Intent of taxing stock options not clear

"...The task force has rubbished all that was said and done in 12 years"... P Chidambaram commented on November 17, 2002, on the report of the task force on direct taxes headed by Dr Vijay Kelkar.

True to the trend of springing surprises, the Finance Bill, 2007, has included employee stock option plans (ESOPs) within the ambit of fringe benefit tax, subjecting it to the maximum marginal rate of tax for Indian corporates. The proposed legislation shall impose an obligation on the employers to pay FBT on the fair market value of ESOP at the time the employee exercises the option. The exercise is marked by paying the exercise/strike price for acquiring the security usually within a determined time-frame. From the government perspective, I think this is the easiest, fastest and the most effective way of recovering the tax. Under the current legislation, effective from 2001, taxability of ESOPs was dependent upon whether the stock options qualified under the government-compliant plan (qualified option) or not.

Under the qualified plan, tax incidence did arise at the time of the sale of the security, pursuant to the exercise and was were taxed as capital gains.

The tax treatment under the non-qualified plan was a two-stage process -- at the time of exercise, the difference between the fair market value of the security and the exercise price was taxed as "perquisites" at normal rates in the hands of the employee and at the time of the sale of security, the difference between the sale price and the exercise price at which the option was exercised was taxed as capital gains.

The now-proposed legislation tends to reverse the single stage taxation process for a qualified plan and has in a way concluded that the act of exercise of options would trigger off tax as if it were revenue income and hence should get taxed at that stage itself . Subsequent sale of security, of course, would get taxed as capital gains. Hence, besides partly accelerating the process of taxability (from sale to exercise), it is also the characterisation of income that has undergone a change under the proposed regime "� from capital gains (which is either exempt or taxed at concessional rate) or perquisites to fringe benefit, proposed to be taxed at full rate. It is important to evaluate the rationale for granting ESOP.

The primary purpose of an ESOP is to allow an opportunity to the employee to participate in the corporation's success which is partly getting reflected in the price of its securities. The question is not an academic one. Should stock appreciation until the time it vests or is exercised by the employee be characterised as capital in nature or not ought not to be turned into an ideological issue.

It is arguable whether appreciation in the value of the options whilst in employment should be classified as revenue income in its true sense. It is undoubtedly income though and one is not trying to defend the horizontal/vertical equity argument put forth by the government. The correct approach is to understand the rationale behind grant of options, importance of employee participation in a listed stock, need and dependence of a company on capital contributed by employees and the overall vibrancy of the capital markets to facilitate wider participation.

Several aspects and challenges would surface should the government go ahead with its intention. Firstly, a plain reading of the law suggests that the levy should ordinarily not apply to options granted or allotted prior to April 1, 2007. As a matter of fact, I would even go ahead and argue that options allotted prior to April 1 2007, and exercised thereafter should not attract FBT.

This is based on the premise that the charging provisions of the law lays emphasis on the term "allotment". The machinery provisions of the law also does not seem to suggest that there is any intent to tax options granted under the qualified plan and 2001 government guidelines. It would otherwise be against the spirit of law and render the 2001 guidelines redundant.

If the intent is to make the exercise point as the sole factor for the levy, it would result in rush for exercise of options before March 31,2007, and I am sure that is not the legislative intent. It is therefore imperative that the intent of the law be clarified. Whereas the industry seems to be recovering from the shock of the new levy, I guess, policy makers have already budgeted for enhanced FBT collection for the next fiscal year. Any (re) thinking or roll back on the part of government would give some respite to HR heads of large corporates who are budgeting for enhanced cost of hiring people, already in short supply. I guess, most people either misread or partly read the finance minister's message on moderate tax rates. In his recently released book, he is quoted" "I pleaded for moderate rates of tax and stable tax policies. I did not rule out new taxes." We shall have to wait for the next Budget to experience, What's next !

The author is a partner with BMR & Associates. The views here are personal