ESOPs are now taxable as perquisites

The Central Board of Direct Taxes (CBDT) has notified the rules regarding the valuation of perquisites. Accordingly, certain employment related benefits like using a company provided car, chauffeur, accommodation, concessional loan, etc will be subject to tax.

Though these guidelines have been issued recently, the precursor to this move was laid down in Budget 2009. Readers may remember that the budget had discontinued Fringe Benefit Tax (FBT). All these items of benefits were (prior to the budget) taxable as FBT. Now that FBT no longer applies, the earlier perquisite based taxation has been brought in. So in a sense this is not a new move but a revert to the earlier system of taxation.

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Employee Stock Options (ESOPs) is another significant employer granted benefit that too is subject to the above FBT/Perquisite based taxation system. In fact, it almost seems as if the authorities cannot quite make up their minds as to how they wish to tax shares given to employees by their employers on a concessional basis. Having been subject to various changes in their valuation norms, the following is the latest position.

The perk tax will be the difference between the Fair Market Value (FMV) of the shares on the date of exercise of the options less the exercise price. And the story does not end here. Upon sale, capital gains tax will also be payable. Capital gains will be calculated on the difference between the sale price of the shares as reduced by the aforementioned FMV.

Also note that this new law shall apply only in cases where the allotment or transfer of shares is made on or after 1-4-2009. In other words, if allotment is made prior to 1-4-2009, the same continues to attract FBT.

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So what is important is not the date of announcement or date of grant or date of vesting or date of exercising the option but the date of allotment or transfer of shares/securities to employees. If shares are allotted or transferred on or after April 1, 2009 - the same will be taxed as perquisite in employees' hands. This is even applicable if the option is vested with the employee or the option is granted or exercised before April 1, 2009.

Incidentally, date of allotment here means the date on which the Board of Directors pass the necessary resolution for making the allotment.

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Let's understand the above changes by means of an example.

Say Sanjay has been granted the option of buying 10 shares of his company at a price of Rs 500 per share on the 1st of April 2008. At this time, the market price of the share is Rs. 700. However, the shares vest only on the 1st of September. But Sanjay actually exercises his option to buy the shares only in April 2009 when the market price of the shares is Rs. 1,000. Three months later, in July 2009 he sells the shares for a price of Rs 1,300 per share. Let's also assume that the price of the share on 1st of September (the date of vesting) was Rs 800.

First and foremost, till Sanjay actually exercises the option, there is no tax payable - this was the case during the earlier FBT regime and this remains so even now. Therefore, in terms of our example, tax liability will only arise in April 2009.

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The difference between the market value of the shares on the 1st of September i.e. Rs. 8,000 (10 shares x Rs. 800) and Sanjay's purchase cost of Rs 5, 000 (10 shares x Rs 500) would have been the Fringe Benefit Value and consequently FBT would be payable by Sanjay's employer on this Rs 3,000 @ 33.99%. This amount works out at Rs 1,020.

Now, the concept of adopting the vesting date to calculate the FMV has been done away with. Instead, the market price as on the date of exercise has to be taken to calculate the perquisite value.

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Therefore, in terms of our example, the difference between the market value of the shares on the 1st of April i.e. Rs 10,000 (10 shares x Rs 1,000) and Sanjay's purchase cost of Rs 5,000 will be the perquisite value. This amount will be added to Sanjay's taxable income to arrive at the tax payable by him. Assuming Sanjay is in the highest tax bracket of 30.9% (surcharge is no longer applicable), the tax payable by him on the ESOP perk would be Rs 1,545.

Moving on, when Sanjay sells the shares, he will be liable to capital gains tax. The holding period of the shares for Sanjay has to be reckoned from the date the shares were allotted to him.

However, earlier his cost would be the FMV on the date of vesting and not what he has actually paid. In terms of our example, Sanjay's short-term capital gains (STCG) would work out at Rs 5,000 (Rs 13,000 – Rs 8,000). Now, his cost would be taken as the FMV on the date of exercise and hence the STCG would have worked out to be Rs 3,000 (Rs 13,000 – Rs 10,000).

An interesting point to note here is that under both systems, the aggregate amount brought to tax (FBT / Perk + Capital Gains) remains the same i.e Rs 8,000. However, the break up differs as 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.

Another point that needs to be emphasised is that it is not as if the employee is being additionally burdened by the new rules. Earlier, it used to be the FBT that was being recovered from the employee, now instead the employee will be paying perk tax. As far as the employee is concerned, only the name of the tax has changed, tax incidence one way or another stays put.

Back to old rules

Actually, this dual layered taxing of ESOPs is not new. Till 1999-2000, ESOPs were being taxed similarly, only the first stage, instead of being taxed as FBT in the employer's hands was being taxed as a perquisite in the hands of the employee.

This also gives rise to a practical difficulty. The first stage i.e. the difference between the market value and the exercise price - is only a notional profit - the employee has not sold the shares yet to realise it.