Employee Stock Options (ESOPs) is a significant employer-granted benefit, subject to the perquisite-based taxation system. Employee benefits used to be subject to Fringe Benefit Tax (FBT) earlier.
But, now that FBT no longer exists, the earlier perquisite-based taxation has been brought in. So, in a way, this is not a new move but a reversion to the earlier system of taxation.
The perquisite tax is the difference between the Fair Market Value (FMV) of the shares on the date of exercise of the options and the exercise price. Upon sale, capital gains tax will also be payable.
Suppose Sudheer Ranade has the option of buying 10 shares of his company at Rs 500 a share on April 1, 2008 when the market price is Rs 700.
However, the shares are vested to him only on September 1, 2008 when the price is Rs 800.
Sudheer exercises his option by buying the shares in April 2010 (market price Rs 1,000). In July 2010, he sells them for Rs 1,300 a share.
The mere act of granting the options (in April 2008) or vesting of it (in September 2008) is completely tax-neutral. Tax liability will arise only in April 2010 when he actually exercises the option.
Earlier, in the FBT regime, the difference between the market value of the shares on vesting date and purchase date would be the value of the fringe benefit. Consequently, FBT would be payable by the employer on this amount at 30 per cent.
Now, the market price as on the date of exercise has to be considered to calculate the perquisite value. Therefore, the difference between the market value of the shares on April 1, that is Rs 10,000 (10 shares x Rs 1,000) and Sudheer's purchase cost (Rs 5,000) will be the perquisite value.
This amount will be added to Sudheer's taxable income to arrive at the tax payable by him. If he is in the highest tax bracket of 30 per cent, the tax payable by him on the ESOP perk would be Rs 1,500.
When Sudheer sells the shares, he will also be liable for capital gains tax. The holding period of the shares has to be calculated from the date the shares were allotted to him.
Earlier (during the FBT regime), his cost would have to be taken as the FMV on the date of vesting and not what he has actually paid. Sudheer's short-term capital gains (STCG) would have worked out to Rs 5,000 (Rs 13,000-Rs 8,000).
Now, the cost would be taken as the FMV on the exercise date and, hence, the STCG would work out to be Rs 3,000 (Rs 13,000-10,000).
An interesting point is that under both systems, the aggregate amount brought to tax (FBT/perk plus capital gains) remains the same, that is Rs 8,000.
However, the break-up differs. 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.
Earlier,employers recovered FBT from the employee; now, the employee will be paying tax on the perquisites he gets.
The perk-based tax system gives rise to a practical difficulty. The difference between the market value and the exercise price, is only a notional profit.
The employee has not yet sold the shares to realise it. However, paying tax needs cash. The numbers in the illustration (see table) are small.
But, if Sudheer had been granted 5,000 shares instead of 10, the notional profit would work out to be Rs 25 lakh and he would need to cough up a tax of Rs 7.50 lakh on income not yet earned.
This results in employees selling the shares immediately, just to pay tax, defeating the point of allotting stock options to participate in the growth of the company.
The writer is Director, Wonderland Consultants