Isha Dalal, CNBC-TV18

Employees Stock Option or ESOPs have over the years become the preferred form of remuneration. They give the employees the opportunity to partake in a company’s fortunes on the stock markets. But where there is a gain there is inevitably a tax. In 2007, Finance Minster P Chidambaram ruled that ESOPs were a fringe benefit and hence should be subject to the Fringe Benefit Tax (FBT). Sure, there was opposition to this move but not as much against the tax as against the way it was being imposed. Now in a falling market, FBT threatens to substantially destroy the remuneration and value of ESOPs.

Honors and rewards fall to those who show their good qualities in action” says Aristotle and rewarding good employees is exactly why companies around the world and in India have Employees Stock Option or ESOPs. But starting April 1^st 2007, this reward was not quite easy to come by. That’s because ESOPs became liable to FBT. Which meant that employees to their employers have to pay a tax of about 34% while exercising their stock options.

Rakesh Dharawat, Partner, PwC said, “Earlier there was a single point taxation for plans which were as per central government guidelines. So employees would have to pay tax only on the gains that he made. Under the new FBT regime, the tax will have to be paid at a vesting value by the employer and then recovered from the employee regardless of whether the employee has sold the shares or not.”

So what does this mean? ESOPs are first granted on grant date to the employee. He then receives the right to apply for shares on a vesting date and then exercise this option on the exercise date. Under the FBT scheme implemented from 2007, the employee while exercising his option pays tax on the benefit that he receives. That’s the difference between the fair market value of the shares as of the vesting date and the exercise price of the shares.”

Not a bad deal when the stock market’s rising but what if it isn’t?

Dharawat said, “If the employee were to exercise his right to apply for and get the shares today, he would end up paying FBT or the employer would end up paying FBT on a January value which is significantly higher than today’s value. Effectively this means that if the stock has fallen down by 25%, you’re effective tax rate of FBT instead of 33% will workout to 55%.”

That’s not all. A higher taxation rate means further problems for employers. FBT is paid as advance tax, which means that the fair market value of the stock as on the exercise date needs to be estimated by the employer.

Seshagiri Rao, Director, JSW Steel said, ”So far this situation has not arisen in India because when the prices were going up, you’re FBT liability goes on increasing, so whatever you have paid is fine. In fact situation will undergo a dramatic change when the financial year changes because whatever advance tax you have paid, that gets adjusted only in that particular year. So in the following year when the share price falls, and if one has paid the advance tax in the last year, then one has to get the refund of that advance tax in the next year. That will again take a longer time.”

So is there help at hand? Experts say there could be from employers by bearing some of the tax burden or simply from the government by amending the law.

Sonu Iyer, Partner, E&Y said, “What they could do is either not recover the Fringe Benefit Tax fully from the employee, take part of the hits in such a situation. They could reprice their options and this is something in several years ago when the technology stocks crashed in the US, we saw lot of companies repricing the options, so that they became more attractive to the employees. So that’s one of the tools open to the employers for making the Employee Stock Option Plans (ESOPs) more attractive even in a falling market.”

Rao says, “Instead of really worrying about fair valuation on the date of the Board meeting, whatever market price is there that market price and the vesting price or exercise price - that difference has to be paid as Fringe Benefit Tax (FBT); so that the matter ends. In every year during the vesting period if we have to go on calculating what is the fair value and then recalculate your FBT liability, I think it is a very complex situation.”

The Sensex is down about 25% since January making ESOPs not so attractive. But markets are dynamic they are down today they could be up tomorrow. So tax authorities will probably use that as an argument to avoid amending FBT on ESOPs.