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Taxability of ESOPs depends on Assessee's residential status

Companies view ESOPs as employee retention tools, serving the dual objective of rewarding employees for performance and loyalty and creating a vibrant ownership culture.

Updated: Jul 26, 2011, 01.24 AM IST
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- By Sandip Mukherjee, Executive Director, Tax and Regulatory Services, PwC India

In today’s era of employee-oriented management, employers have realised the value of skilled human assets and are increasingly laying emphasis on several factors such as work environment, perks, and performance-related incentives to keep them motivated and happy. One tool that has evolved in this context over the years is the employee stock option plan, or ESOP, which gives employees the option of buying shares of their company at a fixed price, or within a fixed period. Companies view ESOPs as employeeretention tools, serving the dual objective of rewarding employees for performance and loyalty and creating a vibrant ownership culture.

As regards the taxability of ESOPs, it has undergone numerous changes in the last decade. Prior to the fringe benefit tax (FBT) introduced in 2005, ESOPs were taxed as perquisites and the employee was liable to pay tax on the benefit enjoyed. During the FBT era, the onus of payment of taxes shifted to the employer, with an option to recover the FBT from the employees. The Finance Act, 2009, abolished FBT and again brought back the perquisite taxation norm.

TERMS ASSOCIATED WITH ESOPS GRANT DATE: It is the date on which the employer and employee agree to the terms of the ESOP.

VESTING DATE: It is the date when an employee is entitled to receive the shares after satisfying the specified conditions.

VESTING PERIOD: It is the period between the grant date and vesting date, also known as the “lock-in period” of the plan.

EXERCISING THE OPTION

Employees are eligible to exercise the option anytime after the vesting date. Although the taxable event would be triggered by the actual date of allotment of shares, the perquisite would be valued with reference to its date of exercise.

RESIDENTIAL STATUS AND SCOPE OF TAXATION

The perquisite value of shares allotted under ESOP is the difference between the fair market value (FMV) of shares on the date of exercise and the exercise price (ie, the price, if any, recovered from the employee). The FMV depends on whether the shares are listed on a recognised stock exchange or not. In India, the taxability of income depends upon the residential status of the assessee.


The taxability of ESOP is not an exception to this rule. Resident and ordinarily residents have to pay tax on their global income. Hence, the entire perquisite value is taxable in India. But, in case of residents but not ordinary residents or non-residents, only the perquisite value proportionate to their accrual in India is taxable in India. This is of utmost importance in case of internationally mobile employees.

CAPITAL GAINS

Once the shares allotted under ESOP become the property of the individual, the employee may choose to sell them. The sale would give rise to capital gains tax. To avoid double taxation, the cost of acquisition of the ESOP is considered as the FMV on the date of exercise of shares considered for the computation of the perquisite. Further, to determine whether capital gains is long term or short term, the period of their holding is determined from the date of allotment. The tax treatment remains the same even if the shares issued are of a foreign parent.

TAXABILITY UNDER DTC

Though ESOPs have found a place in the direct tax code (DTC) as well under the chapter ‘income from employment’, its taxability will remain a mystery till valuation rules under the DTC are prescribed.

Although the intention of ESOPs is to inculcate a sense of ownership amongst employees, market analysis reveals that employees generally sell the shares immediately on allotment. This defeats the very purpose of ESOPs. Also, as far as the employees are concerned, they end up paying tax at the time of exercise as well as on sale of shares. Hence, the issue that often gets debated is to what extent ESOPs can be regarded as taxefficient compensation tools.

(with assistance from Basant Porwal & Komal Kotecha)

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