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Fringe Benefit Tax on ESOPs growing steadily
March, 11th 2008
With March 15 approaching, the buzz around Fringe Benefit Tax (FBT) on ESOPs or employee stock options is growing steadily louder, as companies will have to pay FBT by this date. There have been several calls to review or pull back FBT in many areas, especially on ESOPs.

And there's good reason for this. ESOPs are widely seen as a reward and retention tool for companies that are in the growth phase of their life cycles. Given in lieu of a lower fixed salary component, ESOPs are a way to encourage employee ownership for many start-ups. But ever since ESOPs were brought under the ambit of FBT three years ago, many feel that they have become less attractive for fast-growing, talent-hungry employers as they might have to focus on the 'fixed' component of employee salaries to avoid losing out to bigger employers.

India Inc reacted with disappointment to the Finance Minister's sidelining of the FBT issue on ESOPs in this year's Budget. Several corporations, especially SMEs, have been asking for either a modification in the existing regime to defer the payment date or at the very least, a rate reduction from the current 33.99%. "For a large section of the industry, there is some disappointment.

However, there is also a kind of resigned acceptance that this Government is not going to modify the current rules on taxation of stock options," says Amitabh Singh, tax partner at Ernst & Young. According to current rules, FBT is levied on the difference between the sum of money the employee pays for the options and the fair market value (FMV) of those options as on vesting date-when the employee is formally vested with the right to buy options. He/she can formally buy those options after the vesting date.

If the company is a private limited company, the stock's FMV as on vesting date will be calculated by a category 1 merchant banker. To illustrate the taxation on ESOPs with an example, if an employee is given the option to buy 100 units of stock for one rupee each, totalling Rs 100, and the overall stock on the vesting date is worth Rs 200, the employee pays 33.99 percent on the difference of Rs 100, i.e. Rs 33.99. Since FBT is levied on the company, the company pays the tax but after levying it from the employee.

And this is one of the pain points for SMEs, who contend that there's no way they can absorb the FBT on their own without taking a substantial hit on the bottomline. "The employee will wonder why he or she has to pay tax for the options he/she holds. After all, a small company's stock doesn't grow overnight and employees feel that options are a risk because if their value doesn't appreciate in due time, they will end up losing their own money," says Kamal Samtani, company secretary, Simbhaoli Sugars, a Rs 1,000-crore company that introduced its own ESOP programme last year. The programme encompasses around 6 lakh share units and covers 200 mid and senior level employees. Adds Samtani, "We have grown four times in the last three years and wanted to give our employees the benefit of becoming participants in our growth story."

Another bone of contention is the point of taxation. The employer has to pay FBT on the vesting date according to current rules. While the logic could be that the stock is expected to appreciate in future and therefore, taxation on vesting date will be more beneficial, that may not always be the case. "The taxation is being done on notional profits that may be accrued to the employee in the future," says Cherian MJ, vice president, Keynote ESOP Consulting, adding, "Applying tax when the employee has received the profits and is in a position to pay tax on it obviously makes more sense." SMEs feel the current market churn may reduce the value of the employees' stock options and again, result in employee dissatisfaction.

However, Tarun Gulati, vice president of ESOP Direct, believes these fears are irrational and result from a lack of communication about the real purpose of an ESOP policy. "Mind-boggling increments may have become the norm in the industry, but aren't sustainable in the long run. Stock options promote an equity ownership culture within a company. But at the same time, the compensation package shouldn't be ESOP-heavy at the cost of fixed compensation."

So are companies buying this argument? Haranath Lokanadham, CEO of Ticketvala.com, an e-ticketing site with 70 employees that's less than two years old, doesn't think so. "The rates should be tenable for all parties concerned-the employee, the employer and the Government," he says. But he agrees that ESOPs and fixed pay components in employee salaries should be well balanced. Lokanadham adds that ESOPs are unattractive for smaller companies. "We are expecting a year-on-year growth of 25% and want to give our employees the opportunity to create wealth. That, I believe, is one of the main drivers of an attractive employer brand."

Gulati says that today many VCs insist on an ESOP clause before investing in a fledgling venture, and this adds to the confidence of the investor in the entrepreneur's commitment and ability. So how does the head of a small business go about setting up an ESOP programme? The best thing is to work with a consultant who helps design the programme according to the needs of the organisation and avoid unnecessary hassles, since ESOPs are complicated and the tax impact can be a bit difficult to follow at first.

Sanjiv Sharma, founder of content creation company Optimystix, which is contemplating its own ESOP programme, says, "The idea behind stock options is straightforward. Though I don't fully follow the implications of FBT, I have gleaned that ESOPs are still attractive for employers of any size. We are now considering working with a consultant to design our own ESOP strategy."

Despite the market churn and the FBT issue, smaller companies seem keen to go ahead and develop stock options programmes for their employees. But the Finance Ministry might want to keep the concerns of SME promoters in mind during the next Union Budget. After all, distributing ownership is easier when there isn't a stiff price to it.
 
 
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