchase price of the stock acquisition rights and the exercise price, etc. for paid SOs. What is taxed is the capital gain itself, i.e., the sale price less the prescribed amount.

For an overview of tax-qualified stock options and the details of the requirements, see What Are Tax-Qualified Stock Options? The Basics of Taxation and Requirements and Advanced Issues in Tax-Qualified Stock Options, which explain them with statutory provisions and specific figures. The annual limit on the exercise price is JPY 12 million as a rule, but the FY2024 tax reform added relief measures: for a company less than five years from incorporation on the grant resolution date, the exercise price is divided by 2 for the purpose of the test, and for a company five years or more but less than 20 years from incorporation that is unlisted or less than five years from listing, it is divided by 3. Eligible grantees are limited to directors, executive officers, employees, etc., excluding major shareholders and their relatives, but certain outside highly skilled professionals who have received certification may also be included.

Trust-type does not appear as a separate column in this comparison table because it is the name of a "delivery method": the issuing company first delivers stock acquisition rights to a trust, the trustee holds them, and they are later delivered to designated officers and employees. Whether a trust-type SO is tax-qualified or non-qualified depends on how the trust agreement is designed. In an ordinary direct grant, grantees are determined through individual applications and allotments or total-subscription agreements. It is not always necessary to determine everyone at the time the offering terms are resolved; there is room to grant to future hires by delegating to directors or by using a stock option pool. There are methods other than trust-type that give flexibility in grant timing. The advantage of trust-type is that the stock acquisition rights can remain in the trust and members who join later can be designated as beneficiaries. However, the tax treatment at exercise is determined separately from the form of the delivery method.

How Trust-Type SOs Work and Their Tax Treatment

The trust-type structure addressed in the example in Question 3 of the National Tax Agency Q&A has three stages: the issuing company or its representative director, etc. entrusts money to a trust company to form a corporate-taxed trust; the trust company uses that money to purchase the issuing company's transfer-restricted stock acquisition rights at fair market value; and during the trust period, officers and employees who have contributed to the company are designated as beneficiaries and receive the stock acquisition rights.

Question 3 of the National Tax Agency Q&A (November 2024 revised edition) sets out the tax treatment of the type of this structure that does not meet the tax-qualification requirements. When the trust is formed, corporate tax arises on the money; no economic benefit arises when the trust company purchases the stock acquisition rights at fair market value; and in that example, no tax consequence arises when officers and employees are designated as beneficiaries either. However, when officers and employees exercise the stock options and acquire shares, the economic benefit is taxed as salary income, and the issuing company must withhold and pay income tax. In the example, the share price at exercise of 800, less the acquisition cost of 50 carried over from the trust and the exercise price of 200, gives 550, which is treated as taxable salary income. If those shares are then sold for, say, 1,000, the sale price of 1,000 less the share price at exercise of 800 gives 200 as the capital gain, to which separate self-assessment taxation applies. Question 3 showed a judgment that places weight on the substance, namely that the issuing company is granting stock options to its officers and employees and that the officers and employees themselves bear no burden of money or the like, rather than on the outward form that the trustee acquired the stock acquisition rights for value. If there are cases in which trust-type SOs introduced in the past did not pay withholding income tax, the tax must be paid promptly, as Question 4 of the National Tax Agency Q&A indicates. Note also that if the issuing company chooses not to seek reimbursement, a gross-up calculation is required because the amount is treated as additional salary, etc.

That said, there are trust-type designs that are tax-qualified. Question 12 of the same Q&A shows a path by which even a trust-type option can be treated as a tax-qualified stock option if prescribed requirements are met. The premises are a provision in the trust agreement that the trustee cannot exercise the rights or transfer them to third parties at its own discretion, plus grants free of charge to directors and the like of the issuing company, and prohibition of transfer of both the stock acquisition rights and the beneficial interests. The exercise period must fall within the period from the day two years have passed after the beneficiary designation date until 10 years (15 years for a company less than five years from incorporation and unlisted, etc.), and management of the annual exercise price limit is also required. It is further required that the exercise price be no less than the amount equivalent to the per-share value at the time the agreement granting the trust beneficial interest is concluded, and that shares be placed in custody upon delivery or be managed in the prescribed manner by the issuing company itself (in the case of transfer-restricted shares). The difference from an ordinary tax-qualified SO is that the starting point of the exercise period is shifted from the "grant resolution date" to the "beneficiary designation date". The name trust-type does not directly determine the tax treatment; the conclusion depends on how far the trustee's discretion is restricted and whether the requirements based on the beneficiary designation date are built into the agreements. Merely putting contract documents in proper form does not necessarily establish qualification, so each company should individually determine whether its design falls under the non-qualified type in Question 3 or the qualified type in Question 12.

Fair Value Valuation and Issuance Procedures for Paid SOs

A paid SO is a stock acquisition right issued with a set payment amount. It is said that no tax arises at exercise here in the type where the officer or employee pays the fair market value with their own funds or the like, and that market value is calculated by an objective valuation method. Because officers and employees purchase the stock acquisition rights at market value, they are treated for tax purposes in the same way as an investment in shares, and the gain at exercise is not taxed (National Tax Agency Q&A Question 2). However, this treatment presupposes purchase at fair market value. In the example in Question 2 of the National Tax Agency Q&A, the share price at purchase of 200 and the fair market value of the stock acquisition right itself of 50 represent different values. This is a separate valuation from a transaction in which the share itself is discounted from 200 to 50. The capital gain at sale is calculated by deducting the purchase price of the stock acquisition right (50) and the exercise price (200), etc. from the sale price. If the design waives payment or, through a set-off structure, effectively has the company bear the consideration, the difference may be treated as an economic benefit subject to salary taxation. One cannot conclude that salary taxation at exercise is uniformly avoided simply because the form is "paid".

When issuing paid SOs, the first step is to calculate the fair value of the stock acquisition rights. Models widely used as reasonable pricing models for stock options, such as the Black-Scholes model and binomial models, are selected according to the conditions for exercise and forfeiture. For unlisted companies, there is an accounting treatment that uses intrinsic value (ASBJ Statement No. 8 (Japanese), paragraph 13), but this is merely a simplified method for the purpose of measuring accounting expense and must not be confused with the method for determining the payment amount of paid SOs or fair market value for tax purposes. A valuation that examines whether the payment amount is appropriate differs in both purpose and method from the share valuation that underlies the exercise price of tax-qualified SOs (such as methods following the Basic Circular on Property Valuation, which can be used in certain cases). Distinguish among the value of the shares, the value of the stock acquisition right itself, and the measurement of accounting expense, and confirm that the valuation materials suit each purpose.

On the accounting side, expenses may also be recognized for paid SOs. Under Practical Issues Task Force No. 36 (Japanese), for transactions covered by paragraph 2 of that report, such as paid stock acquisition rights without a market price that carry both service conditions and performance conditions, or performance conditions, they are treated as stock options under the stock option accounting standard unless it can be proven that they are not used as consideration for services received from employees and the like. Expense is calculated according to the required service period, etc., based on the fair value for accounting purposes less the payment amount. If there is no calculated difference, no expense may arise. However, because there are revisions in response to changes in the expected number of vested options and the like, even if the expense is zero at issuance, it does not follow that no expense will need to be recognized later. The report applies in principle on and after April 1, 2018, but there is also a transitional treatment that allows continuation of the previous accounting treatment for transactions granted before application. It is important to confirm the grant timing and the accounting policy the company has adopted.

As for the payment method, in addition to payment in money, there is a structure in which, with the company's consent, a claim for remuneration or the like is set off against the payment obligation (Article 246, Paragraph 2 of the Companies Act). This is a provision on payment upon issuance of stock acquisition rights and should be distinguished from the provision on payment of contributions upon exercise. In a design in which directors are given claims for remuneration as consideration for their duties and these are set off, confirm that the remuneration was determined through the procedure under the articles of incorporation or a shareholders' meeting resolution (Article 361 of the Companies Act, etc.). It is a mistake to think that using the label "paid" takes the arrangement outside the regulation of officer remuneration. Separate a transaction in which the holder purchases at market value with their own funds from one in which the company pays remuneration that is used for the purchase, and also understand the tax treatment of the remuneration itself and whether withholding is required.

The overall flow of the issuance procedure (determining the offering terms, allotment agreement, registration, register management) has much in common with tax-qualified SOs, and is explained step by step in Stock Option Issuance Procedures in Practice. Work specific to paid SOs includes preparing the fair value valuation report, keeping a record of the payment (or of the manifestation of intention to set off or the conclusion of a set-off agreement), and, where the design includes vesting conditions, building the recognition of accounting expense into the plan.

Flexibility in Grant Timing and Design Considerations

Tax-qualified SOs limit grantees to directors, executive officers and employees (excluding major shareholders and the like) of the issuing company and certain subsidiaries, and outside collaborators are not eligible as they are (except outside highly skilled professionals who have received statutory certification). Paid SOs, on the other hand, have no such restriction on grantees, so they can be granted to outside experts, advisers, service providers and others who do not meet the certification requirements. When designing incentives for advisers or service providers, this difference separates the practical options. The correspondence with the content of services and conflict-of-interest issues that should be considered when granting to service providers are covered in detail in The Place of Stock Options in Capital Policy.

A major motivation for choosing trust-type is that the timing of determining grantees can be pushed back. In a direct grant, allotment procedures and the like are carried out for each grantee, but delegation of the determination of offering terms and the use of stock option pools are also options, so dealing with members who will join in the future is not a mechanism limited to trust-type SOs. With trust-type, stock acquisition rights can first be deposited in a trust and pooled, and individual grantees can then be determined on the subsequent beneficiary designation date, which secures the opportunity to deliver options to members who join long after incorporation.

However, when aiming for tax qualification with a trust-type option, the share price and the like at the time of the beneficial interest grant agreement are used as the basis for the exercise price, so the low exercise price of the early stage cannot necessarily be applied as is to everyone who joins later. In designing the trust agreement, you must confirm that the tax-law qualification requirements are actually met, including the scope of the trustee's authority, objective criteria for beneficiary designation, and records of designation decisions. Merely putting documents in proper form cannot be said to establish qualification as a matter of course. While flexible operation is gained, the increase in documents and procedures to be managed, such as the trust agreement, the agreement with the trustee, and the decision-making process for beneficiary designation, is a factor that should be anticipated before introduction.

Reviewing Previously Issued SOs and Advance Preparation

In due diligence (DD) for fundraising or M&A, previously issued stock options are reviewed for the terms of each issuance and the holdings and exercise status of each holder. The materials to be reviewed are the basic set of the terms of issuance, allotment agreements, resolutions of the shareholders' meeting and board of directors, and the stock acquisition rights register; in addition, for paid SOs, the materials supporting the fair value calculation and the records of payment; and for trust-type SOs, the trust agreement, the agreement with the trustee, and the records and dates of beneficiary designation.

At companies that have already introduced trust-type SOs, records of how they responded after the National Tax Agency Q&A was published are also reviewed. If the company determined that its scheme falls under the non-qualified type in Question 3, check whether there are records of additional payment of withholding income tax and explanations to holders; if it takes the position that it meets the qualification requirements in Question 12, confirm the grounds through the agreements, operating records and, where necessary, the opinion of a tax accountant or the like. Obtaining an opinion letter is not itself a qualification requirement. If this review is put off, investors in the next round or buyers in M&A may raise it at the negotiating table, which can stall the process.

When considering the design of trust-type or paid SOs, organizing a term sheet to hand to tax accountants and attorneys at the outset allows concrete discussion to begin from the first meeting. The items to include in the term sheet are as follows.

• Attributes of grantees (directors, employees, service providers, etc.) and the expected number
• The expected exercise price and the method of valuing the shares on which it is based (to be distinguished from valuation of the payment amount for the stock acquisition rights themselves)
• Whether fair value valuation of the stock acquisition rights is needed for paid SOs, and to whom the valuation will be commissioned
• If trust-type is being considered, the outlook for meeting the requirements based on the beneficiary designation date
• Whether there are previously issued stock options, and their types, issuance dates and number of holders
• The expected issuance schedule and the planned dates of upcoming shareholders' meetings and board meetings

In addition, preparing basic materials such as the latest capitalization table, the full set of terms of issuance for previously issued SOs, a list of expected grant candidates and their roles in the company, and the net asset position based on the latest financial statements or provisional financial statements allows experts to proceed smoothly with concrete design while checking them against the term sheet. The scope of our support from stock option design to issuance procedures is summarized in Startup Legal and Fundraising Support.

Frequently asked questions

Are trust-type stock options no longer usable?

It cannot be said across the board that they are unusable. Question 3 of the National Tax Agency's "Taxation of Stock Options (Q&A)" set out the view that, for trust-type stock options that do not satisfy the tax-qualified requirements, the economic benefit at the time of exercise is taxed as employment income and the issuing company has a withholding obligation. On the other hand, Question 12 of the same Q&A indicates that trust-type stock options may also be treated as tax-qualified stock options if the trustee's discretion is restricted and requirements such as the exercise period and exercise price measured from the beneficiary designation date are satisfied. It is necessary to check individually which category an existing scheme falls into.

With paid stock options, can we assume there is no taxation at the time of exercise?

This presupposes that the stock acquisition rights are purchased at an appropriate fair value. Question 2 of the National Tax Agency Q&A indicates that, for stock options acquired for consideration, the gain in value at the time of exercise is not taxed, but this presupposes that the purchase price is a fair value reflecting the theoretical value. Where a design waives payment, or a set-off structure is used in which the company effectively bears the consideration, it may develop into an issue of employment income taxation on the ground that an economic benefit has arisen.

When considering trust-type or paid stock options, what should we prepare first?

If stock options have already been issued, the full set of their terms of issuance, allotment agreements and resolutions; the most recent capital policy table; a list of the intended grantees and their roles; and the policy for calculating the exercise price (whether the special method following the examples in the Basic Circular on Property Valuation or, for paid SOs, a fair value assessment using an option pricing model). If you compile these into a term sheet and hand it to your tax accountant and attorney, you can move into concrete design discussions from the first meeting.