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Of vesting and tax timing in ESOPs
October, 27th 2007

To appreciate the implication of the changes in employee stock option (ESOP) guidelines, let us
understand what is meant by the term `vesting'.

Note that getting stock options is not the same thing as getting shares of the stock. An option is the right but not the obligation to purchase the shares. You purchase the shares by exercising the options.

Generally this right to exercise is spread over a number of years. In other words, you must earn the right to purchase those shares; you need to become vested in those shares.

In terms of an example, say at the beginning of the year, XYZ Ltd. grants its employees options to buy 100 shares of the company at Rs 200 per share.

The employees can buy 25% of the shares at the end of the first year, another 25% at the end of the second year and so on over a four year period.

This means the shares are being vested one fourth at the end of every year.

Though options have been granted at the beginning of the year, it is only at the end of each year that the employee is being vested with one-fourth of the shares he is entitled to.

The vesting schedule determines when the employee gets control over his options. Once vested, the employee still has to exercise the options at the exercise price during the exercise period in order to become the owner of the shares.

The vesting schedule, exercise price and the exercise period are all specified in the stock option plan.

Tax timing has not changed. Note that the vesting date does not have any influence on when the FBT becomes payable.

The liability to tax will still be attracted on the date of allotment or transfer of the shares. The
notification points out that "In a case where, on the date of the vesting of the option, the share in the company is listed on a recognized stock exchange, the fair market value shall be the average of the opening price and closing price of the share on that date on the said stock exchange".

For a stock which is listed on more than one exchange, the FMV will be the average of opening price and closing price of the share on the recognised stock exchange which records the highest volume of trading in the share.

For a stock which is not listed on a stock exchange, a merchant banker will determine the fair value.

FBT to be recovered from the employee. In a significant move, now an employer has been legally empowered to recover the fringe benefit tax from the employee.

Though this has been legally allowed only in the case of Esops, FBT has essentially taken the form of a surrogate tax on the employee.

Other items already under the ambit of FBT are being in any case recovered from the employee either by paying the employee net of FBT liability or by including FBT payable in the CTC (cost to company) computation.

ESOP compensation would also suffer the same fate.

In fact the legal recovery of the FBT actually will cause an accounting problem for employers as the law does not specify the treatment to be given to the amount recovered from the employee.

Secondly this also 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 sold the shares yet to realize it.

However, paying tax needs cold cash. The numbers in the example are small for ease of understanding, however, imagine if Rahul had been granted 10,000 shares instead of 10.

The notional profit would work out to Rs 30 lakh and Rahul would have needed to cough up a tax of Rs 10.20 lakh on income not yet earned.

This resulted 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 stood defeated.

Secondly, this 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 and the employee has not sold the shares yet to realise it.

However, paying tax needs cold cash. If the FBT liability is indeed passed on to the employee, it would mean paying tax on income not yet earned.

This may also result 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 stood defeated.

 
 
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