Statutory definition

Article 29-2 of the Act on Special Measures Concerning Taxation provides as follows:

The exercise price per share for the exercise of the said stock acquisition rights shall be at least equal to the amount equivalent to the value per share of the shares of the stock company that concluded the agreement pertaining to the said stock acquisition rights at the time of the conclusion of the said agreement.

One requirement for tax-qualified stock options is that the exercise price be at least equal to the value per share at the time the grant agreement is concluded. Determining that value can be difficult for unlisted startups.

Overview

When does "at the time of the conclusion of the said contract" refer to?

The requirement is based on the stock price at the time of contract execution, but the contract is not necessarily executed immediately after the resolution for grant or the resolution to determine subscription matters. Regarding this point, the National Tax Agency Q&A states as follows:

Regarding "the time of conclusion of the said contract," if the date of conclusion of the contract pertaining to the grant has not passed six months from the date of the resolution regarding the grant or the date of the resolution for determining matters for solicitation, the date of these resolutions may be used instead.

Whether or not more than six months have passed from the date of the resolution to the date of contract conclusion is the dividing line for whether this treatment can be applied.

How to calculate the value per share (principal method)

The stock price at the time of the grant agreement is first calculated according to the examples in Income Tax Basic Directive 23–35 Common-9. This directive states that for listed stocks, the price is based on the final published price, or the price of old shares if they are listed, substituted with the market quotation price if available, and for all other cases, calculated according to categories such as the presence or absence of actual trading examples or the value of shares in similar companies. For cases that fall under none of these, the directive provides the following stipulations:

the value recognized as being traded in the ordinary course of business, taking into consideration the net asset value per share or per unit of the issuing corporation of the shares on the exercise date, etc. or on the date closest to the exercise date, etc.

For shares acquired by exercising non-tax-qualified stock options, Question 5 of the National Tax Agency’s Q&A also refers to the same approach under Income Tax Basic Circular 23–35 Common-9.

two situations for using the Basic Circular on Property Valuation

Among the principal methods (Income Tax Basic Directive 23-35 common - 9 (Note) 1)

Regarding the "value recognized as being normally traded by taking into consideration the net asset value, etc." mentioned above, Income Tax Basic Directive 23–35 Common-9 (Note) 1 provides as follows:

If the calculation is made in accordance with the examples in paragraphs 178 through 189-7 ((Valuation of Unlisted Stocks)) of the "Basic Circular on Property Valuation" (Ruling Interpretation Circular) dated April 25, 1964 (Chokushi No. 56, Chokushin (Shi) No. 17), the calculated value may be used, unless it is recognized as being extremely inappropriate.

There are three conditions: when a "central family shareholder" applies, the issuing corporation shall always be treated as a "small company"; land or listed securities shall be based on the value as of the exercise date, etc.; and the amount equivalent to corporate tax, etc., on the evaluation difference shall not be deducted.

as a "special exception method" (Q&A Question 7 (Reference 3))

The National Tax Agency Q&A provides a separate "special exception method" solely for the purpose of calculating this strike price requirement.

The special method can only be selected when calculating the share price at the time of the grant agreement regarding the requirements concerning the exercise price of tax-qualified stock options.

The conditions for Q&A Question 7 (Reference 3) are also the same three points, but the timing in (2) is considered to be at the time of contract rather than the exercise date, etc.

When provisional settlement of accounts is required (Q&A Question 8)

National Tax Agency Q&A Question 8 states that, as an example of the net asset value method, calculation based on the financial statements at the end of the immediately preceding fiscal period is the principle. However, if six months have passed since the end of the immediately preceding fiscal period as of the grant agreement date and the net asset value on that date exceeds twice the net asset value at the end of the immediately preceding fiscal period, or if shares have been issued between the end of the immediately preceding fiscal period and the grant agreement date, it is necessary to prepare provisional financial statements. In the case of a share issuance, a simplified treatment of adding the amount paid in is also permitted.

What happens if preferred shares (class shares) are issued?

For startups that have received investment from venture capitalists via preferred stock, the existence of preferred stock cannot be ignored when calculating the value of common stock. The Basic Income Tax Directive 23–35 Common-9 also states that when an issuing corporation has issued class shares, the value of the shares shall be calculated by taking into account the characteristics of those shares.

National Tax Agency Q&A Question 9 outlines the calculation procedure when there are preferred shares: calculating the net asset value on the basis of inheritance tax evaluation value, deducting the portion distributed to preferred shares from it, and dividing the remainder by the number of issued shares to calculate the price per share of common stock. Regarding the treatment when the preferred distribution amount exceeds the investment amount, the Q&A states the following:

Even if the preferential distribution amount for preferred stock exceeds the investment amount (e.g., 1.5 or 2.0 times), that preferential distribution amount is deducted to calculate the value of the common stock. In addition, share acquisition rights that are entitled to a preferential distribution of residual assets, such as so-called J-KISS type share acquisition rights, may be treated as preferred stock that is entitled to a preferential distribution of residual assets.

Can the exercise price be lowered later (contract modification)

Since exercising the stock acquisition rights in accordance with the contract is a requirement, modifying the contract will, as a rule, cause the loss of tax-qualified status. Q&A Question 10 states as follows:

If the matters stipulated in the relevant contract are changed, as a general rule, it will no longer qualify as a tax-qualified stock option.

However, based on the revision of the Act on Special Measures Concerning Taxation circular in July 2023, the following limited treatment is also indicated:

Regarding agreements that meet the requirements for tax-qualified stock options, if a contract modification is made to lower the exercise price after the revision of the circular, and the exercise price after such contract modification satisfies the requirements regarding the exercise price stipulated in the said circular, it will be recognized as a tax-qualified stock option.

The determination is based on the calculated amount under the same circular at the time of concluding the grant agreement, rather than at the time of the contract modification. In addition, the following point is also added.

Since there is the requirement under Article 29-2, Paragraph 1, Item 5 of the Act, if the exercise price after the contract modification would be contrary to the exercise price determined in the resolution for granting, a resolution to modify the exercise price is also required.

Points that require care in practice

• Question 7, Reference 1, Note 4 of the National Tax Agency’s Q&A distinguishes the approach that takes net asset value and similar factors into account from the special method. To determine how the “clearly inappropriate” limitation applies to each, it is necessary to read that note together with Income Tax Basic Circular 23–35 Common-9, Note 1, and Question 7, Reference 3 of the Q&A.
• The terms of preferred shares, including liquidation-preference multiples and participating or non-participating rights, vary by company. Their effect on the calculation procedure in Question 9 of the National Tax Agency’s Q&A must therefore be checked against the actual terms.
• When lowering the exercise price through a contract modification, it is necessary to refer to Question 10 of the National Tax Agency's Q&A and the original text of the relevant circular to determine whether the requirements following the amendment of the Act on Special Measures Concerning Taxation circular in July 2023 are met.

Legal basis

• Article 29-2, Paragraph 1, Item 3 of the Act on Special Measures Concerning Taxation (Non-taxation, etc. of Economic Benefits Pertaining to Acquisition of Shares through Exercise of Stock Options Received by Specified Directors, etc.) / Cited wording: "The exercise price per share pertaining to the said stock option is equal to or higher than the amount equivalent to the value per share of the shares of the stock company that concluded the contract pertaining to the said stock option at the time of the conclusion of the said contract."

Relevant administrative guidance, Q&A, and cases

• Basic Directive for Income Tax 23–35 Common-9 (Value of Shares under the Main Text of Article 84, Paragraph 3 of the Cabinet Order) / Quoted wording: "value recognized as being in the course of ordinary transactions, taking into consideration the net asset value or the like per share or per unit of the issuing corporation of the shares on the exercise date, etc. or the day closest to the exercise date, etc."
• Basic Income Tax Circular 23–35 Common-9 (Value of Shares under the Main Text of Article 84, Paragraph 3 of the Enforcement Order) / Cited wording: "If the calculation is made according to the examples in 178 to 189-7 ((Evaluation of Shares without Quoted Market Prices)) of the 'Basic Directive on Property Evaluation' (Administrative Ruling/Interpretation) dated April 25, 1964 (Chokushi 56, Chokushin (Shi) 17)..., such calculated value may be accepted, unless it is recognized as extremely inappropriate."
• National Tax Agency "Taxation on Stock Options (Q&A)", November 2024 Last Revision, Question 7 / Quoted text: "Regarding 'the time of the execution of the relevant contract,' if the date of the execution of the contract pertaining to the grant is not more than 6 months after the date of the resolution regarding the grant or the date of the resolution for determining the subscription matters, the date of these resolutions may be used instead."
• National Tax Agency, "Taxation on Stock Options (Q&A)", November 2024 final revision, Question 7 (Reference 1) / Quoted text: "The special method can only be selected when calculating the stock price at the time of the grant agreement regarding the requirement concerning the exercise price of tax-qualified stock options."
• National Tax Agency, "Taxation on Stock Options (Q&A)", November 2024 final revision, Question 9 / Quoted text: "Even if the preferential distribution amount of preferred stock exceeds the investment amount (for example, 1.5 times or 2.0 times), the value of common stock shall be calculated by deducting that preferential distribution amount. In addition, stock options capable of receiving preferential distribution of residual assets, such as so-called J-KISS type stock options, may be treated as preferred stock capable of receiving preferential distribution of residual assets."
• National Tax Agency, "Taxation on Stock Options (Q&A)", revised November 2024, Question 10 / Quoted text: "If the matters stipulated in the relevant contract are changed, as a principle, it will no longer fall under the category of tax-qualified stock options."
• National Tax Agency, "Taxation on Stock Options (Q&A)", November 2024 final revision, Question 10 / Quoted text: "Regarding a contract that meets the requirements for tax-qualified stock options, if a contract modification is made to lower the exercise price after the revision of the circular, and the exercise price after said contract modification meets the requirements regarding the exercise price stipulated in the same circular, it will be recognized as a tax-qualified stock option."
• National Tax Agency "Taxation on Stock Options (Q&A)", November 2024 Last Revision, Question 10 / Quoted text: "Since there is the requirement under Article 29-2, Paragraph 1, Item 5 of the Act on Special Measures Concerning Taxation, if the exercise price after the contract modification would conflict with the exercise price determined in the resolution for grant, a resolution to change the exercise price is also required."