The issue today is not about whether ESOP (employee stock option) should be taxed or not. But how? At what point? And in whose hands? The proposal, as in the Finance Bill, 2007, is not only inefficient but also inequitable and is likely to open the floodgates for three-way litigation among the employer, the employee and the Revenue.

The proposal is to treat the difference between the vesting price (the price the employee is required to pay) and the fair market price (yet to be defined, but which cannot be very different from the market-based price) on the date the employee exercises his option, as fringe benefit allowed to the employee, on that date and subject it to taxation in the hands of the employer. The employee, when he sells the share, will be taxed for capital gains for the difference between the fair market price (not the vesting price) and the selling price.

ESOP stages

A typical ESOP goes through at least three stages in its life. In stage one, an option gets granted, either directly or indirectly, to an employee. The option is exercisable at a pre-determined price, after a waiting period and before its expiry. In stage two, the employee, if he continues in the service of the company, exercises the option, by paying in money and becomes a shareholder. This event can happen anytime after the initial waiting period and before the expiry of the option, depending upon the market price, volatility of the share, and availability/willingness of employee to invest cash, and the prevailing interest rate in the market. At this stage the option ceases to exist and the employee becomes a shareholder.

In stage three the employee sells the share, and offers the gains to capital gains tax depending on the holding period.

As the law stands today, an employee by holding the shares for at least 12 months can escape taxation completely. However, under the proposed tax arrangement, in stage two, that is, when he exercises his option, he will be subjected to FBT through the employer. In other words, even if the employee holds the share for over 12 months, there will be an element of tax, at the corporate rate, of course indirectly through the employer passing it on to the employee.

The legality/sustainability of such passing on for the employer/employee is subject to testing, though it holds to logic that the employee can claim it to be part of his cost of acquisition. Whether the employee would be better off if ESOP is taxed as perquisite would, however, depend on the quantum of gain over the fair market price, the holding period and his marginal tax rate.

The employee, in fact, has received only an option and it does not become a share automatically. The option has its own life, and derives its value from the underlying share and the way the option is structured.

An employee option, unlike the traded ones, has limitations in respect of tradability and waiting time. On the other hand, being longer-term, they have a larger time to play out the upside potential/capture the volatility in the share.

An option gets its value from two counts the time value, on account of the expectancy/volatility, and the intrinsic value, represented by the difference between the exercise price and the market price.

An option is a decaying asset, in the sense the time value of the option goes down as it approaches its expiry, and the intrinsic value may or may not go up, depending on the market price of the share.

At the point when the option gets exercised, its time value drops to zero or the option ceases to exist as option.

Because of the limitations placed on the option by the employer (in accordance with the scheme) the value of the employee option is latent till the time of earliest vesting and becomes apparent on vesting date. From this point on, the option, like the market-traded option, begins to reflect the value of the underlying share.

Since options can be cash settled, the employee is in a position to trade on the back of the option he has obtained from the employer, even without actually exercising the option

If the ESOP has a longer expiry, the employee can actually repeat the process by moving the strike and time in sync with the market, a process familiar to the investors.

An employee need never exercise his option and yet get away with better earnings without the ESOP being taxed as fringe benefit. He does not even need to invest his cash.

No doubt he will end up offering his option premium for taxation, but he also gets a valuable opportunity for cross setting off the income.

Gaps in proposals

The legislation, as proposed, has large gaps.

It is not accident that when the employee exercises his option, that is, the taxing point, the option ceases to exist. All what the employee got from the employer is an option, and the proposal is to tax it at the point it ceases to exist! Irony.

Is it sustainable to tax the outcome of an option, possibly received one or two financial years before, immediately after what the employee actually received has ceased to exist?

Granting the employee benefit, or the event giving raise to taxation, has taken place possibly in an earlier financial year, and the taxing event the trigger and the event are removed from the original benefit granting. Apart from issue of sustainability of taxing on the basis of such disjoint events, it delays cash flow/receipt to the Revenue.

If the markets are volatile it might even deny the Revenue the advantage of taxing ESOP, which is otherwise valuable at the point of grant. All an employer will have to do is give a longer expiry post vesting and lower price level for vesting, with the explicit or implicit understanding that the employee will let the option expire, but only use it for his trading cycles. The FBT goes for a toss.

Absence of vertical equity

While horizontal equity is about taxing equals equally, vertical equity revolves around taxing un-equals, unequally. Today the spectrum of employees who receive ESOP ranges from start-up to highest-ranking employees. The quantumalso varies accordingly. On the assumption (which is proved to be true so far in respect of FBT) that the employer will transfer the FBT to the employee directly or indirectly, how logical it is to tax a small-time employee who receives a few thousand rupees worth ESOP and a big fish who receives several lakhs if not crores, equally at the applicable corporate rate?

If it is only the employee who has to suffer the tax impact of ESOP, whether it is taxed as FBT or perquisite/salary, it makes little sense to tax the unequal, equally.

While taxing ESOP itself is a welcome step in the right direction, the way it is proposed to be done is neither efficient nor equitable, and lot more detailing/restructuring will need to be done, if only to really tax the big fish and leave the small employees with at least some benefits. If this means taxing it as a perquisite and arriving at a valuation model, more appropriate for employee options, it would need to be done. One is sure that the Finance Ministry has the best of talent and capability in its fold to face up to this challenge, rather than choose a sub-optimal path of taxing as FBT.

P. B. Ramanujam
(The author is Partner, Managing Consortium.)