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Valuing options
November, 03rd 2007

Stock options invented in the US some time back were regarded as the next best thing to happen to an eligible employee. The software sector set the trend rolling by making millionaires of ordinary mortals although there is backdoor talk that these very millionaires have kept real-estate prices at unrealistic levels.

Fair market value

Options went through a tortuous process for accounting and taxation purposes till a couple of US companies took a stance and expensed all options. Unwilling to let them go scot-free, the authorities decided to tax the option on vesting. When the Fringe Benefit Tax (FBT) was extended to options in this years Budget, the question of valuing the options vexed everyone. After many unfulfilled promises, Rule 40C effective from assessment year 2008-09 has found its way into the Income-Tax Rules, giving guidelines as to valuing options. It is not disputed that the fair market value would be the benchmark to value options.

Just to close out any open doors, Rule 40C states that where, on the date of vesting of the option, there is no trading in the share on any recognised stock exchange, the fair market value shall be (a) the closing price of the share on any recognised stock exchange on a date closest to the date of vesting of the option and immediately preceding such date; or (b) the closing price of the share on a recognised stock exchange, which records the highest volume of trading in such share, if the closing price, as on the date closest to the date of vesting of the option and immediately preceding such date, is recorded on more than one recognised stock exchange.

For unlisted companies, the fair market value shall be such value of the share in the company as determined by a SEBI registered merchant banker on the specified date.

Market lingo

The circular also updates us on some stock market lingo by stating that closing price of a share on a recognised stock exchange on a date shall be the price of the last settlement on such date on such stock exchange and opening price shall be the price of the first settlement on such date on such stock exchange. There is also a proviso which states that where the stock exchange quotes both buy and sell prices, the closing price shall be the sell price of the last settlement.

Specified has been notified to mean the date of vesting of the 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. One does not see the possibility of any other date than the date of vesting coming into operation, but apparently the CBDT (Central Board of Direct Taxes) is erring on the side of caution.

There have been some indicators that options are losing their sheen due to the tax effect and also since the days of employees getting options at par or discount appear to be over. The Circular would also make the option plan for unlisted companies a bit costlier as the merchant banker is going to charge a fee for valuing the share and the company would not like to bear the cost which would mean that the cost would be recovered from the employee.

There are a couple of litigations pending about double-taxing options both as capital gains as well as a fringe benefit. Although the decision appears only a formality, the trend of many employees cashing their options in 2007 prior to the new Rule 40C becoming law seems set to continue.

Mohan R. Lavi
(The author is a Hyderabad-based chartered accountant.)
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