Taxability of ESOP

A recent decision of the Income Tax Appellate Tribunal stated that Employee Stock Options (ESOPs), which give employees a right to buy shares of the company at a predetermined price should be considered as capital assets re-opens the controversy regarding taxation of ESOPs. Currently when shares are allotted to an employee under a Stock Option Plan at a concessional price or free of cost, the benefit arising to him is treated as taxable perquisite. When such shares are ultimately sold by such an employee, these become subject to capital gains taxation in the same manner as any other shares i.e. if the shares are held as short-term capital assets then capital gains tax is charged at the rate of 15 per cent; and if the shares are held as long-term capital assets then the capital gains is charged at the rate of 10 per cent if these are of unlisted companies and if the shares are of listed companies and transferred on a recognised Stock Exchange after payment of Securities Transaction Tax then there is no long term capital gains tax . The Tribunal has held that ESOPs should be considered as capital assets at both stages i.e. at the time of allotment by the employer and later on at the stage of their sale by the employee.

What are Employee Stock Options

Employee Stock Option is one of the several ways in which companies try to retain, reward, compensate and attract their employees. However, these HR practices pose interesting questions in lieu of perquisites so offered. 'Employees' Stock Option' refers to the option given to the whole time directors, officers or employees of a company which gives them the benefit or right to purchase or subscribe at a future date the securities offered by
the company at a predetermined price. This essentially amounts to offering employees (and often Directors also) shares under the stock option plan at prices much below their fair market values. These offers may be made by the company to employees as part of a public issue or otherwise. The 'Option' so offered is a right granted to the employees to apply for the specified security or sweat equity shares at a pre-determined price but there is no obligation on them to accept the offer.
The employees may 'exercise' the option for issue of shares by making an application to the company within the 'exercise period' given in the Employee Stock Option Scheme. The Scheme may offer the option at no price or a concessional price, called 'exercise price'. 'Exercise price' refers to the price payable by the employee at the time of exercising the option granted under the Employee Stock Option Scheme. When an employee exercises his right to purchase the shares being offered, he gets a vested right to get the shares offered under the Scheme subject to fulfilment of the other conditions laid down in the Scheme.

Taxation of ESOPs

Earlier an effort was made by the government to tax these benefits through the Fringe Benefits Tax. When the Fringe Benefits Tax was abolished by Finance (No. 2) Act, 2009 from 1-4-2009, the allotment of such shares was made a taxable perquisite in the hands of the employees with effect from the assessment year 2010-11 by an amendment to section 17(2)(vi) of the Income Tax Act which deals with taxation of perquisites given by an employer to his employees. Simultaneously rules were also introduced in the Income Tax Rules for valuation of these perquisites.
The amended Section 17(2) provides that from assessment year 2010-11 and onwards the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly by the employer free of cost or at concessional rate to his employees (including former employee or employees) shall be taxed as perquisites in employees' hands.
The definition of the term 'Specified security' has been adopted from the Securities Contracts (Regulation) Act to include securities offered as employees' stock option under any plan or scheme. The 'Security' has been given wide definition to cover shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate; derivatives; units or any other instrument issued by any collective investment scheme to the investors in such schemes; securities under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002; any certificate or instrument (by whatever name called) issued to an investor by any issuer being a special purpose distinct entity which possesses any debt or receivable; units or any other such instrument; government securities; and rights or interest in securities.
The phrase 'Sweat equity shares' is defined slightly differently from the term 'specified security' or 'stock options'. 'Sweat equity shares' refer to 'equity shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called'.

Taxability of ESOPs on allotment

Specified securities or sweat equity shares allotted or transferred on or after 1-4-2009 by an employer or former employer to an employee directly or indirectly either free of cost or at a concessional rate are now taxable in the hands of employee in the assessment year relevant to the previous year in which shares or securities are allotted or transferred to the employee. The shares offered under the Employee Stock Option Scheme or the 'Sweat equity shares' may be company's own shares or the shares of any other company. However, mere exercise of option under an Employee Stock Option Scheme does not trigger taxability. The taxability arises on the date of allotment of the shares which is the date on which the underlying assets are allotted by the Board of Directors or are transferred to the employee.

Lock-in period

When shares allotted under an Employee Stock Option Scheme are subject to a lock-in period, then these are not available for use by the employee. Since the shares cannot be sold, the benefit is only notional. Therefore, when shares allotted under the Employee Stock Option Scheme are subject to a lock-in-period, the same will be taxable as perquisite under only in the year in which the lock-in restrictions cease to apply.

Employees

The expression 'employees' has been expanded to cover former employees, executive directors and whole-time directors but it does not include part-time directors as in their cases there is no employer-employee relationship between them and the company. The expression 'employees' includes in its ambit 'promoters' if they are also 'employees' or former employees. Any benefit arising out of Employee Stock Option Scheme to non-employees cannot be taxed as perquisite as there is no employer-employee relationship. However, such benefit may become taxable in their hands as income under the head 'other sources'. Even where allotment or transfer of 'specified security' or 'sweat equity shares' is made by the employer to an employee or former employee indirectly then also it is taxable as perquisite.

ESOPs given by foreign companies

The question whether the stock options given by foreign parent company to employees of its 100 per cent Indian subsidiary would attract tax under section 17(2)(vi) was decided by the authority for Advance Ruling. The authority held that such a situation will fall within the purview of 'directly or indirectly' and the Tax authorities will be justified in invoking the doctrine of 'lifting of the corporate veil' to ascertain the real facts. This Advance Ruling will also apply to the case of employees of a 100 per cent subsidiary of an Indian company. Thus, if a holding company offers its shares to employees of its 100 per cent subsidiary or vice versa, it would come within the scope of the expression 'directly or indirectly'.

Valuation of ESOPs for taxation of perquisites

The value of ESOP required to be taxed as perquisite is the difference between the fair market value of the shares on the date of exercise of the option and the price recovered by the employer from the employee. Therefore for determining the value of the taxable perquisite, one has to first find out fair market value of shares or securities. For this, the fair market value of the securities has to be calculated on the date on which the option is exercised by the employee.

Fair Market Value

When the shares offered under the Employee Stock Option Scheme are quoted on a recognised Stock Exchange in India, their fair market value is the average of the opening and closing price on the date of exercise of option. If on the date of exercise of option, there is no trading of the share on any recognised stock exchange in India; its fair market value is taken as the closing price on any recognised stock exchange on a date closest to the date of exercise of the option. In cases, where shares are not listed in India at all or are listed only outside India, these are required to be valued by Merchant Banker registered with SEBI.

Stock Appreciation rights

Stock appreciation rights (SAR) are another form of benefit given by the employer to the employees but their tax implications are different. These differ from ESOPs as these do not come under the definition of 'specified security' or 'sweat equity shares'. 'Stock Appreciation Rights' are a type of bonus granted to employees which is based on increase in share prices of the company over a defined period of time. Though SARs have similarities with ESOPs, the key difference is that when a stock option is exercised, the employee acquires the right to the underlying security but when a SAR is granted, the employee does not acquire any security. Instead, in SAR, the employee becomes eligible to receive the appreciation in the value of the underlying security, equal to the difference between the current market value and the grant price. Unlike a stock option plan, which aims at employee's participation in ownership, a stock appreciation right is a varied form of bonus payable on the basis of financial performance of the company. Thus, the SARs are not taxable as perquisite but as salary at the time when cash payment is actually received under SAR scheme.