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FRINGE BENEFIT TAX ON EMPLOYEE STOCK OPTIONS - BY -
Praveen Boda, ACA & Grad CWA

Finance Bill 2007 which proposed Fringe Benefit Tax (FBT) on the Stock Options (ESOP) has received the assent of the President of India on May 11, 2007 and is now in effect retroactive to April 1, 2007.

Original Proposal

The Original proposal in the Finance Bill 2007 was to levy FBT on the employer on expenditure incurred on certain specified benefits for `employees based in India'. The Finance Bill, 2007 proposed to bring ESOPs under the ambit of the FBT. Before this amendment, there is no tax liability on ESOPs in the hands of employer. It’s noteworthy to refer to Question No: 8 of Circular: 8/2005 issued by Central Board of Direct Taxes on August 29, 2005:

“Whether the value of any benefit provided by the employer to its employees by way of allotment of shares, debentures, or warrants directly or indirectly under any Employees Stock Option Plan or Scheme of the company, is liable to FBT?

Ans. The value of any benefit provided by the employer to its employees by way of allotment of shares, debentures, or warrants directly or indirectly under any Employees Stock Option Plan or Scheme of the company is a fringe benefit within the meaning of clause (a) of section (1) of section 115WB. However, in the absence of a computation provision in respect of such benefits, the charging section fails. Therefore, the value of such benefits is not liable to FBT.”

Per Finance Bill 2007, the value of the benefit was sought to be taxed as FBT in the hands of the employer at the time of exercise of ESOP. Therefore, options granted under an ESOP plan before April 1, 2007 would attract FBT at the time of exercise, on or after April 1, 2007. For the purpose of computing the FBT, the value of the fringe benefit was to be the difference between the fair market value (FMV) of the “securities” on the date of exercise and the amount recovered from the employee (exercise price). The method for computing the FMV was to be notified by the Central Board of Direct Taxes. The employer was to pay FBT at the rate of 30 per cent (plus applicable surcharge and cess) on the date of exercise of options by the employee. The benefit or concession would not be taxable in the hands of the employee. The tax implications in employee's hands at the time sale of shares would remain as before the Finance Bill, 2007 — that is, to be taxed as `capital gains'. However, the cost of acquisition at the time of sale of the shares would be the FMV on the date of exercise, if such value has been taken into account for levy of the FBT.

Amended Proposal

Per Finance Act, 2007, it is now proposed that to determine the value of the fringe benefit, the FMV should be ascertained as of the date on which the option ‘vests’ as opposed to date of ‘exercise’. The liability for payment of the FBT would arise on the date of exercise/allotment of specified securities or shares. The mode and manner of calculation of the FMV as on a specified date would be notified at a later stage. Furthermore, a new provision has been inserted that allows the employer to recover the FBT paid from the employees. At the time of sale, employees would be subject to capital gains tax on the difference between the sale considerations as reduced by the cost of acquisition, which is the FMV as on the date of vesting of the option.

Amended Provision

Clause (d) has been inserted in section 115WB (1) by Finance Act, 2007, which is as follows:
115 WB (1) (d) 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).

For the aforesaid purpose, “specified security or sweat equity shares have been defined as follows:
• Specified security means the securities as defined in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and includes employees stock option;
• Sweat equity shares means 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.

As per Securities Contracts (Regulation) Act, 1956, “security” includes:

• Shares, scrip’s, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate
• Derivative
• Units or any other instrument issued by any collective investment scheme to the investors in such schemes
• Security receipt as defined in Section 2(zg) of Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002
• Units issued to the investors under any mutual fund scheme
• Government securities
• Such other instruments as may be declared by the Central Government to be securities
• Rights or interests in securities
From the above, it is clear that Restricted Stock Units (RSU), Employee Stock Purchase Plan (ESPP) and Employee Stock Option Plan (ESOP), fall with in the definition of “security” liable to FBT in India. However, Stock Appreciation Rights (SAR), Phantom Stock Plans (PSP) that doesn’t provide shares or securities is unlikely to be subject to FBT.

Year of Taxability

As per Sec 115WB (1) (d), FBT is payable in the year in which specified security or sweat equity shares are allotted or transferred (exercised) by the employer’s to employee, regardless of the fact whether stock option plan is offered to the employees free of cost or at concessional rate. Note that the vesting date does not have any influence on when the FBT becomes payable. The liability to tax will be attracted on the date of allotment or transfer of the shares.

Value of Fringe Benefits

Clause (ba) has been inserted in section 115WC (1) by Finance Act, 2007, which is as follows:

115WC.(1) for the purposes of this Chapter, the value of fringe benefits shall be the aggregate of the following, namely:

(ba) the fair market value of the specified security or sweat equity shares referred to in clause (d) of sub-section (1) of section 115WB, on the date on which the option vests with the employee as reduced by the amount actually paid by, or recovered from, the employee in respect of such security or shares.
Explanation. For the purposes of this clause,
(i) Fair market value means the value determined in accordance with the method as may be prescribed by the Board;
(ii) Option means a right but not an obligation granted to an employee to apply for the specified security or sweat equity shares at a predetermined price

Concept of Vesting

An option is a right and not an obligation to purchase the shares. Granting stock options is not the same thing as “allotting”/”transferring” shares of the stock. Shares are purchased by exercising the options. Generally, this right to exercise is spread over a number of years.

For example, say at the beginning of the year, ABC Ltd grants its employees options to buy 100 shares of the company at 200 per share. Employees can buy 25% of the shares at the end of the first year, another 25% at the end of the second year and so on over a four-year period. This means, the shares are being vested one-fourth at the end of every year. In other words, though options have been granted at the beginning of the year, it is only at the end of each year that the employee is being vested with one-fourth of the shares he is entitled to. The vesting schedule determines when the employee gets control over his options. Once vested, the employee still has to exercise the options at the exercise price during the exercise period in order to become the owner of the shares.

What the aforesaid provision, as regards Valuation of Fringe Benefits states in simple terms is

• Fair market value (FMV) of shares has to be taken for valuation purpose
• Valuation date for FMV is the date on which the shares are vested in employee.
• FBT is payable in the year the shares are allotted or transferred or exercised
• Value of fringe benefit shall be FMV reduced by amount paid by employee (exercise price).
• FBT will be charged @ 33.99%

FBT on Restricted Stock Units (RSU)

A restricted stock unit is a grant valued in terms of company stock, but company stock is not issued at the time of the grant. After the recipient of a unit satisfies the vesting requirement, the company distributes shares or the cash equivalent of the number of shares used to value the unit. If the plan rules allow it, the company may require or the recipient may choose to defer distribution to a later date. Vesting requirements may be met by the passage of time or by either company’s or individual’s performance. If the recipient does not meet the requirements that the company set forth, prior to the end of the vesting period, the units are typically forfeited to the company. Depending on plan rules, the participant may be allowed to choose whether to settle in stock or cash.

For restricted stock units, the amount of the FBT will be the fair market value of the shares (assuming there is no consideration paid by the employee to receive the award or the shares) at the time the shares are "allotted"/”transferred”. This is the vesting date of the award.

Hence, for example, if an RSU award of 1,000 shares (granted at no consideration) vested on May 1, 2007, and the value of the stock on that date was 30 per share, then the taxable amount would be 30,000 and the FBT would be equal to 10,197 (33.99% x 30,000).

FBT on Employee Stock Purchase Plan (ESPP)

An employee stock purchase plan, (ESPP) is a type of broad-based stock plan that allows employees to use after-tax payroll deductions to acquire their company's stock, usually at a discount of ranging from 5-15%. Usually all employees are eligible to participate, however, depending on the plan rules, each company may have unique eligibility requirements.

With respect to ESPPs, FBT will be based on the discount at the date of purchase of the shares. Hence, for example, if shares worth 100 on the purchase date are purchased for 85 per share (15% discount off the stock price at the end of the purchase period), then the taxable amount would be 15 per share and tax rate of 33.99% would be applied against that amount.

FBT on Employee Stock Option Plan (ESOP)

A stock option is the opportunity, given by employer, to purchase a certain number of shares of company's common stock at a pre-established price, known as the grant price , over a specific period of time, known as the vesting period. ESOP is primarily a kind of incentive to hold the employees to the company's fold. Employees who are granted stock options have a vested interest in the performance of their company's stock. An increase in performance by the employees can be reflected in the profitability, which in turn, benefits the price of the stock. In addition, because stock options tend to be granted in regular schedules, with vesting periods at intervals in the future, stock options increase employee commitment to their company.

In the case of options, it is somewhat more complicated, as the FBT will be determined based on the fair value at vesting, but not payable until exercise. Hence, for example,

A company announces an ESOP plan under which company will allot 500 shares of company to certain employees at a price of 100 (grant price). Those eligible employees will have option of getting allotment of 100 shares on October 1 every year starting from April 1, 2007 for next five years. He is vested with 100 options on October 1, 2007. The market value on October 1, 2007, (vesting day) is 500. Let us say, an employee fills out the ESOP application form on August 1, 2008 for allotment of shares (exercise day). These 100 shares are sold by the employee on March 31, 2010 at a price of 1200 (sale day).

• FBT is payable in the year of transfer of allotment/transfer i.e. PY: 2008-09
• Valuation date for Fair Market Value is October 1, 2007
• Value of Fringe Benefit Tax is the difference between FMV as on vesting day and the grant price i.e., (500-100)*100 Shares

However, as noted above, the FBT will not be due until the option is exercised.

Recovery of fringe benefit tax by the employer from the employee

Section 115WKA has been inserted enabling employer to recover fringe benefit tax by in respect of sweat equity shares, etc from employees. If sweat equity shares are allotted or transferred, directly or indirectly, by an employer on or after April 1, 2007, it shall be lawful for the employer to vary the agreement or scheme under which specified security or sweat equity shares has been allotted or transferred. Such scheme can be altered so as to recover from the employee the fringe benefit tax to the extent of total or partial employer’s liability.

The method of collecting FBT reimbursement from the employee raises some legal issues. The collection could be accomplished through withholding from salary, although this obviously presents both administrative and HR issues. Employers might prefer to withhold either in shares or through a forced sale of shares, with the proceeds used to cover FBT liability. Apart from the above, it is possible that any FBT recovered from employees may be considered taxable income to the employer, and corporate tax may be due on this benefit.

Taxability in the hands of Employee

Prior to Finance Act, 2007, tax incidence in the hands of employees depends, whether the plan is in accordance with guidelines issued by CBDT (Qualified or Non Qualified).

Post Finance Act, 2007, there is no tax liability in the hands of the employee at the time of exercise of stock options, vesting of restricted stock / restricted stock units or purchase of shares, irrespective of whether the plan is qualified or non-qualified. For the purposes of computing the capital gains arising to the employee on the transfer of specified security or shares, the cost of acquisition will be the fair market value which has been taken into account while computing the value of the fringe benefit (FMV on vesting day). Therefore, any capital gain will be calculated as the excess of the sales proceeds less the fair market value at vest.

Stock Option Exercises between April 1, 2007 and May 11, 2007

Qualified Plans: For companies with qualified plans and Stock option exercises, vesting in shares under an employee stock plan, and/or purchases under an employee stock purchase plan between April 1, 2007 and May 11, 2007, these companies should also pay the FBT as per the Sec 115 WJ, for all employee stock plans.

Non-Qualified Plans: For companies with Non-qualified plans and Stock option exercises, vesting in shares under an employee stock plan, and/or purchases under an employee stock purchase plan between April 1, 2007 and May 11, 2007, if the income tax has been withheld on the taxable spread at exercise of stock options, taxable value at vesting of shares (i.e. the fair market value at vesting) and/or purchase of shares under an employee stock purchase plan (i.e. the excess of the fair market value of the underlying shares at purchase over the purchase price paid by the employee) then these companies would have to pay FBT. These companies cannot offset the income tax withheld since April 1, 2007 against the FBT due. Instead, the company should reduce the employee's annual tax liability (i.e. future income tax withholdings) by any amount of income tax withheld from the employee’s stock plan income between April 1, 2007 and May 11, 2007.

Payment of Advance Fringe Benefit Tax

As per Sec 115 WJ, every corporate assessee shall pay advance tax on his current fringe benefits calculated in the manner laid down:

The advance tax for each quarter is paid based on a specified percentage (set forth above) of the estimated actual expenditures (benefits i.e., income realized from ESPP purchases, option exercises, and vesting of RSUs). Failure to pay advance tax by the due date, or payment of less than the tax applied to the quarterly percentage of the value of fringe benefits for the first three quarters of the financial year, will attract interest at the rate of 1% for the shortfall for each month or part of a month in which the shortfall continues, up to three months. A shortfall in the quarterly estimate for the fourth quarter carries interest of one percent for one month. In addition, if there is a failure to pay at least 90% of the total year's tax by April 1, interest will be due at one percent per month until the tax is assessed and paid.

Because a company will not know in advance when the employee applies for allotment/transfer (exercise pattern) of stock plan transactions covered by the FBT for the year, it will need to adopt a procedure to estimate the taxable benefits. Estimating the value of RSUs scheduled to vest during the year and scheduled ESPP purchases may not be too difficult, with the primary unknown being the stock value on the vesting/purchase date. Option exercises are much more difficult to predict and estimate in advance. Employer need to adopt administratively feasible procedure of estimating the tax for the year, with a true-up after the end of the financial year, with only moderate interest exposure.

Addressing HR Issues on “Reimbursement” from Employee

Aside from a direct pass-through of the cost of FBT, there may be other financially advantageous ways to reach a similar result. Particularly with respect to companies which had issued equity awards under non qualified plans, the employees would have been fully taxed at marginal rates on exercise. Hence, for example, an employee receiving an award of 1,000 RSUs which vested at a time when the shares were worth 20 a share would have 20,000 of income and would owe over one-third of that in taxes. The same economic result to the employee could be achieved by having a grant to the employee of 667 shares rather than 1,000, since the employee would not be taxed on the receipt of the 667 shares (FBT Payable by employer, now). In both cases, the employee would receive, net of taxes, 667 shares. This would also work for options, although obviously not for ESPPs. Of course, reducing the award grants by one-third would not necessarily capture all of the FBT. In the case of RSUs, for example, if the shares stay flat in value or go up only a modest amount, then the reduction of the award by one-third would more than offset the FBT liability, since this liability would be applied only on the 667 shares in the example above. However, of course, if the shares increased in value substantially, then the company might be paying more FBT then it has saved from a financial accounting standpoint by granting fewer shares. Similarly, with options, this would depend on the comparison of the fair value of the option as reported from a financial accounting standpoint and the ultimate intrinsic value at vesting of the option.

Clarification Required

Clarification from CBDT is awaited on certain issues viz. treatment of under water “stocks” (where the FMV on vesting date is lower than the grant price), exercise of securities by the employee after termination from the employment (during the cool off period, after which the options are forfeited), determination of FMV on Vesting Date etc

Going Forward

Going forward Company’s should:

• Develop MIS to track stock options liable to FBT at the time of allotment/transfer
• Develop feasible measures to pay advance FBT
• Ensure adequate communication processes with employees and payroll departments

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AUTHOR - Praveen Boda
E MAIL - pboda@nvidia.com
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