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ShareIn a classic case of one man's meat being another man's poison, while abolition of fringe benefit tax (FBT) is great news for employers, it is not so for employees -- especially those that receive employee stock options (ESOPs).
The reason is that many of those items that were earlier taxable as fringe benefits will now be in all probability subjected to perk tax in the hands of the employees.
For example, immediately after the Budget speech, several people had hailed abolition of FBT as something that will bring back the bang in ESOPs. However, what was lost sight of was the fact that while ESOPs will no longer be subject to FBT, now they will be subject to perquisite tax in the hands of the employees.
The perk tax will be the difference between the fair market value (FMV) of the shares on the date of exercise of the options less the exercise price. The story does not end here. Upon sale on such shares, capital gains tax will also be payable. Capital gains will be calculated on the difference between the sale price of the shares as reduced by the aforementioned FMV.
Note that this new law shall apply only in cases where the allotment or transfer of shares is made on or after April 1, 2009. If allotment is made prior to April 1, the same continues to attract FBT.
So what is important is not the date of announcement or date of grant or date of vesting or date of exercising the option, but the date of allotment or transfer of shares/ securities to employees. If shares are allotted or transferred on or after April 1, 2009, the same will be taxed as perquisite in employees' hands. This is even applicable if the option is vested with the employee or the option is granted or exercised before April 1.
Incidentally, the date of allotment here means the date on which the board of directors pass the necessary resolution for making the allotment.
Let's understand the above changes by means of an example.
Say Sanjay has been granted the option of buying 10 shares of his company at a price of Rs 500 per share on April 1, 2008. At this time, the market price of the share is Rs 700. However, the shares vest only on September 1. But Sanjay actually exercises his option to buy the shares only in April 2009 when the market price of the shares is Rs 1,000. Three months later, in July 2009, he sells the shares for a price of Rs 1,300 per share. Let's also assume that the price of the share on September 1 (the date of vesting), was Rs 800.
First and foremost, till Sanjay actually exercises the option, there is no tax payable -- this was the case during the earlier FBT regime and this remains so even now. Therefore, in terms of our example, tax liability will only arise in April 2009.
The difference between the market value of the shares on September 1, i.e. Rs 8,000 (10 shares x Rs 800) and Sanjay's purchase cost of Rs 5,000 (10 shares x Rs 500) would have been the fringe benefit value and consequently, FBT would be payable by Sanjay's employer on this Rs 3,000 @ 33.99%. This amount works out to Rs 1,020.
Now, the concept of adopting the vesting date to calculate the FMV has been done away with.
Instead, the market price as on the date of exercise has to be taken to calculate the perquisite value. Therefore, in terms of our example, the difference between the market value of the shares on April 1, i.e. Rs 10,000 (10 shares x Rs 1,000) and Sanjay's purchase cost of Rs 5,000 will be the perquisite value. This amount will be added to Sanjay's taxable income to arrive at the tax payable by him. Assuming Sanjay is in the highest tax bracket of 30.9% (surcharge is no longer applicable), the tax payable by him on the ESOP perk would be Rs 1,545.
Moving on, when Sanjay sells the shares, he will be liable to capital gains tax. The holding period of the shares for Sanjay has to be reckoned from the date the shares were allotted to him. However, earlier, his cost would be the FMV on the date of vesting and not what he has actually paid. In terms of our example, Sanjay's short-term capital gains (STCG) would work out to Rs 5,000 (Rs 13,000 - Rs 8,000) under the old rules.
Now, his cost would be taken as the FMV on the date of exercise and hence the STCG would have worked out to be Rs 3,000 (Rs 13,000 - Rs 10,000).
An interesting point to note here is that under both systems, the aggregate amount brought to tax (FBT / Perk + Capital Gains) remains the same i.e. Rs 8,000. However, the break-up differs, as in the FBT regime, the FMV as on the date of vesting was to be taken to arrive at the fringe benefit value whereas now the FMV on the date of exercise has to be taken to arrive at the perquisite value.
Another point that needs to be emphasised is that it is not as if the employee is being additionally burdened post Budget 2009.
Earlier, it used to be the FBT that was being recovered from the employee, now, the employee will be paying perk tax. As far as the employee is concerned, only the name of the tax has changed, tax incidence one way or another stays put.
Back to old rules
Actually, this dual layered taxing of ESOPs is not new. Till 1999-2000, ESOPs were being taxed similarly, only that the first stage, instead of being taxed as FBT in the employer's hands, was being taxed as a perquisite in the hands of the employee.
This also gives rise to a practical difficulty. The first stage i.e. the difference between the market value and the exercise price -- is only a notional profit -- the employee has not sold the shares yet to realise it. However, paying tax needed cold cash. The numbers in the example are small for ease of understanding, however, imagine if Sanjay had been granted 5,000 shares instead of 10. The perk value (notional profit) in such a case would work out to Rs 25 lakh and Sanjay would need to cough up a tax of Rs 7.72 lakh -- on income not yet earned. This resulted in the employee needing to sell the shares immediately, just to pay tax, and the entire raison d'etre of getting allotted stock options to participate in the growth of the company stands defeated.
The writer is director, Wonderland Consultants, a tax and financial planning firm. He may be contacted at sandeep.shanbhag@gmail.com
