How to Set Up an Employee Benefit Trust: Incentivising Staff in Family Business Succession

The Hong Kong Inland Revenue Department (IRD) issued Departmental Interpretation and Practice Notes (DIPN) No. 60 in December 2024, clarifying the tax treatment of share awards and options granted under employee benefit trusts (EBTs). This circular directly impacts the cost structure of long-term incentive plans for family businesses undergoing succession planning, where retaining non-family executives is critical. For a family office or privately held group transitioning to the second or third generation, an EBT offers a mechanism to align senior management interests with the family’s long-term capital preservation goals without diluting voting control in the operating company. The 2024-25 Hong Kong Budget further extended the profits tax exemption for qualifying family-owned investment holding vehicles (FIHVs) managed by single family offices (SFOs) in Hong Kong, creating a more favourable environment for structuring EBTs as part of a holistic wealth transfer strategy. This article outlines the legal, tax, and governance architecture for establishing an EBT in Hong Kong, referencing the relevant provisions of the Trustee Ordinance (Cap. 29) and the IRD’s latest guidance.

The Legal Structure of an Employee Benefit Trust in Hong Kong

An EBT is a discretionary trust established by a family business (the settlor) for the benefit of a defined class of employees and their dependants. The trust holds shares or cash, which are allocated to employees based on performance or tenure criteria set out in a trust deed and an accompanying employee benefit plan document. The trustee, typically a licensed trust company or a professional trustee, holds legal title to the assets, while the beneficiaries hold equitable interests that vest upon satisfaction of conditions.

Choice of Trustee and Trust Jurisdiction

Hong Kong is the preferred jurisdiction for EBTs serving Asian family businesses due to its common law framework, absence of capital gains tax, and the availability of professional trustees regulated under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO, Cap. 615). The trustee must be either a registered trust company under the Trustee Ordinance (Cap. 29, s. 79) or a licensed corporation under the Securities and Futures Ordinance (Cap. 571) if it engages in asset management. For a family business with a Hong Kong-incorporated operating entity, the trust is typically a Hong Kong trust governed by Hong Kong law, ensuring that the trust deed is enforceable in the same jurisdiction as the employee contracts.

The Trust Deed and the Employee Benefit Plan Document

The trust deed must specify the class of beneficiaries, the vesting schedule, and the powers of the trustee to allocate assets. The employee benefit plan document, which is not part of the trust deed but is incorporated by reference, details the operational rules: performance metrics, forfeiture conditions (e.g., “bad leaver” clauses), and the mechanism for share valuation in a private company. The IRD’s DIPN No. 60 (2024) requires that the plan document be in place before any award is granted to establish the tax treatment of the benefit as a deduction for the employer at the point of grant, not at vesting.

Share Valuation and Funding Mechanisms for Private Companies

For a family business that is not listed on the HKEX Main Board or GEM, the shares held in the EBT must be valued at fair market value for both tax and accounting purposes. A professional valuation firm must be engaged annually to determine the share price, using the discounted cash flow (DCF) method or the comparable company analysis (CCA) approach, depending on the nature of the business. The family business must decide whether to fund the EBT with newly issued shares (diluting existing shareholders) or with existing shares purchased from the family holding company or individual family members. In a succession context, the latter is more common, as it avoids dilution of the controlling family’s stake and allows the family to monetise a portion of their holdings in a controlled manner.

Tax Implications for the Employer, the Trustee, and the Employee

The IRD’s DIPN No. 60 (2024) clarifies that the employer is entitled to a deduction under section 16 of the Inland Revenue Ordinance (Cap. 112) for the cost of shares or cash transferred to the EBT at the time the award is granted to a specific employee, provided the employee is chargeable to salaries tax on the benefit. This represents a shift from the previous practice, where deductions were often deferred until vesting. The deduction is capped at the amount included in the employee’s assessable income.

Employer Deduction Timing and Conditions

The deduction is available only if the employer makes a written election in the tax return for the year of assessment in which the award is granted. The election must specify the number of shares or the cash amount, the employee’s name and Hong Kong Identity Card number, and the date of grant. The IRD will reject the deduction if the employee is not resident in Hong Kong or if the services are performed wholly outside Hong Kong, as the benefit would then not be subject to salaries tax under section 8(1A) of the IRO.

Tax Treatment of the Trustee

The trustee of an EBT is generally not subject to profits tax on dividends or capital gains from the sale of shares, provided the trust is not carrying on a trade or business in Hong Kong. The IRD’s position, as stated in DIPN No. 44 (Revised, 2020), is that a trust holding shares for employee benefits is not trading, as its primary purpose is to hold and distribute assets, not to generate profit through active dealing. However, if the trustee engages in active share dealing or lends shares to third parties, the IRD may assess the trustee on the resulting gains.

Employee Taxation at Grant and Vesting

The employee is subject to salaries tax on the market value of the shares at the date of grant, if the shares are freely transferable and not subject to forfeiture. If the shares are subject to a vesting period and forfeiture conditions (e.g., a three-year cliff vesting), the tax point is deferred to the date of vesting, when the shares become unconditionally vested. The IRD’s DIPN No. 60 (2024) confirms that a “bad leaver” clause, which forfeits unvested shares upon voluntary resignation or termination for cause, is a valid condition for deferring the tax point. The employee must report the benefit in their tax return for the year of vesting, and the employer must issue a Form IR56B for the value of the shares.

Governance and Succession Planning Integration

An EBT is not merely a compensation tool; it is a governance mechanism that can be integrated into the family’s succession plan to separate ownership from management. The family’s holding company can retain voting rights in the shares held by the EBT, ensuring that the family retains control of the board while non-family executives benefit from economic ownership.

Voting Rights and Control Preservation

The trust deed can specify that the trustee must exercise voting rights in accordance with the directions of a “voting committee” appointed by the family’s holding company. This structure ensures that the family retains control over strategic decisions, such as the appointment of directors and major capital expenditures, while the EBT shares are entitled to dividends and capital appreciation. This is a common structure in Hong Kong-listed family-controlled companies, such as those on the HKEX Main Board, where the family’s stake is held through a BVI or Cayman holding company, and the EBT holds a separate tranche of shares.

Alignment with Family Office Objectives

For a family office managing assets exceeding USD 10 million, the EBT can be structured as a sub-trust of the family’s main trust, allowing for consolidated reporting and tax planning. The Hong Kong SFO tax concession, introduced in the 2022-23 Budget and refined in the 2024-25 Budget, provides a 0% profits tax rate for qualifying FIHVs managed by SFOs. If the EBT is a beneficiary of the FIHV, the dividends received by the EBT from the family’s operating company can be distributed tax-free to employees, as the FIHV’s income is exempt from profits tax under section 20AN of the IRO.

Managing “Bad Leaver” and “Good Leaver” Scenarios

The trust deed must define the consequences of an employee leaving the family business. A “good leaver” (e.g., retirement, death, or redundancy) typically allows the employee to retain vested shares and receive a cash payment for unvested shares at fair market value. A “bad leaver” (e.g., resignation or termination for cause) results in forfeiture of unvested shares and a compulsory sale of vested shares back to the EBT at a discount, typically 10% to 30% below market value. This discount serves as a deterrent to voluntary departure and protects the family’s capital. The IRD’s DIPN No. 60 (2024) recognises that a compulsory sale at a discount is a valid condition for deferring the tax point, as the employee does not have unfettered ownership until the sale is completed.

Practical Steps for Implementation

Establishing an EBT in Hong Kong requires a structured process involving legal, tax, and corporate advisory professionals. The following steps are based on standard practice for family businesses with assets exceeding HKD 100 million.

Step 1: Define the Beneficiary Class and Vesting Schedule

The family must decide which employees are eligible: typically, senior management and key technical staff. The vesting schedule should be aligned with the family’s succession timeline. A common structure is a three-year cliff vesting followed by monthly vesting over the subsequent two years, creating a five-year retention period. The trust deed must specify the performance conditions, which can include EBITDA targets, revenue growth, or personal KPIs.

Step 2: Appoint a Licensed Trustee and Execute the Trust Deed

The trustee must be a Hong Kong-licensed trust company, such as a subsidiary of a major bank or an independent trust firm registered under the Trustee Ordinance. The trust deed must be executed as a deed, stamped with the appropriate stamp duty under the Stamp Duty Ordinance (Cap. 117). Stamp duty on the transfer of shares to the trustee is payable at 0.2% of the higher of the consideration or the market value of the shares, plus HKD 5 per instrument.

Step 3: Fund the Trust and Value the Shares

The family business must transfer cash or shares to the trustee. For a private company, a valuation report from a qualified valuer must be obtained within six months of the transfer. The IRD may challenge the valuation if it is not supported by a detailed DCF or CCA analysis. The trustee must maintain a register of awards, recording the name of each employee, the number of shares awarded, the grant date, and the vesting schedule.

Step 4: Communicate the Plan to Employees and File Tax Returns

The employee benefit plan document must be provided to each eligible employee, explaining the vesting conditions, the tax consequences, and the process for selling shares upon leaving. The employer must file a Form IR56B for each employee at the point of grant (if the shares are freely transferable) or at the point of vesting (if forfeiture conditions apply). The employer must also make the election for the deduction in its Profits Tax Return (Form BIR51) for the relevant year of assessment.

Actionable Takeaways

1. Engage a Hong Kong-licensed trustee and execute a trust deed that explicitly separates voting rights from economic ownership to preserve family control over the operating company.
2. Obtain a professional valuation of the family business shares at least annually, and ensure the valuation methodology is documented to withstand an IRD challenge under DIPN No. 60 (2024).
3. Structure the vesting schedule with a three-year cliff and forfeiture conditions to defer the employee’s tax point to vesting, maximising the employer’s deduction under section 16 of the IRO.
4. Integrate the EBT as a sub-trust of the family’s FIHV to benefit from the 0% profits tax rate under the Hong Kong SFO tax concession, effective from the 2022-23 year of assessment.
5. Define “bad leaver” and “good leaver” provisions in the trust deed, including a compulsory sale discount of 10% to 30%, to protect the family’s capital and align management incentives with long-term succession goals.