Don't club Diwali gifts with ESOPs

LEGAL EYE

In March 2005, India Inc got an unpleasant shock with the introduction of the fringe benefit tax (FBT) on every form of expenditure incurred and amenity provided by an employer organisation to its employees.

Other than wages and insurance benefits, the FBT covered travel, hospitality, festivals and welfare expenses, even if deductible in the employer's books, taxed as an employee cost. But the unkindest cut was inflicted in the current Budget, with FBT being imposed on stock options plans and schemes.

An incentive trend started by software companies, employee stock option plans (ESOPs) have evolved as effective remuneration tools, enabling employers in retaining employees by offering the scope of creating wealth alongside the company's growth.

For a salaried employee, the income from "salary" includes prerequisites like any benefit or amenity provided free of cost or at concessional rate. In 2001, Section 17 (2)(iii) of the Income-Tax Act was amended to exclude ESOPs from the definition of prerequisites, if issued in compliance with the Central government guidelines.

Till such time, ESOPs were taxed at both points in the hands of the employees only. As prerequisites, ESOPs were taxed at the point of exercise of option, and as capital gains at the point of sale.

The 2001 amendment preceded a notification laying down the criteria for such exemption, whether applicable to stock option/ownership/purchase schemes/plans "" all forms of sweat equity, irrespective of nomenclature, for buying shares or stock equivalents in the employer's company.

The actual acquisition or exercise of option is after a stipulated period, at a predetermined concessional value. To qualify for the tax relief, the scheme had to contain details of the employees, number of shares being issued, lock-in period and pricing formula. Listed companies additionally were to comply with various Sebi regulations. ESOPs issued by non-compliant companies (if any) would continue to be taxed twice.

In reinstating the first point of tax in ESOPs, there has been a shift in the levy, from income tax to FBT.

Apart from the dissents from industry and additional employer outflows, there are certain moot questions of law that arise. Before 2000, the first-point tax was payable by the employee on his notional income, on the share value at the time of the exercise of the option.

Here, the entire concept of notional income of income tax is questioned. Should anyone be taxed on an unrealised gain when there is a second point of tax on the realisable value?

Likewise, the first point tax is payable not on any actual gain, but on the notional concept of income on the date of exercise of option, at the fair market value (FMV) price. Therefore, in granting to the employee an ostensible pre-requisite of value without hard cash, the employer has to fork out 33.99 per cent on tax.

Tax on notional income is justified only if it operates as a relief. The FBT is levied on the employer, in situations where the employee prerequisite involves collective enjoyment, and it is not possible to isolate the personal element or identify it to a particular employee.

In case of ESOPs, it defeats logic how this could be classified as a fringe benefit, when the right to exercise options, the issued stock, the sale, are all identifiable only with the holder.

Costs such as maintaining a database for erstwhile employees etc, and the fact that FBT cost is not allowed as a deductible expense, will hike the employer's effective cost on ESOPs upto 45.54 per cent.

Employees are relieved that the onus is not on them, though clarity is awaited that in determining their capital "gains", the FMV will form the basis. But the relief is likely to be shortlived. It appears that the levy will cover past grants exercisable in future. The burden on the employer will impact employees, and the viability of granting ESOPs is bound to be reviewed.

A number of cross-border issues may arise, making expatriate employees, subject to personal taxation in an overseas jurisdiction, liable to tax twice on the same income, as the FBT is paid by the employer, may not entitle the employee to tax credit paid by employer in India.

Clubbing Diwali gifts with ESOPs is fundamentally wrong "" one is a jamboree, the other a long-term time-tested strategy, which has created institutions. Let us not skew our visions for a fistful.

Kumkum Sen is a partner at Rajinder Narain & Co

kumkumsen@rnclegal.com