Finance minister P Chidambaram dashed hopes of the IT industry, last week, when he retained the original Budget proposal to levy a fringe benefit tax (FBT) on companies offering employee stock option plans (Esops).

But he softened the blow for companies by tweaking the method of computing the levy of FBT. Employers have also been given the legal sanction to recover the amountpaid as FBT on Esopsfrom employees. In real terms, the tax burden on Esops will be borne by employees, as in most countries.

The Finance Bill 2007, passed by Parliament, empowers employers to vary the agreement under which Esops have been allotted or transferred to employees. Employers always had the option of passing on the FBT burden to their employees. For the first time, the government has given them the legal right to do so.

It has, however, steered clear of prescribing the manner in which firms can recover FBT on Esops from employees. Companies have to take a call on this and there are quite a few options: deduct the amount from employees salary or grant loans to employees to reimburse the amount. The employee can also sell a part of his shares to discharge the liability.

The fact is that employees have to take the hit if companies decide to pass on the FBT burden. Not just this. Employees will not be able to claim a tax deduction on the amount reimbursed to the employer. Simply put, the employee cannot lower his tax liability.

However, companies will feel the bite a lot less following changes in the method of computing FBT. The fair market value (FMV) of shares will now be calculated on the date on which the option vests with the employee and not on the date of exercise as was originally proposed in the Budget. What this means is that the date of vesting will be the point of valuation while the exercise date will be the point of taxability.

The difference between FMV on the date on which the option vests with the employee and the actual amount paid by the employee will be the value of the fringe benefit. The Central Board of Direct Taxes will prescribe the method for calculating FMV. For example, if FMV of the shares on vesting is Rs 200 and the actual amount paid by the employee is Rs 100. Then, the value of the fringe benefit will be Rs 100. The employer has to pay Rs 33.99 as tax.
 
Tax experts acknowledge that the new method will lower the tax burden for employers when the stock market is on an upswing. This is because the value of Esops on the vesting date would be lower than the value on the date of exercise. Of course, the reverse will hold true in a falling market.

Employers can make an accurate forecast of the FBT cost and pay advance tax more accurately. While the tax burden may be lower for the employer, the changes in the method of computing FBT could translate into a higher short-term capital gains tax liability for employees who sell shares within a year, says Amitabh Singh of Ernst &Young.

As things stand now, the government has given a clear indication of the tax treatment of Esops offered by Indian companies. Many Indian subsidiaries of MNCs also offer stock options to their employees in India. Similarly, a foreign parent can also offer Esops to employees who are sent on assignments from the Indian subsidiary.

Is there clarity on the tax treatment of Esops in cross-border situations? Tax experts reckon that there are ambiguities but policy managers dispute this contention. Take the case of an employee of an Indian subsidiary of an MNC who is offered a stock option by the parent firm. Would the MNC be liable to pay FBT in India?

There is no employer-employee relationship between the employee of the Indian subsidiary and the MNC. The parent company and the Indian subsidiary are two distinct legal entities. Tax authorities cannot lift the corporate veil to levy an FBT on the foreign parent, says Daksha Baxi, a senior tax consultant.

However, policy managers say that shares that have been, directly or indirectly, allotted or transferred to the employee will attract FBT, which means the foreign parent may be liable to pay the levy. This is just one example. There could be a cross-border situation where the option vests while the employee is outside India but are exercised when he is in India, or the reverse.

Here again, revenue authorities say that the law is clear: the employer has to pay FBT if the employee is in India at the time of exercise of the option. The government may be open to clarifying the tax-treatment on cross-border situations if need be.

But the bottom line is that stock options could well lose their sheen as an employee retention tool, particularly in the IT sector where start-ups and biggies have, over the last decade or so, been luring employees with this incentive. FBT on Esops is here to stay. In the days ahead, employers will have to reassess their employment costs, factoring in this new liability.