Employee Stock Options Plans (ESOPs) and its different variants like Employees Stock Purchase Plans, Stock Appreciation Rights, Stock Awards, etc, have been used by employers to attract, retain and motivate employees. ESOPs have been popular primarily in the knowledge-based industries like information technology, biotechnology, etc. However, in the recent past, they have gained prominence even in traditional industries like manufacturing.
The tax law relating to the taxability of ESOPs has been changing and has evolved over a period of time from perquisite taxation to fringe benefit tax (FBT) and now back to perquisite taxation. It is important to understand the distinction between the event of taxability under the erstwhile FBT vis-à-vis the new perquisite rules as there is a significant difference between the two.
Fringe Benefit Tax (FBT)
Under the FBT regime, which was effective till March 31, 2009, the benefit arising to the employee under the stock option plan being the difference between the fair market value (FMV) of the ESOPs on the date the option vests with the employee and the amount actually paid by or recovered from the employee was considered to be the fringe benefit and was accordingly liable to tax.An option was available to the employer either to pay the FBT on its own or to recover the same from the employee, subject to the terms and conditions under the stock option agreement.
New perquisite rules
Under the new perquisite rules, it is important to note that the trigger for taxability has shifted from the date when the option vests to the date when the option is exercised. Thus, effective April 1, 2009, the benefit arising to an employee being the difference between the fair market value on the date on which the option is exercised less the amount actually paid or recovered from the employee would be subject to tax as part of the salary income.
Thus, an employer is required to compute the benefit under the stock options, include the same as part of the salary income and accordingly withhold the tax on the same from the employee.
Fair Market Value (FMV)
In case the shares of a company are listed on a recognised stock exchange, the FMV is to be determined as the average of the opening price and the closing price of the share on that date. In case the shares are not listed on the recognised stock exchange, the FMV is to be determined by a merchant banker as specified under the perquisite rules.
The next event of taxability under the stock options would arise in the event of sale/transfer of shares. The difference between the sales consideration and the fair market value on the date of exercise would be treated as capital gains and subject to capital gains tax. The capital gains could be long-term or short-term, depending upon the period of holding of such shares/securities.
Certain open issues
It is possible that on the date of exercise, the employee may not have sufficient cash with him to pay the tax liability. However, as the employer is under an obligation to withhold tax, the same may be done either by withholding the amount from the salary income or by disposing off the specified number of shares to meet the tax liability, subject to the terms and conditions under the plan.
Further, certain clarifications were provided under the FBT regime in respect of taxability of the benefit arising under ESOPs in case of employees who have worked in India and overseas. Similar clarifications should be provided under the perquisite taxation rules as there are still lots of areas which require clarification, especially in case of individuals whose residential status is non-resident/not ordinarily resident and who have worked overseas during the period of the ESOP.
By Vikas Vasal Executive Director, KPMG.