What Are Tax-Qualified Stock Options? The Basics of How They Are Taxed and the Requirements
Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.
When companies are preparing for a Series A round or hiring senior executives, I am often asked, "We want to design our stock options to be tax-qualified." When comparing tax burdens, decide first who will receive the options and when they will be exercised. You also need to check whether the contract terms and actual operation conform to the statutory requirements.
This article is based on Article 29-2 of the Act on Special Measures Concerning Taxation and the National Tax Agency's Q&A as revised in November 2024, among other sources, as of September 13, 2026. The tax rates stated assume the standard treatment for residents of Japan. Individual circumstances, such as grants to non-residents or additional tax burdens associated with high income, should be checked with a tax accountant or other adviser.
Points to Check Before Drafting the Terms of Issue
Before starting on the design, make sure you have sorted out the following basic matters.
- Understanding whether the stock options give rise to taxation at exercise or taxation at sale
- Identifying which provisions of the terms of issue or the allotment agreement satisfy the tax-qualified requirements
- Checking each requirement (eligible persons, exercise period, annual limit and exercise price) in light of your company's years since incorporation and shareholder composition
- Distinguishing internal design choices such as vesting and forfeiture on departure from the tax-qualified requirements
Timing of Taxation and Classification of Income
If you think of the flow in which stock options are exercised to acquire shares and those shares are then sold for cash, the timing of taxation divides into three points: "at grant," "at exercise" and "at sale of the shares." Here I mainly discuss stock options that are granted to officers or employees free of charge or on favorable terms as consideration for their services, and that are subject to transfer restrictions. For this type, no income is recognized at the time of grant. The tax treatment of non-qualified stock options differs depending on the consideration and conditions of the grant.
Where stock options of this type are not tax-qualified, the difference between the share price at the time of exercise and the exercise price is, as a rule, treated as employment income. Because employment income is subject to aggregate taxation, the maximum combined rate of income tax and inhabitant tax reaches 55 percent, excluding the special reconstruction income tax. The holder must prepare funds to pay the tax before converting the shares into cash, and where buyers for the shares are limited, as with an unlisted company, the burden on the holder's cash on hand becomes heavy. Later, when the acquired shares are sold, the amount obtained by deducting the share price at the time of exercise, transfer expenses and the like from the sale price is taxed as capital gains on shares. Where the options are consideration under a service agreement with an independent business operator, the income at exercise may also be classified as business income or miscellaneous income.
On the other hand, for paid stock options purchased at fair market value, there is a treatment under which no income is recognized at the time of exercise even if they are not tax-qualified, so they are handled separately from free grants. In the case of paid issuance, the acquisition cost at the time of sale of the shares reflects both the acquisition price of the share options themselves and the amount paid in at the time of exercise.
By contrast, for tax-qualified stock options that satisfy the requirements of Article 29-2 of the Act on Special Measures Concerning Taxation, taxation of the economic benefit at the time of exercise is deferred. Tax is first imposed when the shares are actually sold, and separate self-assessment taxation applies to the capital gain obtained by deducting the exercise price, transfer expenses and the like from the sale price. The basic rate for residents of Japan is 20.315 percent, consisting of 15 percent income tax, 0.315 percent special reconstruction income tax and 5 percent inhabitant tax.
Compared with free-grant non-qualified stock options, the major differences are that taxation can be deferred until the shares are sold and that the gain is taxed as capital gains on shares instead of employment income. That said, because the actual tax rate applicable to employment income varies with the individual's total income, being tax-qualified does not necessarily reduce everyone's tax burden by a uniform proportion.
As for trust-type stock options, the National Tax Agency's Q&A indicates that, for certain designs, employment income taxation is applied at the time of exercise. At the same time, Question 12 of that Q&A also explains a path by which trust-type options meeting the prescribed requirements can be treated as tax-qualified. To determine the tax treatment of a trust-type arrangement, check the content of the trust agreement and the method of designating beneficiaries, and compare them against the specific grant conditions.
Qualification Requirements Under Article 29-2 of the Act on Special Measures Concerning Taxation
The requirements for recognition as tax-qualified stock options are set out in Article 29-2 of the Act on Special Measures Concerning Taxation. The premise is that the options are share options issued free of charge, requiring no payment of money, based on a resolution under the Companies Act (Article 238, Paragraph 2 of the Companies Act, etc.), and on top of that, the following conditions must be set out in the agreement relating to the grant.
1. Scope of Eligible Persons
For ordinary grants to officers and employees, eligible persons are limited to directors, executive officers, employees and similar persons belonging to the issuing company and certain related companies. A related company here means a corporation that satisfies the criteria set by law, such as one in which the issuing company directly or indirectly holds more than 50 percent of the issued voting shares or equity interests. Certain heirs of the right holder are also included. Note that corporate auditors and accounting advisors are not included in the category of directors and the like solely by reason of that position.
In addition, major shareholders as of the date of the grant resolution and persons with a special relationship with them are excluded. The ownership threshold for a major shareholder is more than one-third of the issued shares or equity for an unlisted company, and more than one-tenth for a listed company. Check in advance how ownership is calculated and the scope of persons with a special relationship, including spouses and others. Founders are also assessed against this ownership threshold, their positions and similar factors.
Outside collaborators who have no employment or officer relationship are, in principle, not eligible, but a system has been established under which certain outside highly skilled personnel can be included within the scope of tax-qualified options by obtaining certification of a plan under the Act on Enhancement of Small and Medium-Sized Enterprises' Business Operations (the scope was expanded by the 2024 amendment).
2. Restriction on the Exercise Period
The period during which the options may be exercised is set as running from the day on which two years have elapsed from the date of the grant resolution until the day on which ten years have elapsed. This means there is a limit on the period during which the options can be exercised as tax-qualified; it does not mean that holding or exercising the rights outside this period is uniformly prohibited.
As an exception, where the options are granted by a company that, as of the date of the grant resolution, is "less than five years since incorporation" and "unlisted," the end of the exercise period is extended to the day on which fifteen years have elapsed (FY2023 tax reform). It is important not to assume mistakenly that "every startup can exercise for 15 years," and to confirm that both requirements, years since incorporation and unlisted status, are met as of the date of the grant resolution.
3. Annual Limit on the Exercise Price
There is an upper limit on the total exercise price that the same person may exercise in one year (calendar year), which is JPY 12 million as a rule. If exercises exceed this limit, not only the excess amount but the entire exercise that causes the limit to be exceeded loses tax-qualified treatment.
Since the 2024 amendment, for a company that is less than five years since incorporation as of the date of the grant resolution, the exercise price is divided by 2, and for a company that is at least five but less than twenty years since incorporation and satisfies conditions such as being unlisted or less than five years since listing, the exercise price is divided by 3, and the resulting amount is compared with the JPY 12 million limit. If only a single category applies, the effective limit is JPY 24 million or JPY 36 million, but where an individual has received grants from multiple companies or on multiple occasions, the amounts adjusted for each category are aggregated on an individual basis. Any fraction of less than one yen in the amount after division, calculated for each exercise, is rounded up. Check whether the grant agreement reflects the amendment, and take care not to misunderstand the transitional measure that expired at the end of 2024 as a system that still allows existing agreements to be amended retroactively.
4. Exercise Price per Share
The exercise price per share must be set at or above the value per share (fair market value) at the time the grant agreement is concluded. The lower the exercise price, the greater the economic benefit to the grantee, but if it is set below the fair market value at the time the agreement is concluded, the options will fail to meet the tax-qualified requirements at that point.
For unlisted shares with no market price, a special method based on the Basic Circular on Property Valuation can be selected, subject to the conditions set out in Question 7 and following of the National Tax Agency's Q&A. Under this framework, the net asset value method or similar methods are used, but for a company that has issued class shares, the value of the common shares is calculated reflecting the content of rights such as preferred dividends and distribution of residual assets. The issue price of preferred shares in the most recent financing round does not necessarily become the valuation of the common shares as is. Also, this special method applies only to the valuation at the time of the agreement for determining the exercise price requirement for tax-qualified options; it is not a system that can be used generally, for example for valuation at exercise of non-qualified stock options.
5. Prohibition on Transfer of the Share Options
The contract must expressly state that transfer of the share options themselves to others is prohibited. Officers and employees who have received grants are not permitted to sell the rights to a third party while they remain in the form of stock options.
6. Delivery and Custody of Shares
Shares delivered upon exercise must be delivered in a manner that does not contravene the offering terms set out under Article 238, Paragraph 1 of the Companies Act. For shares acquired by exercise, in accordance with a prior arrangement, the company chooses either to place them, immediately after acquisition, in a prescribed book-entry transfer, custody or management trust through a securities company or similar institution, or to have the issuing company itself manage the restricted shares separately for each right holder. The latter is an option newly added in 2024, but it is not enough simply to state in the contract that "the company will manage them"; it requires the preparation of the records required by law and actual segregated management.
7. Procedural Requirements (Written Pledge and Statutory Report)
Upon exercise, the right holder submits a document pledging, among other things, that they were not a major shareholder or similar person as of the date of the grant resolution, and also reports on the status of other exercises within the same year. Separately, the company is obliged to submit a statutory report on the grant to the tax office, and the deadline is, as a rule, January 31 of the year following the year of the grant (taking into account extensions of the deadline due to holidays and the like). Manage the pledge and report at the time of exercise and the company's submission of the statutory report as separate procedures, and do not conclude that a delay in submitting the statutory report immediately negates tax-qualified status altogether; calmly examine what procedure was missed and its legal effect.
Consistency Between Contract Terms and Actual Operation
To satisfy the tax-qualified requirements, it is not enough to include the prescribed provisions in the terms of issue and the allotment agreement; exercises and share management must actually be carried out in line with the content of those agreements. Confirm the attributes of the grantees, and check at each exercise that the exercise period, the annual limit and the prescribed management procedures are being observed.
The design of tax-qualified stock options cannot be completed with tax knowledge alone, or with contract drafting alone. It is important to cross-check which provisions of the terms of issue and the allotment agreement reflect each requirement, such as the exercise period, the annual limit, the prohibition on transfer and share management, and to put procedures in place so that future exercises are carried out in accordance with those provisions. Reviewing the drafts of the contract and the terms of issue can be described as precisely the process for maintaining this practical consistency.
Distinguishing Vesting and Forfeiture on Departure from the Tax Requirements
This is a point that is often confused in practice: vesting, which fixes rights according to the period of service, and forfeiture clauses on departure are not statutory requirements for tax-qualified status under the Act on Special Measures Concerning Taxation. "How many years must someone work before they can exercise the options" and "how unvested or unexercised rights are handled on departure" are design matters that the company decides on its own initiative through the terms of issue and the allotment agreement. That said, the exercise period starting after two years, the annual limit required by the tax rules and the restrictions under the Companies Act must still be observed.
A typical design example is "four-year vesting with a one-year cliff," in which 25 percent of the total vests after twelve months from the allotment date and the remaining 75 percent vests at the rate of one thirty-sixth per month over the following thirty-six months. There are also examples that, as a rule, restrict exercise until the shares are listed, while including a clause that exceptionally permits exercise if an acquisition occurs. However, even if the exercise conditions are relaxed contractually, to receive tax-qualified treatment, the options must also satisfy "two years having elapsed after the grant resolution" and "the annual limit of JPY 12 million (after category adjustment)."
Issues such as whether to forfeit unexercised rights on departure, what measures to take in the event of competing activities or misconduct, and whether to allow inheritance on the right holder's death are also left to the company's internal design decisions. If a disadvantageous change is made after a grant, depending on the content of the change, check the basis in the allotment agreement, whether the individual's consent is required, and the resolutions and procedures for changing the terms under the Companies Act. For this reason, I think it is important to envisage several concrete cases from the outset of the system design, such as "a person who served for four years and then left," "a person who left after one year" and "a situation in which an acquisition has been completed."
Advanced Issues and the Issuance Procedure
Tax-qualified stock options are a system in which the tax requirements, the procedures under the Companies Act and the company's own capital policy are consolidated into a single set of terms of issue and allotment agreements. Once you have grasped the basic structure, in practice you proceed to consider two further aspects.
The first is advanced matters of judgment that tend to become issues in actual cases: specifically how much the exercise price for unlisted shares can be set at, how to handle options already issued when the tax rules are amended, how to approach grants to team members residing overseas, and how to respond if an M&A transaction occurs. These vary greatly depending on the company's situation, and their legal effect can turn on slight differences in how the provisions of the terms of issue are designed. These are explained in detail in Advanced Issues in Tax-Qualified Stock Options: Exercise Price, Tax Reform, Overseas Residents and M&A.
The second is managing the procedures leading up to issuance. Working backward from the issue date, you schedule the resolutions of the shareholders' meeting and the board of directors, and manage the deadlines for the registration application and for submitting the statutory report to the tax office. The specific flow of procedures is explained step by step in Stock Option Issuance Procedure in Practice: From the Shareholders' Meeting Resolution to Registration and Statutory Reports.
For the balance of allocation within the company and the design of the stock option pool, please also refer to Avoiding Stock Option Regrets Before Series A and Stock Option Design as Capital Policy: Thinking About the Pool and Grantees.
Consultations on Stock Option Design
As part of our startup legal services, LegalAgent has a system in which attorneys and AI work together to review everything in an integrated way, from the design of tax-qualified stock options and the drafting of the terms of issue and allotment agreements, to the issuance procedures under the Companies Act and verification of consistency with the company's capital policy.
Frequently asked questions
What are tax-qualified stock options?
They are stock options that, by satisfying the requirements under the Act on Special Measures Concerning Taxation, are not taxed at the time of exercise and are instead taxed as capital gains when the shares are sold. Free stock options that do not satisfy the requirements may be taxed as employment income or similar at the time of exercise.
What are the main requirements for tax qualification?
Requirements include the scope of eligible grantees (directors, employees, etc., excluding certain major shareholders), issuance without consideration, the exercise period, an exercise price at or above the market value at the time of the agreement, an annual limit on the total exercise price, and a prohibition on transfer.
What happens if the requirements are not satisfied?
At the time of exercise, the difference between the share price at that time and the exercise price may be taxed as employment income or similar. Because funds to pay the tax are needed before the shares are sold, a practical problem is that the burden on grantees tends to be heavy.
Services connected to this topic