The Hindu Business Line : Is it the end of ESOPs?

Among the many controversial proposals in this year's Budget, the one relating to the levy of the Fringe Benefit Tax on Employee Stock Option Plans is fraught with difficulties for the administration, the company and the employee.

In Para 179 of the Budget speech, the Finance Minister announced his proposal to bring ESOPs under the FBT. The value of the fringe benefit will be determined, in accordance with a prescribed method, on the date of excise of the option.

The taxing of stock options had always presented problems. All along it was considered that such options should be taxed in the hands of the employee only. There were doubts regarding the point and the rate at which the gains from the exercise of such options should be brought to tax. The Finance Act, 1999 inserted proviso to sub-clause (iiia) of Section 17(2) of the Income-Tax Act, 1961, providing for taxing of the options in the year in which the option is exercised.

GUIDELINES

But the Finance Act, 2000 deleted the sub-clause and brought in a proviso to exempt stock options from tax provided they are in accordance with prescribed guidelines. The guidelines were laid down in Notification No 323/2001 of October 11, 2001.

The position before the Amendment is that employees exercising their option to subscribe to shares are not required to pay tax at the time of exercise of such option. The benefit acquired at the time of exercise of option is not treated as a perquisite. However, the employee is required to pay capital gains tax at the time of sale of such shares. If he holds it for more than 12 months, long-term capital gains tax will not be levied and the Securities Transactions Tax will be levied on the listed shares. The company had nothing to do with this exercise.

TAX ON DIFFERENCE

All this is now set to change. Hereafter, if the amendment is carried through, the employee will have nothing to do with the taxing of the stock options. The difference between the fair market value of the shares and the amount actually paid by the employee will be treated as a fringe benefit, taxable in the hands of the employer at 33.99 per cent (corporate tax rate + surcharge + cess).

The Finance Bill has omitted the Proviso to sub-clause (iii) of clause (2) of Section 17 which provides that the value of any benefit provided by the company free of cost or at a concessional rate to the employee under the ESOP will not be treated as a perquisite as per the Central Government notification referred to above.

The Finance Bill also covers sweat equity shares issued to Promoters and Directors. The fair market value of the shares, on the date of exercise of the option, as reduced by the amount actually paid by the employee, shall be the value of the fringe benefit. It has generally been understood that the FBT is a levy on the company, which confers a benefit on a group of employees. The justification was that it is the whole body of employees that stand benefited and it will not be possible to identify particular employees as recipients of fringe benefits.

The present amendment strikes this argument at the very bottom. Not all employees derive benefit from the stock options awarded by companies. These awards are limited to talented senior executives who make a difference to the net-worth of the company. These schemes became popular in the past 15 years and American models have been copied in India. Pharma companies and the IT industry depend heavily on ESOPs to retain talent and to prevent attrition.

The present scheme of taxing ESOPs at the time of sale by the employee in his hand has been in vogue for the past five years. The taxing of the same in the hands of the company and that too at the highest rate will deal a severe blow to the corporate sector. It is feared that ESOPs will die a natural death. Companies may not be inclined to issuing stock options if they are to bear the burden of taxation.

VALUATION PROBLEM

Valuation will also present a problem. The Securities and Exchange Board of India has issued regulations for working out the value of sweat equity shares in the hands of unlisted companies. As long as stock options are issued by listed companies, there can be no problem.

As with the enhancement of the Dividend Distribution Tax from 12.5 per cent to 15 per cent, the move to shift the tax incidence on ESOPs from the employee to the employer has resulted in several leading companies rushing to issue and allot stock options in March 2007 itself to escape the levy of the FBT. The new levy is proposed to take effect from accounting year April 1, 2007, assessment year 2008-09.

(The author is a former Chief Commissioner of Income-Tax.)

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