Rules changed, but Esops still mighty taxing

Last week, we examined the tax incidence on employer provided accommodation along with an analysis of whether it is financially better to choose to receive house rent allowance (HRA) and consequently pay rent on your own or opt for employer provided accommodation.

This week, we shall review the income tax provisions in respect of yet another significant employee benefit —- employee stock option plans (Esops).

Readers may remember that earlier employee benefits were subject to fringe benefit tax (FBT). Now that FBT no longer applies, the earlier perquisite-based taxation has been brought in. So, in a sense, this is not a new move but a revert to the earlier system of taxation.

Esop is another significant employer granted benefit subject to the perquisite-based taxation system. In fact, it almost seems as if the authorities cannot quite make up their minds as to how they wish to tax shares given to employees by their employers on a concessional basis.

Having been subject to various changes in their valuation norms, the following is the latest position.

The perks 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.

And the story does not end here. Upon sale, 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.

Let’s understand this by means of an example.

Say Sanjay has been granted the option of buying 10 shares of his company at a price of Rs500 per share on April 1, 2008. At this time, the market price of the shares is Rs700 apiece.

The shares vest only on September 1, 2008, though Sanjay exercises his option to buy the shares only in April 2010 when the market price of the shares is Rs1,000 apiece.

Three months later, in July 2010, he sells the shares at a price of Rs1,300 per share. Let’s also assume that the price per share on September 1, 2008 (the date of vesting) was Rs800.

First and foremost, till Sanjay actually exercises the option, there is no tax payable —- this was the case during the earlier FBT regime and it remains so even now.

Therefore, in terms of our example, the mere act of granting the options (in April 2008) or vesting of the options (in September 2008) is completely tax neutral, i.e. Sanjay does not have to pay any tax on account of granting or vesting of the option.

Tax liability will only arise in April 2010, when he actually exercises the option.

Under the FBT regime (if FBT had been applicable) the difference between the market value of the shares on September 1, 2008, i.e. Rs8,000 (10 shares x Rs. 800) and Sanjay’s purchase cost of Rs5,000 (10 shares x Rs 500) would have been the fringe benefit value and consequently FBT would be payable by Sanjay’s employer on this Rs3,000 at the rate of 30%. This amount works out to Rs900.

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, 2010, i.e. Rs10,000 (10 shares x Rs1,000) and Sanjay’s purchase cost of Rs5,000 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% (surcharge is ignored for simplicity), the tax payable by him on the Esop perk would be Rs1,500.

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.

Earlier (during the FBT regime) his cost would have to be taken as 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 have worked out to Rs5,000 (Rs13,000 - Rs8,000).

Now, however, the cost of shares would be taken as the FMV on the date of exercise and hence the STCG would work out to be Rs3,000 (Rs13,000 - Rs10,000).

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. Rs8,000.

However, the break up differs as under 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 the new rules.

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.

Practical difficulty
Incidentally, I wonder if the authorities realise that this perk-based tax system sometimes 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 yet sold the shares to realise it.

However, paying tax requires 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 Rs25 lakh and Sanjay would need to cough up a tax of Rs 7.50 lakh —- on income not yet earned.

This more often than not results 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 atsandeep.shanbhag@gmail.com.