Amendments to the Finance Bill, 2007 recommend further changes to the original proposal on taxation of ESOPs (Employee Stock Option Plans). What are the tax provisions affecting ESOPs in the hands of employees and the employer, as proposed by the Finance Bill, 2007 and the subsequent amendments.

Original Proposal

The Fringe Benefit Tax is a levy on the employer on expenditure incurred on certain specified benefits for `employees based in India'.

The Finance Bill, 2007 proposed to bring ESOPs under the ambit of the FBT. The value of the benefit was sought to be taxed as FBT in the hands of the employer at the time of exercise of ESOP. Therefore, options granted under an ESOP plan before April 1, 2007 would attract FBT at the time of exercise, on or after April 1, 2007.

For the purpose of computing the FBT, the value of the fringe benefit was to be the difference between the fair market value (FMV) of the securities on the date of exercise and the amount recovered from the employee (exercise price). The method for computing the FMV was to be notified by the Central Board of Direct Taxes. The employer was to pay FBT at the rate of 30 per cent (plus applicable surcharge and cess) on the date of exercise of options by the employee.

The benefit or concession would not be taxable in the hands of the employee. The tax implications in employee's hands at the time sale of shares would remain as before the Finance Bill, 2007 that is, to be taxed as `capital gains'. However, the cost of acquisition at the time of sale of the shares would be the FMV on the date of exercise, if such value has been taken into account for levy of the FBT.

Amended proposal

It is now proposed that to determine the value of the fringe benefit, the FMV should be ascertained as of the date on which the option vests as opposed to date of exercise, as first . The liability for payment of the FBT would arise on the date of exercise/allotment of specified securities or shares. The mode and manner of calculation of the FMV as of a specified date would be notified at a later stage. Furthermore, a new provision has been inserted that allows the employer to recover the FBT paid from the employees.

At the time of sale, employees would be subject to capital gains tax on the difference between the sale consideration as reduced by the cost of acquisition, which is the FMV as on the date of vesting of the option.

Impact of the proposed changes

The amendments bring certain advantages to tax payers compared to the original proposal:

As FBT will be calculated on the FMV on the date of vesting, there is a greater certainty on the amount of tax payable,

The law now allows the recovery of the FBT from the employee, and

As compared to date of exercise, the vesting date is a more easily determinable in most cases. Hence, employers can make a more accurate forecast of the FBT cost and pay advance FBT correctly.

The proposed changes have left room for doubt, especially in cross-border situations, such as:

Whether the FBT will be payable in cases where the options vest while the individual was outside India but are then exercised when they are in India,

FBT implications where options have vested while the individual was employed in India but are being exercised when he is employed outside India,

Whether the enabling provisions allow recovery of the FBT from employees where the ESOP are subject to regulatory jurisdiction of countries outside India,

The accounting and corporate tax treatment of such recovery in the hands of the employer, especially as the FBT is not deductible for corporate tax purposes, and

Where employees of the Indian subsidiary are offered ESOPs of the foreign parent, will the Indian subsidiary be liable to pay the FBT

These and many other questions are bound to surface as employers start preparing to put the amended proposals into practice. It is ironic that a small change in the legislation can give rise to so many issues.

Sanjay Grover
Deepika Mathur
(The authors are senior tax professionals with Ernst & Young.)