The Hindu Business Line : Re-jigging ESOPs for the FBT era

Given that the taxing event of the ESOP is the employee exercising the option, it makes sense not to do so, but to look for alternate ways of capturing the value. Imaginative employers can re-engineer ESOP without offending the SEBI guidelines. Imaginative employers can re-engineer ESOP without offending the SEBI guidelines.

The Fringe Benefit Tax on Employee Stock Option Plans is now reality and tax at 33.99 per cent will have to be paid by the employer at the point of exercise of the option and legally passed on to the employee. This position will hold at least till the next Finance Bill.

The second reality is that the employee for calculating the capital gains will not treat FBT as part of cost of acquisition of the shares, as the vesting price shall be treated as the cost of acquisition. This deeming provision will also render it difficult for the employee to claim any interest paid on funds borrowed for acquiring the shares.

And the third reality is that the employee will have to outlay cash not only for the vesting price but also for the tax on the unrealised fringe benefit, at the point of exercise of the option. This, apart from liquidity issues, exposes the employee to the FBT impact on price risk, as no adjustment is possible in the FBT collected, in the event of the share price coming down, post exercise, below the vesting price.

Given that the taxing event is the employee exercising the option, it makes sense not to exercise the option, and to look for alternate ways of capturing the value without exercise of the option. And this is precisely where imaginative employers can re-jig the ESOP without offending the SEBI guidelines.

It is not anybody's case that ESOP should not be taxed. The salaried class is the most disciplined for whatever reason. Unfortunately, FBT on ESOP will hit them harder than a normal salary or perquisite, not only due to the flat corporate rate, but also due to the inflexible structure of FBT. This one singular step of subjecting ESOP to FBT makes it unattractive. Corporate India has no alternative to this instrument of incentive, at least in the short run, and to this extent it makes sense to them as well to re-work the schemes.

Rearranging to achieve payment of tax along a more acceptable structure, that is, as applicable to individual employees, as part of the overall tax basket, and at the point of realisation of the gains, appears possible. Mercifully, the regulators have given that little space in the existing guidelines, by not saying what is not permitted in the ESOP schemes.

The extant guidelines were issued by SEBI in the June 1999 when neither the ESOP was subjected to taxes nor was the depth of the options market adequate. The guidelines thus focussed on restricting the transfer of the benefits/how the minimum-vesting price, the minimum waiting period and the process to be gone through in getting the scheme approved by the shareholders. The Tax Department, by and large takes the SEBI guidelines compliant scheme on record.

Listed below are some broad areas where the employer/employee can take steps to regain at least in part the charm of ESOP:

The SEBI guidelines were more for the purpose of protecting the interest of the shareholders and to some extent the employees. Taxation was not the objective. Even the current FBT taxation fails to recognise that the ESOP is more valuable to the employee from the point of un-expired period and upside potential than the share per se. Exercise of the option merely crystallises the value, and that too imperfectly. For those familiar with the way options value decays it should be clear that it is never linear perfectly.

The current ESOP guidelines do not prohibit buying back or cancellation of the options by mutual consent, post vesting (and obviously before exercise) on payment of a good and justifiable price. The employer should consider amending the ESOP scheme to incorporate suitable provisions for buy-back or cancellation, and a method to value such cancelled options.

The income will certainly be taxed in the hands of the employee, but neither as FBT nor on a notional basis.

The employer is also in a position to charge it off, more easily than charging off ESOP as expense.

The shareholders will like it, as the potential dilution is avoided.

Selling a call at a higher strike is a fine way of capturing the upside of the share without actually exercising the option: but a two words of caution:

Ensure that the SEBI requirement of not alienating the option is complied with. An employee can write under normal circumstances a call, without necessarily having the share/lower strike option with him (naked short position), so long as he understands the risk, and the broker is willing to take the risk with appropriate margins. An option sale contract can be done as a standalone transaction, though the employee and the counter party will have the comfort of the vested option, in the back of their mind.

The depth in the term option market is virtually non-existent, and hence the need to approach an appropriate institution/investment bank, on a collective basis to gain traction. One should also ensure that insider-trading guidelines are not violated.

The employer's role will be to take notice of this possibility, post vesting, through the ESOP scheme itself. In fact, to develop a long-term options market (which will play a crucial role in the opening of pension funds market), SEBI should proactively permit sale of vested options, now that the ESOP is under the tax scanner.

Vesting at market pric

A third alternative will be to vest the shares at the fair market price on the date of vesting. This will make the tax value of fringe benefits nil, and therefore no FBT. This will also virtually reduce the value of ESOP to be written off to nil (ICAI guidelines goes back to the fair market on the date of issue of option, which on this basis will also be nil). However, the option will have a longer life to expiry and two things can happen over the life of the option:

Prices go up, and the employee can crystallise, and sell, and end up paying only short-term capital gains. The employee enjoys the advantage of being able to capture the upside potential over a longer period without either investing or the downside of FBT payment. Coupled with the employer buy-back option detailed above, the time value will emerge the big winner.

Price of the share could go down consistently, which will give the employer an opportunity to buy-back based on time value. The employer could also consider re-issue of options at a lower strike to reflect the market, against the option that has gone under water.

These of course will need to be worked through the scheme, with a fine balance between employee interest/shareholder interest and the requirements of law. At least for now, all is not lost and there is some reason to cheer. If not the Finance Minister, the employer can walk that extra mile for the employee!

(The author is partner of Managing Consortium, a Chennai-based management consulting firm. E-mail: pbramanujam@yahoo.com)