Taxability of ESOP for Assessment year 2010-2011

Employee stock options (ESOPs) is a significant employer-granted benefit that too is subject to the above FBT /perquisite-based taxation system. In fact, it almost seems as if the authorities cannot quite make up their minds as to how they wish to tax shares given to employees by their employers on a concessional basis. Having been subject to various changes in their valuation norms, the following is the latest position:

The perk tax will be the difference between the fair market value (FMV) of the shares on the date of exercise of the options less the exercise price. And the story does not end here.

Upon sale, capital gains tax will also be payable. Capital gains will be calculated on the difference between the sale price of the shares as reduced by the aforementioned FMV.

Also note that this new law shall apply only in cases where the allotment or transfer of shares is made on or after April 1, 2009. In other words, if allotment is made prior to that date, the same continues to attract FBT.

So, what is important is not the date of announcement or date of grant or date of vesting or date of exercising the option but the date of allotment or transfer of shares/securities to employees.

If shares are allotted or transferred on or after April 1, 2009, the same will be taxed as perquisite in employees’ hands. This is even applicable if the option is vested with the employee or the option is granted or exercised before April 1, 2009.

Incidentally, date of allotment here means the date on which the board of directors pass the necessary resolution for making the allotment.

Let’s understand the changes by means of an example:
Say Sanjay has been granted the option of buying 10 shares of his company at a price of Rs500 per share on April 1, 2008.

At this time, the market price of the share is Rs700. However, the shares vest only on the September 1. But Sanjay actually exercises his option to buy the shares only in April 2009 when the market price of the shares is Rs1,000. Three months later, in July 2009, he sells the shares for a price of Rs1,300 per share. Let’s also assume that the price of the share on September 1 (the date of vesting) was Rs800.

First and foremost, till Sanjay actually exercises the option, there is no tax payable — this was the case during the earlier FBT regime and this remains so even now.

Therefore, in terms of our example, tax liability will only arise in April 2009.

The difference between the market value of the shares on September 1, i.e, Rs8,000 (10 shares x Rs800) and Sanjay’s purchase cost of Rs 5,000 (10 shares x Rs500) would have been the fringe benefit value and consequently FBT would be payable by Sanjay’s employer on this Rs3,000 @33.99%. This amount works out to Rs1,020.

Now, the concept of adopting the vesting date to calculate the FMV has been done away with. Instead, the market price as on the date of exercise has to be taken to calculate the perquisite value.

Therefore, in terms of our example, the difference between the market value of the shares on the April 1, i.e. Rs10,000 (10 shares x Rs1,000) and Sanjay’s purchase cost of Rs5,000 will be the perquisite value. This will be added to Sanjay’s taxable income to arrive at the tax payable by him. Assuming Sanjay is in the highest tax bracket of 30.9% (surcharge is no longer applicable), the tax payable by him on the Esop perk would be Rs1,545.

Moving on, when Sanjay sells the shares, he will be liable to capital gains tax. The holding period of the shares for Sanjay has to be reckoned from the date the shares were allotted to him.

However, earlier his cost would be the FMV on the date of vesting and not what he has actually paid. In terms of our example, Sanjay’s short-term capital gains (STCG) would be Rs5,000 (Rs13,000 – Rs8,000). Now, his cost would be taken as the FMV on the date of exercise and hence the STCG would have worked out to be Rs3,000 (Rs13,000 – Rs10,000).

An interesting point to note here is that under both systems, the aggregate amount brought to tax (FBT / Perk + Capital Gains) remains the same i.e, Rs8,000. However, the break-up differs as in the FBT regime, the FMV as on the date of vesting was to be taken to arrive at the fringe benefit value whereas now the FMV on the date of exercise has to be taken to arrive at the perquisite value.

Another point that needs to be emphasised is that it is not as if the employee is being additionally burdened by the new rules. Earlier, it used to be the FBT that was being recovered from the employee, now instead the employee will be paying perk tax. As far as the employee is concerned, only the name of the tax has changed, tax incidence one way or another stays put.

Actually, this dual-layered taxing of Esops is not new. Till 1999-2000, they were being taxed similarly, only the first stage, instead of being taxed as FBT in the employer’s hands was being taxed as a perquisite in the hands of the employee.

This also gives rise to a practical difficulty. The first stage, i.e., the difference between the market value and the exercise price — is only a notional profit — the employee has not sold the shares yet to realise it. However, paying tax needed cold cash. The numbers in the example are small for ease of understanding, however, imagine if Sanjay had been granted 5,000 shares instead of 10. The perk value (notional profit) in such a case would work out to Rs 25 lakh and Sanjay would need to cough up a tax of Rs7.72 lakh — on income not yet earned. This resulted in the employee needing to sell the shares immediately, just to pay tax, and the entire raison d’etre of getting allotted stock options to participate in the growth of the company stands defeated.