Employee Stock Ownership Plans (ESOPs) in Japanese SMEs: Tax Benefits, Governance, and Avoiding "Ghost" Plans?

Japanese Attorney at Law - Bengoshi L.L.

• 9 min read

Employee Stock Ownership Plans (従業員持株会 - Jūgyōin Mochikabukai, hereinafter "ESOPs") are a common feature in the Japanese corporate landscape, utilized by both listed companies and Small and Medium-sized Enterprises (SMEs). While officially promoted as a means for employee welfare, asset formation, and fostering a sense of participation, ESOPs in Japanese SMEs often serve a significant underlying purpose for business owners: facilitating business succession and achieving substantial inheritance tax savings. This article delves into the dual nature of these plans, their structuring, governance, the critical issue of share buy-backs, and potential pitfalls such as "ghost" ESOPs.

The Dual Motivations Behind ESOPs in Japanese SMEs

Understanding ESOPs in Japanese SMEs requires acknowledging their often twofold objectives:

  1. The Official Purpose (本来の目的 - honrai no mokuteki): This is the publicly stated aim, focusing on enhancing employee welfare, providing a mechanism for employees to build assets through share ownership, and increasing employee motivation and loyalty by giving them a stake in the company's success.
  2. The Underlying Owner-Driven Purpose (本音の目的 - honne no mokuteki): For owners of closely-held SMEs, a primary driver for establishing an ESOP is often strategic:
    • Inheritance Tax Reduction: This is a major attraction. By transferring a portion of their shares to an ESOP, owners can significantly reduce the value of their personal taxable estate.
    • Business Succession: ESOPs can play a role in stabilizing share ownership and can be part of a broader strategy to manage the transition of the business, sometimes by ensuring shares don't become overly dispersed.

The success and legitimacy of an ESOP hinges on genuinely pursuing the official purpose; neglecting employee benefits in favor of purely owner-centric goals can lead to legal and tax challenges.

Significant Tax Benefits: The Inheritance Tax Advantage

The most compelling reason for SME owners to establish ESOPs is often the potential for considerable inheritance tax savings. The mechanism works as follows:

  • The owner sells a portion of their company shares (e.g., 30%) to the ESOP.
  • For tax valuation purposes when transferring shares to an ESOP (which is generally not considered a "related party" to the owner in the same way family members are), the shares can typically be valued using the "dividend discount method" (配当還元価額 - haitō kangen kagaku). This method usually results in a significantly lower per-share value compared to the valuation methods used for transfers between family members (which often involve net asset value or comparable company valuations).
  • Consequently, the owner can convert a substantial block of high-value shares into a much smaller amount of cash (from the sale to the ESOP) in their personal estate, thereby reducing the base for inheritance tax calculation.
  • The owner can still retain control of the company if they keep a majority of the voting shares (e.g., 70%). If further control assurance is needed, the shares transferred to the ESOP can be structured as a class of shares with restricted or no voting rights.

Setting Up and Governing a Typical ESOP in Japan

Most ESOPs in Japan are established as "Civil Code Partnerships" (民法上の組合 - Minpō-jō no Kumiai), a relatively simple legal structure.

1. Formation and Structure:

  • An ESOP is formed by employees (at least two are required) who agree to contribute funds to jointly acquire and hold shares in their employing company.
  • It operates based on its own rules or bylaws (規約 - kiyaku).
  • Unlike a formal company, a Civil Code Partnership ESOP generally does not require commercial registration.
  • Shares acquired by the ESOP are co-owned by its employee members, with each member holding an interest proportionate to their contribution. In practice, these shares are often registered in the name of the ESOP's chairperson, who holds them in a trust-like capacity for the members.

2. Governance of the ESOP:
Effective governance is crucial, not only for member protection but also to maintain the ESOP's legitimacy in the eyes of tax authorities.

  • Chairperson (理事長 - rijichō): The ESOP is typically headed by a chairperson who represents the association. The selection of the chairperson is important. If the chairperson is seen merely as a proxy for company management or the owner, the ESOP's independence might be questioned. This could lead to the ESOP being deemed a subsidiary of the company, which, under the Companies Act (Art. 135), would prohibit it from holding shares in its parent company.
  • Other Officers: The ESOP may also have other directors (理事 - riji) and one or more auditors (監事 - kanji). The auditor's role is to inspect the ESOP's financial affairs and ensure its operations comply with its bylaws and relevant laws (Civil Code, Art. 673).
  • ESOP Board (Rijikai): If established, the ESOP's board of directors (composed of its riji) would handle matters like amending bylaws, interpreting rules, managing new share subscriptions for the ESOP, and determining how the ESOP's voting rights in the company are exercised (often by majority vote of the ESOP board, as per Civil Code Art. 670(2)).
  • Administrative Office (事務局 - jimukyoku): Day-to-day administration (managing membership lists, processing entries and withdrawals, handling contribution changes) is often handled by an office within the company, typically in the HR or General Affairs department. The company can legitimately bear the costs of external administration services for the ESOP as an employee welfare expense.

3. Key Procedural Aspects:

  • Funding Contributions: Employee contributions are commonly made via payroll deductions. This requires a formal labor-management agreement under the Labor Standards Act (労働基準法 - Rōdō Kijun Hō, Art. 24).
  • Share Source: Shares for the ESOP can come from existing shareholders (typically the owner or retiring employees) or from the company itself (through a new share issuance or disposal of treasury stock).
    • Transfers from owners of restricted shares require company approval. If these shares are to be dividend-preference or voting-restricted for the ESOP, this may first require converting the owner's common stock into such a class, which involves amending the company's articles of incorporation (a special shareholder resolution) and registering the new class of shares.
    • If the company issues new shares to the ESOP via a third-party allotment (第三者割当 - daisansha wariate), this also requires a special shareholder resolution. Such an allotment must be at a fair price to avoid issues of "advantageous issuance" (有利発行 - yūri hakkō), which could be challenged by other shareholders, and to prevent potential gift tax implications for ESOP members if the shares are issued at an unjustifiably low price.
  • Securities Regulations: Depending on the total value of shares being offered and the number of employees solicited, disclosure requirements under the Financial Instruments and Exchange Act (金融商品取引法 - Kin'yū Shōhin Torihiki Hō) might be triggered, necessitating the filing of a securities registration statement (有価証券届出書 - yūkashōken todokedesho) or a securities notification (有価証券通知書 - yūkashōken tsūchisho).

The Pitfall of "Ghost" ESOPs (幽霊持株会)

A significant risk is the creation of "ghost" ESOPs – plans that exist merely on paper, primarily for the owner's tax avoidance, with little to no genuine employee involvement or benefit.

  • Tax authorities are known to scrutinize ESOPs and may disregard those lacking substance, leading to the denial of tax benefits.
  • An example cited in Japanese media (Asahi Shimbun, December 29, 2003) involved an ESOP that was disregarded by tax authorities because the company president controlled all aspects of its administration, members were not properly notified of share transfers, and no ESOP meetings were held.
  • To avoid this, an ESOP must be operated transparently and genuinely for the benefit of its employee members, adhering to its bylaws and legal requirements.

The Critical Issue: Buy-Back Price Upon Employee Withdrawal

Perhaps the most contentious aspect of unlisted SME ESOPs is the determination of the share buy-back price when an employee withdraws from the ESOP (usually upon termination of employment).

  • Common Practice: ESOP bylaws for unlisted companies typically stipulate that shares or the member's interest will be bought back by the ESOP (or a designated party) at the original acquisition price (e.g., par value or the low dividend discount value at which they were initially offered), not at the current fair market value.
  • Rationale:
    1. ESOP Financial Sustainability: ESOPs generally do not have large cash reserves beyond member contributions already used to acquire shares. If the company's actual share value has significantly appreciated, the ESOP would not have the funds to buy back shares at the higher market price.
    2. Affordability for New Members: Shares bought back by the ESOP need to be re-allocated or sold to new or existing employee members. If bought back at a high market price, they would need to be re-sold at that high price, making participation unaffordable for many employees and hindering the ESOP's revolving, self-sustaining nature.
  • The (Major Unlisted Construction Company) Case Study: A well-known case involving a major unlisted Japanese construction company (often referred to as the Takenaka Kōmuten case in commentaries, though not by name in the user's source material) illustrates the risks. This company's ESOP had been buying back shares from a large number of retiring "baby boomer" employees using an internally calculated, escalating share price, funded by substantial loans from the company itself. To eliminate the ESOP's large debt to the company (around ¥32 billion), the company eventually purchased approximately 7.9 million shares from the ESOP at a price (~¥4,000 per share) far exceeding its own book value for those shares (~¥500 per share). Tax authorities recharacterized the difference (~¥3,500 per share, totaling about ¥28 billion) as a "deemed dividend" from the company to the ESOP. Since the ESOP, as a partnership, is generally pass-through for tax, the ultimate incidence could be complex, but the immediate issue was that the company was held liable for withholding tax on this deemed dividend, amounting to roughly ¥5.6 billion, plus penalties, for a total of about ¥6.1 billion. The company ultimately lost its appeal at the Supreme Court in February 2014.
    The core issue highlighted was that the ESOP's buy-back price was not fixed at or near the original acquisition cost but was allowed to escalate based on internal valuations, creating a large artificial gain when the company effectively settled this by acquiring the shares at that inflated internal price.
  • Recommendation: To avoid such severe tax consequences and disputes, the buy-back price for ESOP shares in unlisted SMEs should ideally be clearly defined in the bylaws and linked to the original acquisition cost or a similar fixed, predictable value, rather than fluctuating with internal or market valuations.

Restrictions on Share Disposition During Employment

ESOPs often include rules restricting an employee's ability to freely sell or withdraw their interest before full retirement or a company IPO.

  • Rationale: For unlisted companies, this prevents unwanted dispersion of shares to third parties and avoids triggering complex buy-back obligations at potentially disputed valuations.
  • Legal Limits: Such restrictions must be "reasonable" and not constitute an undue restraint on property rights, otherwise they could be challenged as void against public policy (Civil Code, Art. 90).
    • For companies genuinely preparing for an IPO, a restriction until IPO can be seen as reasonable, as employees anticipate a capital gain. If there are no IPO prospects, very long-term restrictions might be problematic.
    • The Civil Code (Art. 256) limits agreements restricting the partition of co-owned property to five years (renewable). While ESOPs structured as partnerships holding shares might not directly fall under this if the members' interest is in the partnership rather than directly in co-owned shares, the principle of reasonableness for restrictions on realizing value remains.
    • One proposed standard for "reasonableness" (by Professor Kenzō Ichikawa, as referenced in Japanese legal commentary) suggests linking withdrawal rights/prices to length of service. For example, after a certain period (e.g., 5 years), an employee might be allowed to withdraw at a more favorable price, while earlier withdrawals are at acquisition cost, acting as a retention incentive.

Company Incentive Payments (Share Acquisition Subsidies - Shōreikin)

Companies often provide financial incentives (shōreikin) to encourage ESOP participation.

  • Typically, this is a percentage (e.g., 3-10%) of the employee's regular contribution to the ESOP.
  • Treatment:
    • Company: Deductible as an employee welfare expense.
    • Employee: Taxable as salary income, subject to withholding. It is generally not considered part of the base wage for calculating overtime or social insurance premiums.
  • Important Caution: These incentives should be linked to employee contributions, not to dividends paid on ESOP-held shares. Providing benefits related to the exercise of shareholder rights (like receiving dividends) could violate the Companies Act prohibition (Art. 120) against providing benefits for the exercise of shareholder rights.

Officer and Business Partner ESOPs

The ESOP model can be adapted for other stakeholders:

  1. Officer ESOPs (役員持株会 - Yakuin Mochikabukai):
    • For directors and officers of the company (and its subsidiaries).
    • Purpose: To enhance management consciousness and facilitate asset formation, aligning officer interests with the company.
    • Structure: Typically a Civil Code Partnership, separate from the employee ESOP.
    • No Company Incentives: Officers are generally not eligible for company-funded financial incentives (shōreikin) for participation, as this could be viewed as inappropriate preferential treatment not tied to employee welfare.
    • Valuation for "Related Party" Officers: If officers are considered related parties to the controlling owner for tax valuation purposes, shares transferred to their ESOP may need to be valued at a higher "general" valuation standard rather than the lower dividend discount value. This might necessitate separate ESOPs or share classes for related-party versus non-related-party officers.
  2. Business Partner ESOPs (取引先持株会 - Torihikisaki Mochikabukai):
    • For suppliers, customers, or other business partners (individuals or corporations).
    • Purpose: To deepen business relationships, foster mutual understanding, or as part of a strategic collaboration (e.g., small construction firms investing in a shared processing plant company, receiving preferential usage terms).
    • Cautions:
      • The sponsoring company must not abuse a dominant bargaining position in encouraging participation.
      • 25% Voting Rights Restriction Rule: If a corporate member of the business partner ESOP is itself more than 25% owned (in terms of voting rights) by the ESOP's sponsoring company or its subsidiary, that corporate member's voting rights in the sponsoring company (if any are held indirectly via the ESOP) may be restricted under Companies Act Art. 308(1).

Conclusion

Employee Stock Ownership Plans in Japanese SMEs represent a nuanced tool with significant potential benefits for both owners (primarily through inheritance tax savings and succession planning) and employees (through asset formation and participation). However, their successful and legitimate operation demands careful structuring, transparent governance that genuinely serves employee interests, and meticulous attention to critical details, especially the share buy-back mechanism upon employee withdrawal. Avoiding the pitfalls of "ghost" plans and ensuring fair, sustainable buy-back terms are paramount to realizing the intended advantages and avoiding costly disputes or adverse tax consequences. Officer and business partner ESOPs offer further avenues for strategic shareholding but come with their own specific considerations.