Employee Share Ownership Trust Design for Family Businesses

Hong Kong’s Inland Revenue Department (IRD) issued Departmental Interpretation and Practice Notes (DIPN) No. 60 in July 2025, clarifying the tax treatment of employee share ownership trusts (ESOTs) for the first time in over a decade. This long-awaited guidance, effective from the year of assessment 2025/26, resolves a critical ambiguity that had chilled the adoption of ESOTs among Hong Kong-listed family businesses and private groups: whether contributions to a trust for employee share acquisition qualify as deductible business expenses under Section 16 of the Inland Revenue Ordinance (IRO, Cap. 112). The DIPN explicitly states that contributions are deductible only if the trust is structured as a “qualifying employee share scheme” under Section 9A of the IRO, and only to the extent the shares are beneficially owned by employees within 12 months of allocation. For family-controlled enterprises — which constitute over 70% of the 2,600+ companies listed on the Main Board of Hong Kong Exchanges and Clearing (HKEX) — this creates a binary choice: redesign existing ESOTs to meet the 12-month vesting and beneficial ownership test, or lose the tax deduction. Concurrently, HKEX’s Listing Rule amendments in 2024 (Chapter 17) now require all listed issuers to disclose the full economic and voting interest held by any ESOT in annual reports, exposing structures that previously operated with minimal transparency. The intersection of these two regulatory shifts — IRD tax clarity and HKEX disclosure mandates — makes 2025-2026 the most consequential period for family business ESOT design since the introduction of the Employee Share Award Scheme regime in 2010.

The Tax Efficiency Imperative: DIPN 60 and the Section 16 Deduction

Qualifying Employee Share Schemes Defined

DIPN 60 establishes three criteria for an ESOT to qualify as a scheme under Section 9A of the IRO. First, the trust must be established exclusively for the benefit of employees and their dependents, with no residual benefit flowing back to the settlor or its connected persons. Second, shares must be acquired by the trust within 6 months of the employer’s contribution, and allocated to individual employees within 12 months of acquisition. Third, the employee must be the beneficial owner of the shares at the time of allocation — meaning the trust cannot retain voting rights or dividend entitlements beyond a temporary administrative period not exceeding 30 days.

The IRD’s position, as articulated in DIPN 60 paragraph 23, is that failure to meet any of these conditions transforms the contribution from a deductible business expense into a capital expenditure or a distribution of profits. For family businesses where the founding family often retains control through a trust structure, the 12-month allocation window is particularly restrictive. Many existing ESOTs in Hong Kong operate on a phased vesting schedule of 3 to 5 years, with shares held in trust until full vesting. Under DIPN 60, contributions to such trusts would be non-deductible unless the trust can demonstrate that the shares are “beneficially owned” by the employee from the date of allocation, even if legal title remains with the trustee.

Practical Implications for Deductibility

The financial impact is material. A family business contributing HKD 50 million annually to an ESOT would, under the standard 16.5% profits tax rate, lose HKD 8.25 million in tax deductions per year if the trust does not meet the Section 9A criteria. Over a 5-year vesting schedule, this represents HKD 41.25 million in additional tax liability — a cost that directly reduces the economic incentive for using an ESOT as a retention tool.

Hong Kong’s profits tax system under Section 16(1) of the IRO allows deductions for “outgoings and expenses… wholly and exclusively incurred in the production of chargeable profits.” The IRD has historically treated employee remuneration as deductible, but contributions to a trust — where the employee does not immediately receive the shares — fell into a grey area. DIPN 60 resolves this by creating a clear bright line: contributions are deductible only when the employee’s beneficial interest is established within 12 months. For family businesses that use ESOTs to align long-term incentives with succession planning, this means the trust deed must be restructured to provide for immediate beneficial ownership upon allocation, with legal title held by the trustee as bare nominee.

HKEX Listing Rule Chapter 17: Disclosure and Control

Mandatory Disclosure of Economic and Voting Interests

HKEX’s Listing Rule amendments effective 1 January 2024 introduced Chapter 17, which requires all listed issuers to disclose in their annual reports the total number of shares held by any employee share scheme trust, the percentage of issued shares represented, and — critically — the voting rights attached to those shares. For family-controlled listed companies, this creates a transparency obligation that directly impacts control structures.

Under Listing Rule 17.03, an ESOT that holds more than 5% of the issuer’s issued shares must be disclosed as a substantial shareholder under Part XV of the Securities and Futures Ordinance (SFO, Cap. 571). If the trustee exercises voting rights at the direction of the family settlor — a common arrangement in Hong Kong family businesses — the family’s deemed control under the SFO’s attribution rules may require a formal disclosure of their interest in the ESOT shares. The HKEX’s guidance note of March 2024 (HKEX-GL124-24) clarifies that where the trust deed gives the settlor or its nominated directors the power to direct voting, the ESOT shares are deemed to be held by the settlor for SFO purposes.

Impact on Family Control Structures

For a typical family business where the founding family holds 40-50% of listed shares, an additional 5-10% held through an ESOT with directed voting can push effective control above 50%, triggering mandatory general offer obligations under the Takeovers Code (SFC Code on Takeovers and Mergers, Rule 26.1). The SFC’s 2023 consultation paper on the Takeovers Code specifically addressed this risk, proposing that ESOT shares with directed voting be aggregated with the family’s holdings for the 30% threshold calculation. While the final code amendments in 2024 did not adopt this proposal, the HKEX’s disclosure requirements under Chapter 17 now make it impossible to hide the arrangement.

Family offices and private trust advisors must therefore review ESOT trust deeds to ensure that voting rights are either (a) passed through to employees on a pro-rata basis, or (b) held independently by the trustee without direction from the settlor. The latter approach — an independent trustee exercising voting rights in the best interests of beneficiaries — is the safer route from a control perspective, but it requires the family to cede direct influence over the ESOT block, which may be unpalatable for succession planning purposes.

Structural Options for Family Business ESOTs

The BVI VISTA Trust Structure

The British Virgin Islands’ Virgin Islands Special Trusts Act (VISTA, 2003) provides a statutory framework that allows a family business to retain control over shares held in trust while still meeting the IRD’s beneficial ownership requirements. Under a VISTA trust, the trustee holds legal title but the board of directors of the underlying company (typically family members) retains management control. For an ESOT, this structure can be adapted so that the VISTA trust holds the shares for the benefit of employees, but the employees are designated as the “beneficiaries” with immediate beneficial ownership upon allocation.

The key advantage for Hong Kong family businesses is that a VISTA trust can satisfy DIPN 60’s requirement that the employee be the beneficial owner at the time of allocation, while the trust deed can provide that the trustee’s voting rights are exercised in accordance with the directors’ instructions — effectively preserving family control. The IRD’s position in DIPN 60 paragraph 17 states that “beneficial ownership” is determined by reference to the employee’s right to dividends, voting, and capital appreciation, not by the location of legal title. A VISTA trust that passes these economic rights to the employee upon allocation would therefore qualify, provided the 12-month allocation requirement is met.

The Hong Kong Trust with Independent Trustee

For family businesses that prefer a Hong Kong-domiciled structure, the Trustee Ordinance (Cap. 29) and the Perpetuities and Accumulations Ordinance (Cap. 257) provide the legal foundation. The critical design choice is the trustee’s independence. Under Section 41A of the Trustee Ordinance, a trustee must act in the best interests of the beneficiaries. If the trust deed directs the trustee to follow the settlor’s instructions on voting, this may conflict with the trustee’s fiduciary duties and could be challenged by beneficiaries or the IRD.

A Hong Kong ESOT with an independent trustee — such as a licensed trust company regulated by the Hong Kong Monetary Authority (HKMA) under the Trustee Ordinance — offers the cleanest path to DIPN 60 compliance. The trustee would hold legal title, allocate shares to employees within 12 months, and pass through voting rights and dividends to the employees. The family’s control is preserved through a separate shareholders’ agreement or by retaining a majority of shares outside the ESOT. This structure avoids the SFO attribution issues because the trustee exercises voting rights independently, not at the family’s direction.

The Cayman Islands STAR Trust

The Cayman Islands Special Trusts (Alternative Regime) Law (STAR, 1997) offers another option, particularly for family businesses with cross-border operations. A STAR trust allows the trust to have both beneficiaries (employees) and enforcers (family members or a designated person) who ensure the trust is administered according to its terms. This bifurcation of roles means the family can retain oversight through the enforcer while the employees receive the economic benefits.

For Hong Kong tax purposes, the STAR trust must still comply with DIPN 60’s 12-month allocation and beneficial ownership requirements. The enforcer’s role does not affect the employee’s status as beneficial owner, provided the employee receives dividends and voting rights upon allocation. The Cayman Islands’ absence of direct taxation means there is no tax leakage at the trust level, making it a tax-neutral vehicle for holding shares in a Hong Kong-listed company.

Regulatory Compliance and Reporting Obligations

SFC Licensing Requirements for ESOT Trustees

Any ESOT trustee that holds shares in a Hong Kong-listed company and exercises voting rights may be deemed to be carrying on a “business of dealing in securities” under the SFO, requiring a Type 1 license from the SFC. The SFC’s 2022 guidance on employee share schemes (SFC-GL122-22) clarifies that a trustee that merely holds shares as bare nominee and passes through voting rights to employees is not engaged in regulated activity. However, a trustee that exercises discretionary voting authority — even if directed by the settlor — may be considered to be “dealing in securities” and require licensing.

For family businesses using an independent trust company regulated by the HKMA, the trust company typically already holds a Type 1 license. For private trustees — such as a family member acting as trustee — the SFC’s view is that if the trustee exercises voting rights without specific employee instructions, a license may be required. The practical solution is to include a mechanism in the trust deed requiring the trustee to seek employee instructions on all voting matters, thereby preserving the bare nominee character.

HKEX Annual Reporting Requirements

Under Listing Rule 17.04, the annual report must include a table showing the number of shares held by the ESOT at the beginning and end of the financial year, the number of shares allocated to employees during the year, and the number of shares forfeited. For family businesses, this disclosure creates a public record of the trust’s holdings, which may be used by minority shareholders to assess the family’s effective control.

The HKEX’s 2024 guidance on Chapter 17 also requires disclosure of any “material terms” of the trust deed, including the identity of the trustee, the voting arrangements, and any restrictions on transfer. For a family business that uses a VISTA or STAR trust, these terms must be disclosed in the annual report, potentially revealing the family’s control mechanisms to competitors and the public. The trade-off between tax efficiency and confidentiality must be carefully weighed.

Actionable Takeaways

1. Redesign all existing ESOT trust deeds before the year of assessment 2025/26 to provide for immediate beneficial ownership upon allocation and a 12-month maximum holding period, or forfeit the Section 16 deduction under DIPN 60.

2. Restructure voting rights in the trust deed to pass through to employees on a pro-rata basis, or engage an independent HKMA-regulated trust company as trustee, to avoid SFO attribution and mandatory general offer obligations under the Takeovers Code.

3. Review the ESOT’s shareholding percentage against the 5% substantial shareholder threshold under Part XV of the SFO, and prepare SFC disclosure filings if the trust’s holdings — together with the family’s direct holdings — exceed 5% of the issuer’s issued shares.

4. For family businesses with cross-border operations, evaluate a BVI VISTA or Cayman STAR trust structure to preserve family control through an enforcer or director mechanism while meeting the IRD’s beneficial ownership test.

5. Ensure the ESOT trustee holds an appropriate SFC license (Type 1) or operates as a bare nominee passing through voting instructions, to avoid regulatory enforcement action under the SFO.