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ESOP norms: Many issues await clarification
October, 27th 2007

Globally, mobile employees, both inbound expatriates and outbound assignees, may have to face the prospect of economic double taxation, cautions Mr Vikas Vasal, Executive Director, KPMG, commenting about the latest guidelines from the taxman on the valuation of ESOPs (employee stock options) for the purpose of FBT (fringe benefit tax).

In India the tax would be paid by the employer, while in the foreign country, the employee may be liable to pay tax on the same benefit, reasons Mr Vasal. In most of the countries, the benefit arising under ESOPs is taxed at the time of exercise, in the hands of the employee.

Further, it would be difficult to claim credit for the tax paid in the other country, either in India or overseas, as the taxpayers (in the two countries) are different, he adds. This issue is particularly relevant in the case of employees of IT (information technology) companies on overseas secondments.

Recognise top stock exchanges

The taxman may have to consider naming some top ten stock exchanges around the world as recognised stock exchanges for the purpose of Rule 40C, suggest Mr Sanjiv Agrawal and Mr Amitabh Singh, Partners, Ernst & Young, commenting on the new income-tax rule on the valuation of ESOPs (employee stock options) for the purpose of FBT (fringe benefit tax).

The valuation guidelines do not consider shares listed in a stock exchange outside India as listed and, therefore, ESOPs that involve shares listed in a stock exchange outside India shall resort to valuation norms for unlisted companies. This would entail foreign companies obtaining reports from SEBI-registered Category 1 merchant bankers, they reason.

Another issue they highlight is of in the money. While the Income-Tax Act as well as Rule 40C talk about shares and options in the same vein, it is generally assumed that FBT is payable only on the in the money portion (i.e. the fair market value (FMV) of the share, minus its purchase price for the employee) of options upon exercise and not on option value per se, they explain. Value of options with even nil in the money amount can be significant but is not taxable. It may be useful if CBDT (the Central Board of Direct Taxes) clarifies this matter as well.

Ambiguity on foreign securities

While the newly announced valuation norms for ESOPs (employee stock options) provide some clarity for shares listed on recognised stock exchange in India, there is still a lot of ambiguity with respect to valuation of foreign securities, say Ms Hema Atal and Mr Vishal Palwe of Deloitte Haskins & Sells, Mumbai.

As we know, multinational companies use ESOPs as a major compensation and retention tool; and generally the shares of the parent company are granted to the employees.

However, as per the Rules prescribed, as shares of foreign companies are not listed on recognised stock exchange in India, their valuation would be at par with unlisted companies in India. Now, should these foreign companies, which are listed on stock exchanges outside India, obtain valuation report from an Indian merchant banker? The answer seems to be yes.

Exclude foreign securities

Does FBT (fringe benefit tax) apply to foreign securities or ESOPs (employee stock options) of companies listed outside India?

Logically, the levy should not, says Mr Mukesh Butani, BMR & Associates, New Delhi. For a thorough analysis of the recently announced guidelines, it is equally important to interpret the legislative provisions, as enshrined in the Finance Act of 2007, he adds.

Ambiguity, he says, is from the definition of the terms specified security and sweat equity shares. The usage being wide, the term specified security has become a bone of contention. In the legislation, the term specified security is defined to mean the same as under SCRA (the Securities Contract Regulation Act of 1956).

Hence, it is debatable whether one needs to consider the definition of the term as under SCRA, or assign the meaning in the context of SCRA. For illustration, definition under SCRA could cover foreign contracts executed in foreign security.

Three problem areas

There are at least three problem areas in the recently announced guidelines for the valuation of ESOPs (employee stock options), say tax experts from Amarchand & Mangaldas & Suresh A. Shroff & Co.

First, the valuation rules only cater to the specified security or sweat equity, being equity shares in a company.

Secondly, if the shares of an overseas listed parent company are awarded to the employees of an unlisted subsidiary in India, the provision relating to the valuation of unlisted shares would be applicable. And, finally, the rule does not prescribe any particular methodology to be adopted by merchant bankers for the valuation of shares of unlisted companies.

Thus observe Mr Aseem Chawla, Partner and Mr Amit Singhania, Associate, in the New Delhi-based firms Tax Practice Group.

Full text of the interviews

Time ESOP law recognised worlds top stock exchanges

The taxman may have to consider naming some top ten stock exchanges around the world as recognised stock exchanges for the purpose of Rule 40C, suggest Mr Sanjiv Agrawal and Mr Amitabh Singh, Partners, Ernst & Young, commenting about the new income-tax rule on the valuation of ESOPs (employee stock options) for the purpose of FBT (fringe benefit tax).

The valuation guidelines do not consider shares listed in a stock exchange outside India as listed and therefore ESOPs which involve shares listed in a stock exchange outside India shall resort to valuation norms for unlisted companies. This would entail foreign companies obtaining reports from SEBI-registered Category 1 merchant bankers, they reason, during the course of an e-mail interaction with Business Line.

Another issue they highlight is of in the money. While the Income Tax Act as well as Rule 40C talk about shares and options in the same vein, it is generally assumed that FBT is payable only on in the money portion (i.e. FMV of share minus purchase price of share for employee) of options upon exercise and not on option value per se, they explain. Value of options with even nil in the money amount can be significant but is not taxable. It may be useful if CBDT (the Central Board of Direct Taxes) clarifies this matter as well.

Excerpts from the interview.

Do you foresee disputes arising on the valuation of unlisted shares?

For unlisted shares, FMV (fair market value) shall be value of the share on the vesting date or a date not more than 180 days earlier than the date of the vesting. This value shall be determined by a Category I merchant banker. This Rule is likely to create disputes between assessees and revenue officials, as there is no prescribed valuation method and a suggested format of report to be used by the merchant bankers. The challenge of such valuation report by the revenue officials cannot be ruled out.

But it may be mentioned that it is not unique for Government authorities to rely upon merchant bankers for determination of FMV of unlisted shares. RBI (Reserve Bank of India) guidelines Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2000 also require merchant bankers to carry out FMV valuation analysis in cases where a resident entity buys shares of an Indian company from a non-resident entity and this has been going on smoothly for many years now.

How do merchant bankers typically value such shares?

While CBDT (the Central Board of Direct Taxes) is silent on the method of valuation to be used for valuation, it is common to do FMV valuation based on discounted cash flows (DCF), comparable market multiples, and such methods. Accordingly, merchant bankers will be expected to do such valuations using these methods and providing detailed reasoning in their reports for various assumptions and parameters applied in the valuation analysis.

On the in the money.

In case option is in the money on the vesting date but is not in the money on the exercise date, FBT will still be payable even though the employee does not get any benefit or any concession on the allotment date, simply because the valuation methodology prescribed under Section 115 WC (ba) of the Income Tax Act states that the value of the fringe benefit provided by the employer to the employee by way of stock options has to be fair market value on the date of vesting as reduced by the exercise price paid by the employee. CBDT may want to consider clarifying whether tax can be collected even when there is no fringe benefit to the employee.

Other points

Another point to consider is that the valuation guidelines only talk of equity shares, therefore one expects the CBDT to roll out more guidelines for valuation of other financial instruments such as units, derivatives etc. covered within the ambit of FBT.

CBDT would do well to clarify ambiguities at the earliest so that employers can get down to calculating their FBT tax bill for the current fiscal year as the first date of payment (December 15, 2007) is not too far.

***

Further clarity needed in the new ESOP valuation norms

While the newly announced valuation norms for ESOPs (employee stock options) provide some clarity for shares listed on recognised stock exchange in India, there is still a lot of ambiguity with respect to valuation of foreign securities, say Hema Atal and Vishal Palwe of Deloitte Haskins & Sells, Mumbai.

In the interest of the tax payer, it may therefore be appropriate for the Government to issue a circular clarifying the same, they suggest, during an e-mail interaction with Business Line.

The Finance Act 2007, as you may be aware, provided that the employers will be liable to pay FBT (fringe benefit tax) on the value of ESOPs granted to employees as and when these options are allotted or transferred to the employees.

The value of ESOPs for the purposes of levy of FBT is to be computed on the basis of FMV (fair market value) of ESOPS as on the date of vesting of the options, as prescribed by the Central Board of Direct Taxes (CBDT), and as reduced by the amount actually paid by or recovered from the employee.

It was on October 23 that the Board notified the rules for computing FMV. These rules are effective for the ESOPs allotted or transferred on or after April 1, 2007.

Excerpts of the interview.

What is the taxmans guidance for ESOP valuation?

Here is a summary of valuation mechanism under different scenarios:

Where the shares are listed on a recognised stock exchange in India, the valuation formula is the average of opening and closing price of the share.

In case the shares are listed on multiple recognised stock exchanges in India, the value is average of opening and closing price of the share on the recognised stock exchange which records the highest volume of trading.

And where the shares are not listed on a recognised stock exchange in India

a, computation should be on the basis of valuation as determined by the merchant banker on the specified date.

How will the merchant banker do the valuation?

The merchant bankers valuation can be as on the date of vesting of options or any date earlier which is not more than 180 days earlier to date of vesting. Accordingly, to obtain a valuation report, the companies may have to prepare interim financial accounts.

The rules however do not prescribe the method by which a merchant banker is required to determine FMV. It is therefore at the discretion of the merchant banker to determine FMV. There are various methods available by which a merchant banker can value shares of a company.

On the impact of the new rule on foreign companies.

As we know, multinational companies use ESOPs as a major compensation and retention tool; and generally the shares of the parent company are granted to the employees. However, as per the Rules prescribed, as shares of foreign companies are not listed on recognised stock exchange in India, their valuation would be at par with unlisted companies in India. Now, should these foreign companies, which are listed on stock exchanges outside India, obtain valuation report from an Indian merchant banker? The answer seems to be yes.

And currency translation?

Under the Income tax Rules, any income that is derived in foreign currency is required to be converted in Indian rupees based on the rules prescribed. The existing rules, though, do not prescribe any basis on which the value of shares of a foreign company will be converted for computing the FBT. Thus, the valuation of shares of foreign companies is still not clear.

Are there tax issues that individuals need to consider?

Yes. The cost of acquisition of shares that are acquired by way of ESOP is FMV on which FBT is paid. Consequent to rules being prescribed, it is now possible to compute gains arising from sale of shares acquired by way of ESOPs. As the rules were not available, advance tax instalments for the payment of FBT for first and second quarter were deferred till December 15, 2007.

Though the instalment for payment of advance tax for FBT was deferred, no such relief is granted for payment of capital gains tax on such shares. As the interest for shortfall in payment of advance tax is mandatory, individuals would have to pay interest on such capital gains, even where there was no basis for valuing the shares. This, perhaps, is a point that the Government should consider, and relax the advance tax instalments for such individuals.

***

Why FBT on ESOP should not apply to foreign securities?

Does FBT (fringe benefit tax) apply to foreign securities or ESOPs (employee stock options) of companies listed outside India?

Logically, the levy should not, says Mr Mukesh Butani, BMR & Associates, New Delhi. For a thorough analysis of the recently announced guidelines, it is equally important to interpret the legislative provisions, as enshrined in the Finance Act of 2007, he adds, in the course of an e-mail interaction with Business Line. FBT levy, as you may know, was extended to ESOP in the Budget of 2007.

What is causing the ambiguity?

The definition of the terms specified security and sweat equity shares. The wording being wide, the term specified security has become a bone of contention. In the legislation, the term specified security is defined to mean the same as under SCRA (the Securities Contract Regulation Act of 1956).

Hence, it is debatable whether you need to consider the definition of the term as under SCRA, or do we assign the meaning in the context of SCRA. For illustration, definition under SCRA could cover foreign contracts executed in foreign security.

Does the FBT law intend to cover securities under SCRA?

I dont think so. We have to look at the rationale of levy of FBT. In a booming economy, accompanied with a vibrant stock market, corporates have figured out a creative way to compensate their employees through the ESOP scheme. It could be ESOP of a listed company or an unlisted company.

Using the horizontal equity argument, a case was made out by the legislative to tax that portion of the gain, which an employee receives or accrues to him as a result of his employment. The basis of charge is the difference in the value of the security (as at the date of exercise) and price paid for such exercise, levy being on the vesting date.

Isnt FBT levy on foreign securities equitable?

No, it isnt. An employee who becomes the legal owner of the security is taxed on sale of the security under capital gains provisions. Since long term capital gains on listed securities is exempt and short term gain is liable to tax at a concessional rate of 10 percent, the FBT levy should logically not apply to foreign securities, on ESOPs of companies listed outside India.

This is particularly relevant since the employee who is entitled to ESOPs of foreign security does not get the same benefit that an employee receiving ESOP of Indian listed or unlisted security.

In summary, besides the fact that the machinery provisions of the legislation fail for the levy of FBT on foreign securities, the levy is not equitable.

***

Three problem areas in ESOP valuation norms for FBT

There are at least three problem areas in the recently announced guidelines for the valuation of ESOPs (employee stock options), say tax experts from Amarchand & Mangaldas & Suresh A. Shroff & Co.

First, the valuation rules only cater to the specified security or sweat equity, being equity shares in a company.

Secondly, if the shares of overseas listed parent company are awarded to the employees of unlisted subsidiary in India, then the provision relating to the valuation of unlisted shares would be applicable.

And finally, the rule does not prescribe any particular methodology to be adopted by the merchant bankers for the valuation of shares of unlisted companies.

Thus observe Mr Aseem Chawla, Partner and Mr Amit Singhania, Associate, in the New Delhi-based firms Tax Practice Group, during the course of an e-mail interaction with Business Line.

Excerpts from the interview.

On the restricted focus.

The rules do not address the valuation of other instruments of remuneration under stock option plan such as tradable options, stock appreciation rights or any other form of security of overseas listed company. Therefore, whether such securities shall be outside the realm of FBT (fringe benefit tax) needs to be determined.

On the foreign shares.

Here, the FMV (fair market value) shall be determined by a merchant banker registered with SEBI (the Securities and Exchange Board of India). This would pose a practical difficulty for the foreign companies as it implies disclosure of confidential/sensitive financial information to the third party, i.e., merchant bankers for the purposes of valuation.

On the problem of missing methodology.

This implies that the merchant banker is free to choose any method for determining the FMV. A potential contentious area, this can be; because, for assessments, tax authorities may be inclined to use a different methodology that may result in higher valuation. Further, this would also increase the compliance cost for the unlisted companies, who now would require to engage the services of the merchant bankers and bear the cost of litigation created by the said subjectivity.

However, some relief has been provided in respect of the vesting date by providing that such valuation could be done either on the date of vesting of option or an earlier date, not preceding more than 180 days from the date of vesting.

In sum

Hence, further clarification or explanatory note on the lines of the FAQ (frequently asked questions) that the CBDT (Central Board of Direct Taxes) had issued in August 2005 for FBT, is much required, especially with regard to issuance of ESOPs in case of foreign companies.

***

For starters:

With effect from April 1, 2007, ESOPs have been brought within the purview of FBT, which is levied on the employer. The FBT incidence would arise at the time of the allotment or transfer of specified security/sweat equity (security) to the employee. For FBT computation, the FMV of shares on the date on which the option vests with the employee as reduced by the amount actually paid, or recovered from, the employee is considered.

Thus, the formula for FBT (excluding surcharge and education cess) = 30 per cent of (FMV of security on the date on which the option vests with the employee minus amount paid/recovered from the employee).

FMV for this purpose was to be determined in accordance with the rules prescribed by the CBDT. Pending the notification of the said rules, the CBDT had earlier extended to December 31, 2007 the date of payment of advance tax FBT in respect of ESOP.

On October 23, 2007, the CBDT notified Income-tax (Twelfth Amendment) Rules, 2007 inserting Rule 40C for the purposes of valuation of specified security or sweat equity share being a share in the company.

Here is a summary of the new rule:

In the case of unlisted shares, FMV shall be the value of the share in the company as determined by a merchant banker on the date of vesting of option or any date earlier than the date of the vesting of the option, not being a date which is more than 180 days earlier than the date of the vesting.

In the case of shares listed on a recognised stock exchange in India, FMV is the average of the opening price and closing price of the shares on that stock exchange on the date of vesting of the option; where, however, shares are not traded on the date of vesting of the option, FMV is the closing price of the share on the said recognised stock exchange on a date closest and immediately preceding to that date.

In case the shares are listed on more than one recognised stock exchange in India, FMV is the average of opening price and closing price of the shares on the stock exchange, which records the highest volume of trading in the share on that date. Where shares are not traded on the date of vesting of the option, you need to consider the closing price of the share on any recognised stock exchange, which records the highest volume of trading in the share on a date closest and immediately preceding to the said date.

***

FBT guidelines on ESOP: many issues await clarification

Globally mobile employees, both inbound expatriates and outbound assignees, may have to face the prospect of economic double taxation, cautions Mr Vikas Vasal, Executive Director, KPMG, commenting about the latest guidelines from the taxman on the valuation of ESOPs (employee stock options) for the purpose of FBT (fringe benefit tax).

In India the tax would be paid by the employer, while in the foreign country employee may be liable to pay tax on the same benefit, reasons Mr Vasal. In most of the countries, the benefit arising under ESOPs is taxed at the time of exercise, in the hands of the employee.

Further, it would be difficult to claim credit for the tax paid in the other country, either in India or overseas, as the taxpayers (in the two countries) are different, he adds, interacting with Business Line over the e-mail. This issue is particularly relevant in the case of employees of IT (information technology) companies on overseas secondments.

Excerpts from the interview.

Would it be justifiable to tax the entire benefit in India, in the case of globetrotting employees?

In the case of globally mobile employees, it is possible that grant and vesting of options may take place while the employee is outside India, however, the exercise of options and allotment of shares may take place when the employee is in India. A plain reading of the provisions suggest that the entire benefit may be liable to FBT in India.

Can you give an example?

Say, an employee working with an overseas company is granted options in year 1, which vests in him in year 3 while he is outside India. He has an exercise period of 7 years starting from the date of vesting, out of which he continues to work outside India for first 6 years. Now, in the 7th year, he is seconded to India and this being the last year, he exercises his options and is allotted shares. It is likely that his employer is liable to FBT on the entire benefit arising to him over 10 years (grant Year 1, vesting Year 3 and exercise Year 7 from date of vesting).

What can be a better alternative?

Ideally, only the proportionate amount of benefit, in relation to services rendered in India should be taxable in India, particularly if the employees residential status is that of non-resident or not ordinarily resident.

Is FBT leviable on ESOPs issued by foreign companies that do not have any employee based in India?

This issue needs clarification, because different views are being expressed on the taxability, adding to the confusion. Many foreign companies have issued ESOPs to the employees of their Indian subsidiary companies. At times, ESOPs are issued directly by the foreign company even without involving / knowledge of the Indian subsidiary company.

On the ambiguity as to the valuation of shares of listed foreign companies.

The FBT guidelines specify that FMV is to be computed in reference to the price quoted in a recognised stock exchange. Further, it has been clarified that recognised stock exchange shall have the same meaning as assigned to under the Securities Contracts (Regulation) Act, 1956. Therefore, in the case of foreign listed companies, valuation methodology needs to be clarified whether it would be the same as listed shares of an Indian company or on the lines of unlisted shares.

And in the case of unlisted foreign companies?

Here, the question is whether the valuation is to be done by the merchant banker registered with SEBI (the Securities and Exchange Board of India) or whether an independent valuation done by any foreign merchant banker, or other experts (as are recognised for the purposes of valuation in the foreign country where the unlisted company is based) can be treated as sufficient compliance for the purposes of valuation of ESOPs of an unlisted foreign company.

If FBT is leviable on the ESOPs issued by the foreign company, then who would be liable to pay the same foreign company or the Indian company?

FBT is to be paid by the employer in respect of the benefits provided to the employee. It is pertinent to note that there is no employer-employee relationship between the foreign company and the employees of the Indian subsidiary company. If the intention is to levy FBT on the foreign company, then it would cause lot of administrative hardship, as the foreign company would have to first pay FBT on a quarterly basis, and then file an annual FBT return.

We have no single valuation method for unlisted companies?

In the case of unlisted companies, no particular method has been prescribed for the purposes of valuation of ESOPs by the merchant bankers. A question arises, whether it has been left to the discretion of the merchant banker to use a particular method / a combination of methods to determine the FMV.

In practice, the merchant bankers use different methods like discounted cash flow, market comparable multiples and so on, depending on the facts and circumstances of a particular situation. In the absence of any prescribed method by the government, it is likely that valuation done by different methods / different experts could yield different results. This may lead to possible debate / litigation at a later date, if in the view of the tax authorities, the value could differ based on different methodology for valuation.

On other issues

At least three more, in my view.

First, whether ESOPs issued to non-executive directors / non-employees are liable to FBT. As per the provisions of the Act, any specified security or sweat equity share allotted or transferred directly or indirectly, by the employer free of cost or at concessional rate to his employees (including former employee or employees) is liable to FBT. It needs to be clarified, whether FBT is leviable even in cases where ESOPs are issued to non-executive directors / non-employees by the companies.

Secondly, the tax deductibility of benefit arising under an ESOP. It needs to be clarified whether this benefit on which the employer has paid FBT, can be claimed as deductible corporate expense by the employer.

Thirdly, the position on variations. In the case of listed Indian companies, SEBI guidelines (being mandatory) provide that variations detrimental to employees are not permitted in the ESOP. In a situation where the employer recovers the FBT from the employees by amending the ESOP, would it result in an amendment that is detrimental to the employees? If yes, then the SEBI guidelines may need to be modified.

These are a few of the important and live issues that need clarification, unless we are ready to face different interpretations and prolonged litigation, which would defeat the very purpose of introduction of FBT on ESOPs: i.e., ease and flexibility of collection of tax on the benefit arising under an ESOP from the employer, instead of from thousands of employees!

**

D. MURALI

 
 
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