The finance ministry appears open to modifying its Budget proposal to impose fringe benefit tax (FBT) on Esops given to employees by companies. While upholding the principle that Esops should be taxed, the ministry is vetting a proposal to make the employee who enjoys the benefit pay the tax instead of the employer.

In fact, a few days after the Budget, finance minister P Chidambaram had hinted that the government was open to reviewing its decision to levy a fringe benefit tax on Esops if the industry came up with an alternate and a viable scheme. Within a month Nasscom President Kiran Karnik, along with representatives from the $48-billion IT industry, drew up an alternate plan which was fundamentally different from the Budget proposal. Nasscom recommended shifting the incidence of tax to the employee instead of the employer. The proposal: impose a tax on stock option plans at the maximum rate of 10% in the hands of the employee.

IT firms in India have been offering stock-options to their employees as an incentive to retain talent. Typically, in a stock option plan, options vest with the employee for three to seven years. During this period, the employee cannot transfer or sell the options. Once the period is over, the employee acquires the shares by exercising the option. He does not have to pay tax at the time of exercising the option. However, if he chooses to sell the shares before one year, he has to pay a 10% short-term capital gains tax. If he off-loads the shares after a year, he does not have to pay long-term capital gains tax.

Policy managers are now examining Nasscoms suggestions and a few other representations to take a final view. If the government accepts Nasscoms suggestions, it would mean reverting to the policy that was in vogue between April 1, 1999 and March 31, 2000. Esops were then treated as a perk and taxed in the hands of the employee. The tax was levied on the difference between the fair market value of the stock on the date of vesting of the option and the exercise price in the hands the employee.
 
Public memory is short. The IT industry had, in fact, lobbied against taxing Esops in the hands of the employee, citing cash-flow problems. Former finance minister Yashwant Sinha accepted their demand and withdrew the levy. Later, when FBT was introduced in 2005, the finance ministry had clarified that employers will not have to pay the levy on Esops. But another tool to retain talentcontribution to superannuation fundswas brought under the FBT net. Two years down the line, the government has also reversed its decision and proposed bringing Esops under the FBT net. It plans to prescribe a method to value the fringe benefit on the date of exercise of the option.

India apparently has taken a cue from Philippines where employers pay FBT on Esops. However, this is not so in a majority of countries including Australia, New Zealand, UK, US, Singapore and even South Africa. Australia attempted to introduce FBT on Esops way back in 1994 but had to shelve the plan. Right now, the tax treatment of Esopsqualified stock option plansin India is broadly in sync with the practice in the US and the UK. Qualified plans are not taxed in the hands of the employee on the date of exercise. The employee, however, has to pay a capital gains tax when he sells the shares.

However, the tax treatment is different for an unqualified stock option plan in the US and the UK. In the US, for instance, employees are generally taxed at the time of exercising their option in an unqualified plan. A corporate deduction is allowed in the hands of the employer. There are some exceptions to this rule. In the UK too, an unqualified plan is taxed in the hands of the employees on the date of exercise. Here again, an employer is allowed a corporate deduction, subject to some norms. What are the options before now? One: drop the budget proposal but this seems remote. Two: accept the IT industrys demand and shift the burden of tax to the employee. This means the employee has to pay a tax, may be at a concessional rate, at the time of exercising the option. Three: retain FBT on Esops but soften the blow.

According to Sudhir Kapadia, Partner KPMG, one way to reduce the tax liability for companies would be to lower the base for valuation of Esops. Right now, a 30% FBT is imposed on a defined base for various categories of expenses. The base varies from 5% to 100%, depending on the category of expense.

Companies pay FBT on 5% of the total expenses incurred on tour and travels. However, the base for valuation is 100% in a few other category of expenses. This means the entire expenditure is taken as the base for calculating FBT. A similar dispensation has been proposed for FBT on Esops. If the base is lowered from 100% to 10%, it would lower the tax liability for companies.

The government could consider limiting FBT levy to the discount to the fair market value on the date of the grant. Companies can also be allowed to claim a deduction on such expenditure and this would ensure symmetry of tax treatment in the hands of the employer and employee, said Mr Kapadia. While the suspense will be over next week, chances are that the government will opt for a scheme that would be easy to administer and ensure smooth and fast flow of revenues into the kitty.