The Budgets proposal to tax employee stock options (ESOPs) as a fringe benefit is wholly unreasonable.

To begin with, ESOPs are not fringe benefits. They are part of compensation, bereft of any confusion regarding which individuals they benefit. Fringe benefits benefit employees as a group. At best, ESOPs can be taxed as a perquisite in the hands of the employees.

Ironically, an amendment proposed in the finance bill does away with the earlier provision that specifically disqualified ESOPs to be counted as a perquisite. The logical corollary should be to recognise ESOPs as perks and to tax them as such.

First, some clarity on how ESOPs work. A company allocates to an employee the right to buy, at a specified future date, a designated number of company shares at a designated price, called the exercise price. Till that future date arrives, these ESOPs vest with the employee, who cannot sell or mortgage them. When the ESOPs mature, the company issues to the employee the number of shares agreed upon.

Till now, ESOPs suffered taxation when the employee booked short-term capital gains, not waiting for a year after he gets hold of the shares to sell them off - after one whole year, the gains are classified as long-term capital gains and exempted from taxation when sold on the stock market, paying securities transactions tax.

Let us see what is the actual cost borne by the company in issuing ESOPs and converting them into shares at the time of maturity. An option to buy a share at a future date at a price determined now comes at a price, called the option premium. The formula to arrive at this option price is complex enough to have fetched two of its three principal architects a Nobel prize in economics (Myron Scholes and Robert Merton in 1997 - Fischer Black missed out because he died in 1995).

It takes into account the price of the underlying stock, volatility, the strike price and the rate of interest. The lower the strike price, as compared to the underlying stock price, the higher would be the price of the option. In the case of an ESOP, the employee does not pay any option premium (except, of course, in the form of blood, sweat and tears at the workplace about which the taxman is not bothered). The company bears the cost of this premium. So, count it as a perk. But a normal option purchased from the stock market is tradable, while ESOPs are not. So it would make sense to apply an illiquidity discount to the theoretical value of the option to arrive at the taxable value of the perquisite.

But this is not the only cost the company bears in the case of ESOPs. The company has to deliver the shares when the ESOPs mature. The company cannot act like a normal option writer who would take forward positions on the stocks, whose delivery he undertakes at the strike price at the time of maturity. A company cannot trade in its own shares. The company would have to issue fresh shares from its authorised capital, typically from a chunk set aside for ESOPs.

The employee has to pay the strike price to the company to get his share. And that amount goes to the company as its share capital and reserves. So what is the benefit bestowed on the employee by the company?

If the company were to make a public issue or a preferential issue at the time ESOPs mature, there would be a particular price it could command for its issue. Sebi has a formula for preferential issue pricing. If the strike price, at which stocks are issued to employees under ESOPs, is lower than this preferential or public offer price, the difference would constitute the additional benefit bestowed on the employee. This can be taxed on par with taxation of stock issues to employees at the time of a public issue at a discount to the issue price to the public.

Capital gains booked by the employee subsequently flow from the ESOPs, all right, but are conceptually distinct from the benefit bestowed on the employee by the company. Such capital gains should be treated on par with other capital gains on the market.