The current Income Tax Law, provides for the inclusion of ESOPs under section 17(2) to be taxed as a “perquisite”, consequent to the abolition of FBT.
The section states that ESOPs issued free of cost or at concessional rates will be taxed on the date of exercise on the difference between the “fair market value” and the amount actually paid by the employee. The “fair market value” is to be determined based on stipulated methods which will be separately prescribed by the CBDT.
This suffers from the following drawbacks:
a) It seeks to tax a notional benefit at a time when the actual gain is not realized by the employee. In fact, it is possible that the actual sale of shares could result in a loss for the employee. Since the perquisite tax paid earlier cannot be set off against the capital loss, the employee suffers a double loss, namely tax outgo and loss on sale of shares.
b) The question whether the ESOPs are granted at a concessional rate is being determined with reference to the “fair market value” on the date of exercise of the options. Technically, this is an incorrect approach. If the ESOPs are issued at the prevailing market price on the date of grant, the issue should be treated as “non concessional”. This would be in line with the guidelines issued by SEBI. Any subsequent gain accruing to the employee due to favorable market movements by the date of vesting or exercise of option cannot be treated as a “perquisite” granted by the employer.
c) Further, if such subsequent gains are a perquisite in the hands of employers, it would stand to reason that the value equivalent of such a perquisite should have been a deductible expenditure in the hands of the company issuing the ESOP. Since the tax law does not contemplate such a deduction, the taxation of the perquisite would result in double taxation.
d) Also, from the strictly legal angle, there are a number of differences between ordinary shares and ESOP shares. Therefore, they are not comparable. The taxation principles currently existing result in discrimination. The market value is also strictly not applicable since there are lock-in periods applicable.
Since the actual sale of shares will attract capital gains tax, if applicable, it is unnecessary to subject the employee to perquisite tax. In fact, before FBT was imposed on ESOPs, specific provisions existed in the Income Tax Act for exempting the same from perquisites and subjecting it only to capital gains tax.
Suggestion by ICAI
It is suggested that the tax on ESOPs should be only at the point of sale of the shares by the employees and not at the time of exercise of shares to encourage the companies to grant ESOPs in consideration of the talent pool and the contribution made by the employees.