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Tax Treatment of ESOPs

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Ajay Kumar was handsomely rewarded with Employee Stock Option Plans ( Esops) on the foreign company shares ( listed on European stock exchanges) from his multinational company last year. He was more than happy when he received his paycheck in August last year after he had exercised his stock options and then sold shares to capitalise on the 10 euro per share (approximately ₹ 87) difference ( between the market price and the exercise price) that was available on the Esops. His company withheld the required TDS on the Esops realisation and handed the balance to him. Esops have emerged as one of the most effective compensation tools by Indian and multinational companies alike. A KPMG study on Esops lists some of the popular reasons for implementing them as: wealth creation for employees, retention, attracting fresh talent and inculcating the feeling of ownership in order to motivate employees. The same study noted that Indian companies with overseas operations are increasingly awarding equity incentives in order to attract and retain talent.

How it works?

Under an Esop, top- performing employees are eligible to purchase apre- determined number of shares (option granted) in the company at apre- determined price ( also called the exercise price). This is usually at adiscount to the market price. Once this option vests with the employees, their decision to buy ( or not) such shares has to be conveyed during the vesting period ( generally a year or two). After the vesting period, the shares can be bought at the exercise price. At that time, an employee may sell the stock or hold on to it in hopes of further price appreciation. In some cases, companies provide for a specified lockin period, during which the shares cannot be sold.

Tax implications

The taxation laws of Esops has gone through several changes in the past few years. During the draconian FBT regime, an employer was required to pay a fringe- benefit tax on the benefit derived by employees from Esops, which in turn could be recovered from employees.

At present, benefits derived from Esops are taxed as perquisites and form part of salary income. The perquisite value is computed as the difference between the Fair Market Value ( FMV) of the share on the date of exercise and the exercise price. There are specific valuation rules prescribed for listed and unlisted companies in order to determine the FMV. An employer is required to deduct tax ( TDS) in respect of any tax liability arising from perquisites.

Personal taxes

In addition, the difference between the sale consideration of the shares and the FMV on the date of exercise (as referred above) is chargeable to tax under the head capital gains in the hands of an employee. In order to compute capital gains, the FMV on the date of exercise becomes the cost of acquiring such shares. Depending on whether they have been held for 12 months or more from the date of exercise, capital gains will qualify as long term or short term. Further, if the shares are sold on a recognised stock exchange in India, the longterm capital gains will be exempt and the short- term capital gains will be subject to the preferential rate of taxes at 15 per cent.

Most employees allotted Esops sell the shares immediately to enjoy the gains and regard this money as apart of a bonus. Consequently, this money is spent on luxury holidays, cars or more productive matters such as pre- paying large home loan balances.

After having utilised the money gained from Esops, employees forget the potential tax liability arising out of the capital gains. They are then in for a rude shock when they come face- to- face with the truth during tax- filing season.

The tax soup!

In Kumar's case above, since the Esops were sold immediately on exercise, he had earned short- term capital gains. Again, as the shares were sold on a foreign stock exchange, they were not eligible for preferential tax rates. In other words, Kumar was now liable to pay short- term capital gains tax on the entire capital gains of ₹ 3 lakh at the slab rates applicable, which turned out to be the highest slab rate, before he could file his tax returns in July this year. To add to his woes, the high amount of taxes (approximately ₹ 90,000) that he was now liable for, also attracted interest under various sections of the Income- Tax Act for non- payment of advance- tax installments during the previous year 2012- 13. His total tax liability, including tax and interest amounted to a whopping ₹ 105,000 that was due to be paid by the end of July 2013. Kumar was dumb- struck with these calculations and left feeling that the whole Esop thing did not really benefit him in the way he had perceived it.

Much like him, other employees cash in on Esops by selling them in the stock market. They seem to be content with the TDS by an employer and forget the capitalgains liability. Even with the preferential short- term capital- gains tax rate, the liability works out to quite asum if left till the year- end.

All employees who cashed in on Esops since April this year can work out their potential capital- gains liability and discharge a part of it through the first advance- tax installment due by September, 15. Of course, holding on to the shares for more than 12 months after the date of exercise and then selling it on recognised Indian stock exchanges can help an employee avoid capital gains totally.

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