How taxes affect your ESOP gains

Budget 2007 brought employee stock options in the fringe benefit tax net. Find out why this should also be of concern to employees.

Amitabh Singh        Print Edition: December 13, 2007

What happens when you mix corporate planning with financial wizardry and HR strategy. The result is employee stock option plans (Esops). Esops, under which key employees are offered equity shares of their company as an incentive to remain in the company, have been used extensively by the IT industry to attract and retain talent.

However, Budget 2007 upset the apple cart of the industry when it was announced that Esops offered by a company would be sub -ject to Fringe Benefit Tax (FBT).

Jargon Buster
Grant: An option or a right given to the employees to buy shares of the company in the future
Exercise price: A predetermined price at which the employee is offered shares by the employer
Option: The portion of the total grant that an employee exercises to choose/select/hold
Waiting period: The holding period on completion of which the employee has the right over his shares
Exercise: Converting the options granted into shares on payment of the exercise price is known as exercise of the option

Though corporate houses have more or less reconciled themselves to this reality, there is still a lot of confusion about the implications of the new rule among employees. Let us understand the modalities of a basic Esop, the tax implications prior to the recent amendment in the Income Tax Act, 1961 and the tax laws as they now stand.

The laws governing Esops have been modified several times in the past two decades. Starting 1 April 1999, employees were taxed on the difference between the exercise price and fair market value (explained later) of shares as on the date of exercise. The difference was treated as a “perquisite” and was included in the salary income for tax purposes.

Also, employees were taxed on capital gains arising at the time of sale of shares on the difference between the sale price and fair market value (FMV) on the date of exercise of the option. This resulted in double taxation in the hands of the employees.

For simplifying the system and enforcing a single stage tax mechanism, the central government amended the tax laws with effect from 1 April 2000 to tax Esops only at the time of sale as capital gains. Accordingly, there was no case for a perquisite being paid to the employee at the time of exercise of stock options if these complied with the central government’s guidelines (also generally referred to as Qualified Esops). However, employees were subjected to capital gains tax at the time of sale of shares. For non-compliant Esops the double tax incidence continued.

What happens now? The amendments introduced by the Finance Act, 2007, have shifted the focus from employee taxation to employer taxation, as Esops now fall within the ambit of the FBT. The shares allotted to an employee post 1 April 2007, under Esops will now be treated as a fringe benefit offered to the employee by the company.

Therefore, the employer will be liable to pay FBT on the difference between the FMV of the shares on the date of vesting and amount recovered from the employee. The FBT rate on this difference is the normal corporate tax rate of 33.99%. Even if the options have been granted earlier, they would attract FBT if shares are allotted on or after 1 April 2007.

How FBT is calculated on ESOPS
Suppose a listed company granted stocks options to an employee in March 2007
Grant: 10,000
Granted on: 15 March 2007
Vesting date: 1 April 2008
Exercise date: 25 October 2008
Shares allotted on: 26 December, 2008
Exercise price: Rs 50 per share
FMV (as defined by CBDT): Rs 100 per share
Value of Esops for the purposes of FBT: Rs 5,00,000 [10,000 x 50 (Rs 100 – Rs 50)]
FBT payable by employer: Rs 1,69,950 [Rs 5,00,000 x 33.99%]
The employer could pass on the FBT burden to the employee by restructuring the pay package to account for the Rs 1,69,950 FBT outgo.

Computing fair market value

How does one determine the FMV of shares allotted under Esops. The Central Board of Direct Taxes (CBDT) guidelines say that if the company’s shares are listed on a recognised stock exchange, the FMV would be the average of the opening and closing price of the share on the vesting date. In case the shares are listed on more than one exchange, the price on the bourse which records the highest volume in that share on that date will be considered.

If there is no trading in the share on any recognised stock exchange on the date of vesting of option, the FMV shall be the closing price on a date closest to the date of vesting of option and immediately preceding such date on the exchange.

In case shares are listed on more than one bourse, the exchange with the highest volume in that share on that date will be considered. In case on the date of vesting of options, the share is not listed on a recognised stock exchange, the FMV shall be the value as determined by a category 1 merchant banker. No specific valuation methodology has been prescribed for this purpose.

But if your employer has to bear the FBT obligations, why should you as an employee worry? The reason is simple. The tax laws specifically provide that an employer can recover the FBT from the employee. This can be done by tweaking the employee’s compensation package. This is explained through an example on the following page (see box: How FBT is calculated).

Computation of capital gains on sale of shares by the employee
Sale proceeds as on 25 January 2010Rs 15 lakh
Cost of acquisition (FMV as defined by CBDT)Rs 10 lakh
Long-term capital gainsRs 5 lakh
Has STT been paidYes
Tax on profitsNil

Tax on profits from sale

Employees will be subject to capital gains tax upon sale of shares. In those cases, where FBT has been paid, the capital gain will be the difference between the sale consideration and the FMV as on the date of vesting of the option (this will be treated as the cost of acquisition).

If shares are held for more than a year, then the capital gains arising on sale are long-term capital gains. Long-term capital gains are tax exempt if the transaction is routed through a recognised stock exchange and securities transaction tax (STT) has been paid on the sale. Assuming that the employee sells the shares allotted on 26 December 2008 after holding for a year on 25 January 2010 and pays STT, he will not have to pay any tax on the profits made.

If no STT is paid, long-term capital gains would be taxed at 20% (plus applicable surcharge and edu -cation cess) and benefit of indexa -tion on cost of acquisition would be available. Alternatively, one can choose to pay long-term capital gains at 10% (plus applicable surcharge and education cess) on the capital gain computed without indexation benefit.

But, if shares are held for less than one year from allotment, the resulting short-term capital gain will be taxed at 10% (plus surcharge and education cess), if STT has been paid upon sale. In other cases, short-term capital gains would be taxed at 30% (plus the applicable surcharge and education cess).

This tax will need to be paid either as advance tax by the employee concerned directly or he or she can disclose such capital gains to the employer and authorise that tax be withheld from salary income after taking into consideration the additional taxable capital gains component.

For employers the recently introduced notification which lays down the criteria for determination of FMV is not free from ambiguity. For instance, if the employer company is not listed in India, or the Esops of the global parent or foreign affiliate cover the employees of their subsidiaries in India, only a category 1 merchant banker can be engaged to determine the FMV of the shares granted under the plan. No valuation guidelines have been prescribed in such cases. This could result in tax litigation in the future.

However, it should be remembered that while the FBT burden can be passed on to the employee, the employee will not have to face any litigation related to the fringe benefit tax.

The author is a tax partner, Ernst and Young

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