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Esops could prove taxing for employees
November, 03rd 2007
In recent times, most employers have been inclined to use employee stock option plans (Esops) to remunerate, motivate and retain employees. But the bubble has burst with the imposition of FBT levy on Esops since April this year.

From April 1, 1999, employees were taxed on the difference between the exercise price and fair market value (FMV) of shares as on the date of exercise as perquisites, which was included in salary income for tax purposes.

They did face a cash crunch as the tax liability could be quite heavy. This wasnt the end of the story. On sale, once again employees were subject to tax on capital gains. It resulted in a tax liability at two different stages. Later from April 1, 2000, no perquisite rose to the employee at the time of exercise of stock options where these were issued under plans compliant with central government guidelines, but employees were subjected to capital gains tax at the time of the sale of shares.

Later, with the liberalisation of tax laws relating to capital gains, the employee could well end up with a no tax situation if his employer was a company listed on a stock exchange in India and he had held on to shares for more than 12 months. This was because the act from October 1, 2004, exempted from income tax long-term capital gains (LTCGs) on sale of shares, on which the securities transaction tax (STT) had been paid.

Even if the employee did not hold on to shares after exercising, the employee had to pay a considerably lower tax as a reduced tax rate of 10% was applicable for calculating short-term capital gains tax on the securities transaction tax.

Only in the few instances, where Esops did not meet government guidelines, did the twin tax incidence continue.
However, the Finance Act, 2007, brought a change in the taxation of Esops and this time, the incidence of tax has shifted from the employee to the employer. The employer is now liable to pay fringe benefit tax (FBT) on the benefit arising to employees at the time of exercise of shares.

FBT is payable by the employer on the difference between the fair market value of shares as on the date of vesting of options and the price paid by employees (exercise price) at an effective rate of 33.99%. Of course, the capital gains tax incidence as described above, continues.

In case of LTCGs, on which STT is paid, the capital gains arising on sale of shares will be tax exempt. The Central Board of Direct Taxes has recently issued guidelines for determining FMV. In short, for listed shares listed on any one stock exchange, it is the average of the opening and closing price as on the date of vesting (in case of multiple listing, the stock exchange having the highest volume is to be chosen). For unlisted shares, FMV is to be determined by a recognised merchant banker.

However, an employee cannot afford to shrug off the tax implication of FBT even if these are borne by the employer. The reason? Your employer may want to recover every penny of FBT paid by it from you. The law certainly permits it, even though the mode and manner of recovery is not laid down.

God forbid if in case the employer does choose to recover it from employees, the latter will find themselves in a cash crunch fix, the same situation that existed prior to April 1, 2000. Unless they have ample savings to fall back on, they may have to sell the shares soon after these have been allotted. To be eligible for long-term capital gains, the shares have to be held for a period of 12 months post allotment.

Remember, the employer has to pay FBT on allotment of shares to the employee. Further, short-term capital gains, even if STT has been paid, are not entirely tax exempt and would attract a tax rate of 10%. Let us assume that Mridula has been allotted 20,000 shares at the exercise price of Rs 20 per share. FMV as on the date of vesting is Rs 80 per share. The shares are allotted a few weeks after the vesting date.

The fringe benefit value of Esops in the hands of her employer will be the difference between FMV as on the date of vesting, minus the exercise price, or Rs 60 per share (aggregating to Rs 1,200,000. The fringe benefit tax to be paid by her employer will be 33.99% against Rs 1,200,000 or Rs 407,880. Now, Mridula could well be asked to pay up this tax, forcing her to sell shares in the absence of any adequate savings.
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