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ESOP’s fables and the big change therein

The Finance Bill, passed last week by the Parliament, incorporated a significant change pertaining to tax on employee stock option plans (ESOPs).

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The Finance Bill, passed last week by the Parliament, incorporated a significant change pertaining to tax on employee stock option plans (ESOPs).

Readers would remember that Budget 2007 had proposed to impose fringe benefit tax (FBT) on ESOPs or stock options. While the FBT still remains, there has been a change in the value to be adopted for calculating the tax. Now, instead of the fair market value (FMV) at the time of exercise of the option, the FMV on the date of vesting will be adopted to calculate the FBT liability.

To appreciate the implication of this change, let us understand what is meant by the term ‘vesting’ in the context of ESOPs.

The concept of vesting

Note that getting stock options is not the same thing as getting shares of the stock. An option is a right and not an obligation to purchase the shares. You purchase the shares by exercising the options. Generally, this right to exercise is spread over a number of years. In other words, you must earn the right to purchase those shares; you need to become vested in those shares.

In terms of an example, say at the beginning of the year, XYZ Ltd grants its employees options to buy 100 shares of the company at Rs 200 per share. The employees can buy 25% of the shares at the end of the first year, another 25% at the end of the second year and so on over a four-year period. This means, the shares are being vested one-fourth at the end of every year. In other words, though options have been granted at the beginning of the year, it is only at the end of each year that the employee is being vested with one-fourth of the shares he is entitled to.

The vesting schedule determines when the employee gets control over his options. Once vested, the employee still has to exercise the options at the exercise price during the exercise period in order to become the owner of the shares. The vesting schedule, exercise price and the exercise period are all specified in the stock option plan.

Tax timing has not changed

Note that the vesting date does not have any influence on when the FBT becomes payable. The liability to tax will still be attracted on the date of allotment or transfer of the shares.

Let’s understand all this in terms of an example. Say Rahul has been granted the option of buying 10 shares of his company at a price of Rs 500 per share on April 1, 2007. At this time, the market price of the share is Rs 700. However, the shares vest only on September 1. But, Rahul actually exercises his option to buy the shares only in January 2008, when the market price of the shares is Rs 1,000. Six months later, in July 2008, 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.

Given this, let’s see what the situation was earlier and how it has changed. First and foremost, till Rahul actually exercises the option, there is no tax payable whatsoever either by the employer or by the employee. This was the treatment earlier and it still remains. Therefore, in terms of our example, FBT liability will only arise in January 2008.

The difference between the market value of the shares on the September 1, i.e., Rs 8,000 (10 shares x Rs 800) and Rahul’s purchase cost of Rs 5,000 (10 shares x Rs 500) will be the fringe benefit value and consequently, FBT will be payable by Rahul’s employer on this Rs 3,000 @ 33.99%. This amount works out to Rs 1,020.

Earlier, before the changes were incorporated, the FBT would have been calculated on the difference between the market price on the date of exercise (Rs 1,000) and the purchase price. This would have worked out to 33.99% of Rs 5,000 (10 shares x Rs 1,000 - Rs 500) i.e., Rs 1,700.

But, the story does not end here. Moving on, when Rahul sells the shares, he will be liable to capital gains tax. The holding period of the shares for Rahul has to be reckoned from the date the shares were allotted to him. However, his cost would be the FMV on the date of vesting and not what he has actually paid.

In terms of our example, Rahul’s short-term capital gains (STCG) would work out to Rs 5,000 (Rs 13,000 - Rs 8,000), whereas earlier, the STCG would have been Rs 3,000 (Rs 13,000 - Rs. 10,000).

FBT to be recovered from the employee

In a significant move, now an employer has been legally empowered to recover the FBT from the employee. Though this has been legally allowed only in the case of ESOPs, FBT has essentially taken the form of a surrogate tax on the employee. Other items already under the ambit of FBT are being in any case recovered from the employee either by paying the employee net of FBT liability or by including FBT payable in the cost to company (CTC) computation. ESOP compensation would also suffer the same fate. In fact, the legal recovery of the FBT will actually cause an accounting problem for employers as the law does not specify the treatment to be given to the amount recovered from the employee.

Secondly, 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 needs cold cash. The numbers in the example are small for ease of understanding. However, imagine if Rahul had been granted 10,000 shares instead of 10. The notional profit would work out to Rs 30 lakh and Rahul would have needed to cough up a tax of Rs 10.20 lakh - on income not yet earned. This resulted in the employee needing to sell the shares, just to pay tax, and the entire raison d’etre of getting allotted stock options to participate in the growth of the firm stood defeated.

ESOPs allotted last year could be taxed

When it was announced in the Budget that ESOPs would be taxed, it was observed that several firms rushed to complete their stock option plans before March 31 to avoid the new tax. In this regard, the finance ministry has clarified that FBT will apply on all ESOP offers where the physical transfer of shares was completed after March 31, though the employee may have exercised the option before. In other words, only those cases where the shares have been transferred or allotted to the employee before March 31 would escape FBT and in all those cases where shares under ESOPs have been transferred after April 1, even though option was exercised before March 31, 2007, will have to bear FBT.

sandeep.shanbhag@gmail.com

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