ESOP Taxation post Finance Act 2009

Taxation of Employee Stock Options following amendments by the Finance Act, 2009.

From Assessment year 2008-2009 onwards, ESOPs (Employee Stock Options) were being treated as Fringe Benefits and taxed in the hands of the Employer. However, with the abolition of Fringe Benefit Tax with effect from Assessment Year 2010-2011, there are significant changes in the taxation of ESOPs (Employee Stock Options).

The substituted clause (vi) of sec. 17(2) of the Income Tax Act (Finance Act, 2009) states that the “value of any specified security including ESOP or Sweat equity shares allotted or transferred, directly or indirectly by the employer or former employer, free of cost or at a concessional rate” will be taxed as perquisite. Thus, from 1^st April, 2009 onwards, any specified security or sweat equity which is allotted or transferred (directly or indirectly) by an employer to an employee (assessee), either free of cost or at a concessional rate will be taxed as a perquisite in the hands of the employee.

There is a difference in the method used for valuation of shares and securities in relation to employee stock options. For a comprehensive analysis, we have to understand the method of arriving at the valuation both before and after the amendment.

I. ESOP as a Fringe Benefit (Assessment Year 2008-2009 and 2009-2010):

As mentioned earlier, for A.Y. 2008-2009 and A.Y. 2009-2010, the difference between the fair market value and the concessional price viz, amount ( if any) paid by or recovered from the employee, is to be treated as fringe benefit. In order to provide a means to define “fair market value”, the CBDT vide notification number 264 dated 23-10-2007 inserted rule 40C in the Income tax rules, which prescribed the method of arriving at the fair market value (FMV) of the security. As per rule 40C, the date of vesting of the option was treated as the “relevant date” for the purpose of calculation of fair market value (FMV). In other words, it is the date on which the option is offered or “vested” in the hands of the employee. The employee may exercise this option at a later date which will be the date of exercise of the option. The actual transfer or allotment will follow after the exercise of the option by the employee. Having considered this, let us understand the methods prescribed for determination of the FMV which are as under :-

Particulars	Fair Market Value
a) Shares of a listed Company where there is trading on the relevant date.
Listed in one Registered stock exchange	Average of opening and closing price on relevant date.
Listed in more than one registered stock exchange	Average of opening and closing price in the stock exchange that records the highest volume of trading in shares on the relevant date.
b) Shares of a listed Company where there is no trading on the relevant date.
Listed in one Registered stock exchange	Closing price of the share on any recognized stock exchange on a date closest and immediately preceding the relevant date.
Listed in more than one registered stock exchange	Closing price of the share on any recognized stock exchange on a date closest and immediately preceding the relevant date in the stock exchange that records the highest volume of trading in shares.
c) Shares of an unlisted company.	As determined by the merchant banker on the specified date*.

· Specified date means the date of vesting of the option or, any date earlier than the date of vesting of the option, not being more than 180 days earlier from the date of vesting.

Rule 40D was inserted to specify that in case of security other than shares, the fair market value was to be determined by the merchant banker on the specified date.

Capital Gains computation in case of sale of ESOPs by employee (assessee):

For the abovementioned assessment years, the cost of acquisition of the securities (ESOPs) is to be the fair market value used for computing the value of the fringe benefit [as per section 115WC(1)(ba)] . The period of holding of the security is to begin from the date of allotment or transfer of the said securities [as per sub clause (hb) – clause (i) of Expln. 1 to clause (42A) of section 2]. Further, recovery of FBT by employer from the employee is also permitted under section 115WK.

II. ESOPs as perquisites (Assessment Year 2010-2011) onwards :

Change in the definition of relevant date :

With the ESOPs being taxed in the hands of the employee as perquisites, there is also a change in their method of valuation. In this case, the date of exercise of the option is treated as the relevant date for the purpose of valuation. Therefore, the value of the perquisite is to be the difference between the fair market value (FMV) of the securities (shares) on the date of exercise of the option and the exercise price paid by the employee (assessee). The method of arriving at the perk value will be the same as earlier subject to the change in the definition of “relevant date”.

Applicability of amended provisions :

For the purpose of applying the amended provisions, the date of allotment or date of transfer shall be considered. In other words, if the date of allotment or transfer is on or after 1^st April, 2009, the ESOPs will be treated as perquisites in the hands of the employee. Otherwise, the ESOPs will be treated as a fringe benefit and taxed in the employer’s hands. The “date of allotment” means the date on which the board of directors pass the resolution for making the allotment of the shares.

Capital Gains computation in case of sale of ESOPs by employee (assessee):

Apart from the change in the method of determination of the fair market value (FMV), the period of holding of the security is to begin from the date of exercise of the ESOP instead of on the date of allotment or transfer of the securities.

III. Understanding by example :

In order to understand the concept of taxing as a perquisite, we can consider the following example. A Company has granted a stock option of 50 shares to P an employee at the concessional rate Rs. 50/- per share. The fair market value (under the old provisions) of the shares is Rs. 100/- per share on the date of vesting which is 1^st December, 2009. The exercise period is 6 months from 1^st December, 2009 to 31^st May, 2009. P exercises the option on 15^th April, 2009. At the time of exercising the option, the fair market value of the shares is Rs. 200/- per share. The allotment of the shares takes place on 18^th April, 2009.

Scenario 1.

In the quoted example, P is liable to pay tax on the ESOP since the date of allotment is after 31^st March, 2009. The tax on the perk will be calculated as under :-

Fair Market Value of Shares on date of exercise of option on 15-04-2010.

50 Eq. @ 200/- per share = 10,000/-

Less : Exercise price

(Concessional price 50 Eq.@ 50/- per share) = 2,500/-

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Value of Perquisite in the hands of P 7,500/-

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Since, P is in the highest taxable category, tax payable will be 30.9% on the perk which will amount to Rs. 2,318/-.

In addition, if P also sells the shares at the market value of 500/- per share on say, 30^th June, 2010, he will have to also pay short term capital gains on the difference between the cost of acquisition (fair market value) and the selling price of the shares.

Thus, amount liable for S.T.C.G. tax will be as under :-

Sale price (50 Eq. @ Rs. 500/- per share) = 25,000/-

Less : Cost of Acquisition (Fair Market Value) = 10,000/-

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Short Term Capital Gains (STCG) = 15,000/-

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Short Term Capital Gains Tax will be payable on Rs. 15,000/- as illustrated above.

Scenario 2

Conversely, if P had exercised the option earlier, in February, 2009 and the date of allotment/transfer had been say 15^th March, 2009, the transaction would be liable for Fringe benefit tax (FBT). In such a scenario, the fair market value of Rs. 100/- per share on the date of vesting of the option on 1^st December, 2009, would have been used for calculating the value of the fringe benefit.

The working is as follows :-

Fair Market Value of shares on date of vesting (1-12-2009)

50 Eq. @ Rs. 100/- per share = 5,000/-

Less : Concessional price of Rs.2,500/-

50 Eq. @ Rs. 50/- per share = 2,500/-

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Value of Fringe Benefit (FB) taxed in the hands of Employer Company 2,500/- =========

In case of the sale of shares @ 500/- per share on 30^th June, 2009, the short term capital gains would be liable to tax in the hands of P. The calculation would be as under :-

Sale price (50 Eq. @ 500/- per share) = 25,000/-

Less : Cost of Acquisition (Fair Market Value) = 5,000/-

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Short Term Capital Gains (STCG) = 20,000/-

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Short Term Capital Gains Tax will be payable on Rs. 20,000/- as illustrated above.

Conclusion : -

We can clearly see from the quoted example that there is double layering of tax. The profit element is taxed either as Fringe benefit/perk or as short term capital gain. After the amendment, there is a slight increase in the burden of tax on the employee. This is due to the fact that as a fringe benefit, the tax is borne by the employer and can be recovered from the employee in suitable installments in case of higher tax amount. Whereas, when taxed as a perquisite, the entire amount has be paid by the employee from his own pocket and is a significant drain on his cash-flow.

However, with the introduction of perquisite based taxation of ESOPs, we are taken back to the position which existed till 1999-2000. Ironically, it appears that the government has come full circle in its approach towards taxation of perquisites/benefits to the employees.