Introduction:
Empolyee Stock Option Plan (ESOP) is a contract between the employee and the company for allotment of specified number of shares on a particular date. The price at which it is offered (strike price) may vary; it could be the current market price or a reduced market price few days prior to or after the date of grant. It is very similar to an Option contract which is traded in the stock exchange. The empolyee has the right, but not the obligation to buy the shares. The difference however, is the ESOP does not expire within few months as it does in a conventional Option contract.
In India, many software companies like Infosys, Wipro, Polaris etc. have issued ESOPs. The employee usually holds the contract for a few years. The date on which the company allots the shares is called date of vesting. After the allotment of shares, the employee may wish to book profit by selling the stock in the market. Normally, ESOPs are non transferable and these need to be exercised during the period of employment in the company.
Unlike exchange traded Options, ESOP is a private contract between the company and its employee. Hence, the company is responsible for delivery of shares to the option holder.
ESOPs may be considered as incentives. Previously, some companies used this strategy to retain the employees; however, it is no longer the case.
Fringe benefit tax:
When an employee sells a publicly traded stock that is listed in a stock exchange, he may acquire capital gains as defined by the Income Tax laws. If the employee holds the stock for more than a year and sells through the recognized stock exchange, he will be exempt from capital gains since this is considered long term investment. If he holds it for a period of less than one year and then sells, it is considered short term capital gains and will be taxed at 10%.
According to the Finance Bill passed on May 11, 2007 the following tax rules are applicable.
- No taxation of perquisites (ESOP) for employees.
- Employer to pay Fringe Benefit Tax at the time vesting to employees.
- Employee to pay capital gains tax when shares received under ESOP are sold.
The value of capital gains shall be computed by deducting the cost of acqusition of ESOP shares from the sale value. In order to arrive at the ‘cost of acquisition’ the Indian Government has proposed to determine ‘Fair Market Value’.
The fringe benefit value represents the difference between FMV of the shares on the date of vesting of options and the price paid by the employee. The Government has now issued separate rules for determining the FMV of listed and unlisted equity shares on the date of vesting of options.
Valuation in case of shares listed on a recognised stock exchange:
In a case where the company’s shares are listed in a recognized stock exchange on the date of vesting, the FMV shall be the average of the opening price and closing price of the share on that date on the said stock exchange. However, if the share is listed on more than one recognized stock exchange, the FMV shall be the average of opening and closing price of the share on the recognised stock exchange which records the highest volume of trading in the share.
Valuation of unlisted shares or shares listed only on the overseas stock exchange(s):
In a case where on the date of vesting, company’s stock is not listed on a recognized stock exchange, the FMV of the company’s stock would need to be determined by a SEBI registered Category 1 Merchant Banker on the specified date (i.e. the date of vesting of the option or any date earlier than the date of the vesting of the option, not being a date which is more than 180 days earlier than the date of the vesting).
According to the Finance Bill, with effect from April 1, 2007, the Fringe Benefit Tax will be 33.99% on the fringe benefit value i.e. (Fair Market Value – Strike Price).
Employers’ reaction to this rule:
The employer can now recover tax from the employee, for which, a fresh section has been introduced in the Finance Bill. The date of taxation has been shifted from the date of transfer of ESOPs to the date of vesting. Tax will be payable when the shares are allotted.
V Balakrishnan, Chief Financial Officer of Infosys Technologies, said in an interview to CNBC TV-18 that the industry wanted the employees to be taxed and not the employers; but it is now clear that the tax should be paid on the date of vesting. Earlier, tax was to be paid on the date of transfer of ESOPs. In this case, the company would have no idea whether the options would be exercised at all; or at least when those would be exercised. He also added that all the taxes related to ESOPs should be borne by the employees and there has to be a “mechanism where the employee pays the money before he exercises the stock, that means forcing employees to sell the stock on vesting. It’s not a good thing but that’s the law, so you have to live with it.”
For example, if an employee buys 1000 shares of a company at a strike price of Rs.500 and on the date of vesting, if the market price is Rs.800, fringe benefit value would be (800 – 500) * 100 = 3,00,000. The company will have to pay 33.99% of this value i.e. Rs. 101970 as tax.
Conclusion:
Since most companies will pass on the tax liability to the employees, this would definitely be a disadvantage for those who wish to exercise ESOP. They lose substantial portion of their profits due to this new rule. But those who still want to exercise the ESOP have no choice.