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Anomalies and elegance
October, 26th 2007
Income tax is a complex law but taxation of ESOPs has seen the most complexities. New rules for valuation have been introduced after a long delay. When provisions are quickly introduced, they are messy. When a longer time is taken, they are complex. But when a very long time is taken such as for the present rules for ESOPs valuation, they are surprisingly, and perhaps unintentionally, elegant! But they have anomalies too.
Summarily stated, a simple scheme has been provided. The ESOPs will be valued at the quoted market price as on the vesting date with some simple adjustments. For unlisted companies, the valuation will be done by merchant bankers. In essence, thats all to the rules and no wonder that they barely fit a page.
Some adjustments to the quoted value on stock exchanges are provided. Firstly, the average of the opening and closing price on the vesting date will apply. Small adjustments are made where the shares are quoted on more than one exchange. Where there is no quotation on the date of vesting, the nearest preceding date will be used. The elegance and insight go a little further even in these details. For example, when one takes a preceding date, it is only the closing price that is taken, unlike the average price taken otherwise. In fact, when the date of vesting is to be taken, it is clarified further that when there are two opening quotes one for sell and another for buy, the sell quote would be taken. Again, thus, where complexity is needed, it is provided, but otherwise not. Praise is to be granted where it is due.
For unlisted companies, as stated earlier, it is simply stated that the value would be determined by Sebi-registered merchant bankers.
And I also disagree with views widely expressed that rules and methods should have been provided for such valuation. If even the Nobel-winning Black-Scholes formula has been rejected and simpler and elegant market price adopted for listed companies, why should valuation for unlisted companies be more complex? And why should one try to second-guess merchant bankers who are expected to be experts in this field? Even the Supreme Court has repeatedly upheld the valuation done by experts such as chartered accountants and the methods adopted by them. While on this, a serious anomaly even an absurdity is that chartered accountants (and this author is one) are not permitted to make this valuation. It is unfair because chartered accountants are also valuation experts, as recognised repeatedly by the Supreme Court. It is absurd because merchant bankers have relevance for listed companies and not unlisted companies. This anomaly is unforgivable and is sure to be rectified, howsoever grudgingly.
The major anomaly arises on account of divorcing the date of valuation and the date of charge and recovery of tax, though this perhaps is also the fault of the scheme. For valid reasons, it is provided that the value of the ESOPs for FBT will be taken as on the date of vesting, but the charge would be made if and when the ESOPs are exercised. Thus ESOPs would be taxed only if exercised. However, this wrongly assumes that share prices will always increase after the vesting date. If the prices decrease, there would be undue taxation and other anomalies. For example, if the exercise price is Rs 500, the price on vesting date Rs 1,100, and the value on exercise and sale Rs 1,500. The FBT would be levied on Rs 600 (Rs 1,100 minus Rs 500) and capital gains, if any, on Rs 400. This would appear fair as the price has increased. But what if the price falls to Rs 800? The FBT would still be levied at a 30 per cent rate on Rs 600 but no adjustment would be provided for the decrease. The employee would get a capital loss but for most employees, this would be a useless loss unless they have some capital gains to adjust it against. Thus, there would be a tax of Rs 180 on a gain of Rs 300!
Worse, if the company does not recover the FBT from employees, the employee may happily exercise ESOPs at even lower prices. Thus, in the above example, even if the market price on the date of exercise was Rs 600, the employee would still exercise and pocket a gain of Rs 100 (tax free), though even the tax is higher than such gain! Such short-sightedness also arises when one lives in bullish times!
To conclude, some reversal and amendments are required in these rules and scheme, which otherwise have merits of simplicity, insight and elegance.
Jayant Thakur
The writer, a chartered accountant
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