Will FBT erode value of ESOPs?

By Isha Dalal, CNBC-TV18

Employee stock options, or ESOPs, have over the years become the preferred form of remuneration, giving employees an opportunity to partake a company's fortunes on the stock markets.

The 2007 Budget imposed a fringe benefit tax on ESOPs and there was much opposition to the way it was imposed. In a falling market, FBT threatens to substantially erode the value of ESOPs.

"Honors and rewards fall to those who show their good qualities in action," says Aristotle. That is exactly why companies across the world and in India have employee stock options. But starting April 1, 2007, ESOPs became liable for fringe benefit tax, or FBT, which meant that employees through their employers had to pay a tax of about 34% while exercising their stock options.

“Under the new regime, tax will have to be paid at a vesting value by the employer and then recovered from the employee, whether or not the employee has sold the shares,” said Rakesh Dharawat, Partner, PwC.

What does this mean?

ESOPs are first granted on the "grant date" to the employee; he receives the right to apply for shares on a "vesting date" and then exercises this option on the "exercise date".

Under the 2007 FBT scheme, the employee while exercising his option pays tax on the benefit. That is the difference between the fair market value of the shares as of the vesting date and the exercise price of the shares. That is not a bad deal, when the stock market's rising, but what if it isn't?

“If the employee were to exercise his right to get the shares today, he would end up paying FBT or the employer would pay FBT on a January value which is higher then today's value. This means that the stock has fallen by 25% and your effective tax rate of 34% will be 54%,” said Rakesh Dharawat, Partner, PwC.

And that's not all. FBT is paid as advance tax, which means that fair market value of the stock as on the exercise date, needs to be estimated by the employer.

“So far, the situation has not arisen. Prices were going up so FBT liability keeps on increasing. So, whatever you pay is fine. The situation will undergo a dramatic change when the financial year changes. Whatever advance tax you pay gets adjusted only in the year. In the following year, when the price falls and you have paid the advance tax, you have to get the refund. It will take a longer time,” said Seshagiri Rao, Director - Finance, JSW Steel.

So is there help at hand?

There could be-from employers by bearing some of the tax burden, or simply from the government by amending the law!

“What they could do is either not recover FBT fully from the employee, take part of the hit and re-price their options. This is something that several years ago, when tech stocks crashed in the USA, we saw a lot of companies repricing the options, to make them more attractive,” said Sonu Iyer, Partner, E&Y.

“Instead of worrying about fair valuation, on the date of the board meeting, whatever price is there, that price and vesting price and exercise, difference is to be paid at FBT. So, the matter ends. Every year, during the vesting period, if you go on calculating fair value and recalculate, FBT liability is very complex,” said Seshagiri Rao.

The Sensex is down 25% since January making ESOPs not so attractive. But markets are dynamic. They are down today but could be up tomorrow. And tax authorities will probably use that argument to avoid having to amend FBT on ESOPs.