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`Fringe Benefit Tax on ESOPs amounts to economic double taxation'
March, 08th 2007
"The proposal raises a plethora of cross border taxation issues, especially in the case of globally mobile population."


Post-Budget, we have been hearing much sobbing about ESOPs (employee stock options). For starters, ESOP is `a call option on a company's own stock issued as a form of non-cash compensation,' defines Wikipedia.

"If the company's stock rises, holders of options experience a direct financial benefit. This gives employees an incentive to behave in ways that will boost the company's stock price."

Double advantage

ESOPs offer a double advantage: Employers can use stock options as an incentive tool to attract and retain talent.

And to employees, the options offer a way to create wealth over a period. Software companies, which generally face a shortage of talent, have been effectively using ESOPs for retention and reward. But that sheen may be a thing of the past, fears Mr Nikhil Bhatia, Partner of BSR & Co.

"Until the Budget 2007, ESOPs had great appeal, and the Finance Minister has probably hit where it hurts the most as far as ESOPs are concerned," he says interacting with Business Line. Here's more:

What was the earlier law governing ESOPs?

Hitherto, the value of the ESOP benefit was taxable in the hands of the employee as a perquisite only if the ESOP plan was not compliant with the Central Government ESOP Guidelines. Otherwise, for qualified plans, ESOPs triggered a tax obligation for an employee only at the time of sale of shares.

On sale of shares of Indian listed companies, the tax payable by employee on short-term capital gains is 10 per cent (plus applicable surcharge and cess) and `nil' for long-term capital gains. The Budget 2007 now brings the stock option benefit within the Fringe Benefit taxation (FBT) levy.

So, what happens now?

With this modification, the employers will have to dole out FBT at 33.99 per cent on the differential between the to-be-prescribed `fair market value' (FMV) on the date of exercise less exercise price of the option. FBT payable would not be a deductible expenditure while computing the profits of the company leading to effective cost of 45.54 per cent post tax. On sale of the shares, the employee would need to pay capital gains tax on the difference between sale price and FMV on the date of exercise.

Do you foresee any other implications that the change in ESOP regime?

In addition to higher tax outflows for employers, the proposal raises a plethora of cross border taxation issues, especially in the case of globally mobile population.

Such as?

The issues could pertain to the nature of the stock option income in different jurisdictions i.e. income may be taxed as FBT in India in the hands of the employer, and salary income in the other jurisdiction.

The proposed change would also add to the complexity, as the person paying FBT would be the employer whereas the employee may be subject to personal taxation in the overseas jurisdiction and therefore not entitled to the credit of tax paid by employer in India. While this may not impact the employee twice, it certainly amounts to economic double taxation.

The resultant incongruity is a function of the proposed changes, which seek to tax the employer when the benefit is arising to the employee.

What changes do you recommend to the proposed scheme?

FBT on employer, if at all, should be only limited to the discount to the market value on the date of the grant, as is required to be debited in the books of accounts under the accounting standards/guidelines applicable. Correspondingly, such expenditure should be clearly allowable as a deduction against taxable income of the employer.

Any forfeiture of such options resulting in disentitlement for the employee and reversal of such benefits should culminate in corresponding deduction in FBT obligations in future.

The benefit to the employee in the appreciation of the share price over the exercise price may, if at all, be taxed in the hands of the employee at the time of the exercise.

However, ideally, as the employee does not realise any gain at that stage, there should be no taxation at that stage, but only at the stage of ultimate sale of shares by the employee.

When such gain, which is in the nature of capital gains, arises, it should be treated similar to capital gains on shares as applicable to other normal investors.

D. Murali

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