EMPLOYEE Stock Option Plan (ESOP) is an effective tool to attract and retain valuable human capital. Nowadays employers invest a lot of time, effort and money in recruiting and training employees and would definitely want to ensure that employees are retained over a longer time frame. ESOP schemes are in addition to the base pay of the employees and offer to high performing employees a reward accruing over a period of time by allowing them to share their employer's rising market capitalisation due to increase in share prices. ESOP schemes thus seem to be the perfect incentive for employees to ensure a long term alignment with the organisation.

Although ESOP schemes have been operating in India for many years, attempts to examine the taxability started in 1995 when the Central Board of Direct Taxes (CBDT), having received representations from tax authorities and corporate assesses, had occasion to examine the issue. Vide circular no.710 dated July 24,1995, the CBDT clarified that shares issued to employees at less than market price amounted to a perquisite under section 17(2)(ii). However, to remove any uncertainty with regard to taxability of such benefits, a new sub-clause (iiia) was added to section 17(2) by the Finance Act, 1999 to provide that when any share, security etc. was offered directly or indirectly by the employer, the difference between market value of the stock and the cost at which it was offered was to be taxed as perquisite in the year in which the right was exercised. The difference between the market value on the date of exercise of the option and the sale consideration was to be taxed as capital gains in the year of sale. Following the realization that the difference between the market value and the exercise price represented only a notional profit, which would have needed additional outgo from the employees, in the year 2000, ESOPs granted at concessional rate were not treated as perquisite and the employees were subjected to only capital gains tax on transfer of the shares/stocks. The provision was further amended with effect from April 1, 2001 to the effect that only ESOPs qualifying under the guidelines issued by Securities and Exchange Board of India (SEBI) would not be chargeable to tax as perquisite. Thus, effectively from 2000 till 2007 when Fringe Benefit Tax (FBT) was introduced, ESOP was being taxed only at the time of final alienation of the shares by the employees.

With the advent of the scheme of FBT, ESOP taxation underwent a change. Now, employers were required to pay FBT on the exercise of ESOPs by employees on the difference between the fair market value (FMV) on the date of vesting as reduced by the exercise price. There was no separate taxation in the hands of the employees. This arrangement lasted for three years despite strong protests from the trade and industry. Finally, Finance (No2) Act 2009 abolished FBT and brought various benefits offered to employees by employers including ESOPs within the ambit of perquisite tax and consequently made ESOPs taxable under the head salaries in the hands of employees. Before 2007, ESOPs were specifically excluded from the purview of Perquisite by section 17(2)(iiia). Now these are specifically included as perquisite by Section 17(2)(vi). Employees are now required to pay perquisite tax on the difference between the FMV on the date of exercise as reduced by the exercise price. In both the FBT and perquisite tax regime, capital gains on alienation of shares are chargeable to tax in the hands of employees at the time of transfer of the shares on the difference between the sale price and the FMV. The Fair Market Value of stocks under the FBT regime was based on the average market price as on the date of vesting whereas now, the criterion has been changed to the average market price as on the date of exercise. The amendment to tax perquisites on ESOPs granted at concessional rate in the hands of employees, which is in line with international taxation in most other countries, thus brought back the system that was introduced in 1999. However, over the decade, globalization has become more entrenched creating new problems both for the taxpayers and the tax administration.

In today's world, many multinational companies offer ESOP benefits to employees in the home country as well as to employees based overseas in foreign branches, representative offices and subsidiaries. In the course of their duties, these employees are required to be deputed in different countries and hence taxation rules in the home as well as host country need to be examined to determine the taxability of stock options.

In some countries, tax exemptions are available on share options that are “approved” by the tax authorities on account of the schemes meeting certain criterion for approval. e.g. in the USA, Statutory Stock Option Plans are approved plans to grant employees options to purchase shares. Under these schemes, there is no tax on grant or exercise in the hands of employees and simultaneously the employer is also not entitled to claim deduction on the concessional value of ESOPs. Tax liability arises only on sale/disposal of shares and the gains are treated as capital gains. Similarly, in the United Kingdom, company share option plans can be issued to grant upto a maximum value of GBP 30,000 per annum under the HMRC approved Company Share Option Plan. Under the scheme, no tax is payable at grant or if the option is exercised after 3 years but before 10 years after grant. On sale/ disposal, capital gains tax is payable. Thus, on exercise of such approved share options in the home country, say USA or UK , the notional gain made by the employee is free from tax.

A peculiar situation arises when employees who have been granted tax free stock options are transferred to another jurisdiction, say India , where similar tax benefits are not available in respect of the tax exempt schemes approved by the home country. In such circumstances, internationally mobile employees would be subject to tax in India if the stock options are exercised in the host country.

In case of unqualified/ non approved stock options where ESOPs are subject to tax in the hands of employees, both the home as well as host country would levy tax on exercise of ESOPs. Here again, an issue would arise regarding the right of each jurisdiction to levy tax, i.e. should the country in which the options were granted be eligible to levy tax or the country where the options were exercised be eligible to levy tax on the difference between the exercise price and the grant price or should both the jurisdictions have the right to tax on a proportionate basis.

Some jurisdictions like Hong Kong levy tax on ESOP on a proportionate basis based on the number of days attributable to period in the home country and host country. In respect of share options granted to overseas employees before their employment in Hong Kong or in respect of options pertaining to Hong Kong employment at the time of leaving the country, the ESOPs are taxable on proportionate basis for their stay in Hong Kong . Singapore too has a similar rule of proportionate taxation. Departing expatriates who are neither Singapore citizens nor Singapore permanent residents, are deemed to have derived a notional final gain on “deemed exercise” of ESOPs in respect of all unexercised ESOPs at the time the employee ceases Singapore employment and departs the country. Such tax is required to be discharged by employer after recovering the same from the departing employee.

In India too, under the earlier FBT regime, the CBDT had specifically prescribed the methodology for taxing fringe benefit when employees were present in India only for part of the grant period. The extract of the relevant CBDT circular 9/2007 dated September 20, 2007 - Frequently Asked Question 4 and the reply are reproduced below:

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Question 4: How will the value of fringe benefit be determined in case where employee was based in India only for a part of the grant period?

Answer: In a case where the employee was based in India only for a part of the grant period, a proportionate amount of the value of fringe benefit will be liable to FBT. The proportionate amount shall be determined by applying to the value of the fringe benefit, the proportion which the length of the period of stay in India by the employee during the grant period bears to the length of the grant period.

As explained above, Q4 of the series specifically covers the situation of proportionate taxation in cross border employment. Other relevant questions which cover foreign taxation include Q3 and Q5 reproduced below:

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Question 3. Will FBT apply in case of employees of the Indian subsidiary for shares awarded by the foreign holding company if the employees of the Indian subsidiary are allotted or transferred shares while outside India ?

Answer : In the answer to Question No.20 of CBDT Circular No. 8/2005 dt. 29.8.2005, it has been clarified that an employer is liable to fringe benefit tax on the value of fringe benefits provided or deemed to have been provided to employees based in India. Therefore, an Indian subsidiary would be liable to pay FBT in respect of the value of the shares allotted or transferred by the foreign holding company if the employee was based in India at any time during the period beginning with the grant of the option and ending with the date of vesting of such option (hereafter such period is referred to as ‘grant period'), irrespective of the place of location of the employee at the time of allotment or transfer of such shares.

Question 5. Whether a foreign company is liable to fringe benefit tax in respect of shares allotted or transferred to an employee who is deputed to work in India in the year of such allotment or transfer?

Answer: A foreign company is liable to FBT in respect of shares allotted or transferred to its employee who is based in India . However, in such cases only a proportionate amount of the value of the fringe benefit will be liable to FBT. The proportionate value shall be determined by applying to the value of the fringe benefit, the proportion which the length of the period of stay in India by the employee during the grant period bears to the length of the grant period.

(The value of fringe benefit means the fair market value of the specified security or sweat equity shares, 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 shares.)

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In the absence of a specific mechanism for levy of perquisite tax on ESOP in cases of employees based in India for a part of the grant period, it can be argued that at the time of grant of options, the employees did not enjoy entitlement to the underlying shares and as such no perquisite value arises in India for the proportionate period of time that employees stay in India if the options are exercised outside India. As such, the chargeable event for levy of perquisite tax is “exercise” of ESOPs, and in case employees are not based in India at the time of exercise, no liability to tax would arise in India.

Conversely, it may so happen that the employee was based outside India at the time of grant of ESOPs but was in India at the time of exercise of ESOPs. In such a scenario, in the absence of specific guidelines, the difference between the FMV and exercise price would be fully taxed in India at the point of exercise which would amount to double taxation on the same income if the income was subject to tax in the earlier jurisdiction as well.

Double taxation would also arise in home countries that levy tax on ESOPs at the point of grant and host countries that levy tax at the point of exercise. In Australia , the normal taxing point of ESOPs granted under the Employee Share Scheme is the right of acquisition of shares by employees, i.e. ESOPs are taxed upfront with deferral of tax only in limited circumstances like real risk of forfeiture of shares at the time of grant. In Belgium too, the taxable event is the date of grant in case the beneficiary employee accepts the offer under the stock option plan within 60 days of the employer making the offer.

In cases of double taxation, employees should be eligible to claim relief of the tax paid overseas against perquisite tax payable in India under section 90 of the Income-tax Act, 1961 read with the respective bilateral Double Taxation Avoidance Agreement (DTAA).

To avoid ambiguities on taxation of ESOPs under the new perquisite tax regime in the hands of globally mobile employees, it would be useful if CBDT issues a clarification giving a well defined tax framework akin to circular9/2007 dated September 20, 2007 under the earlier FBT regime which contained 25 frequently asked questions on ESOP. These could deal with specific areas of international taxation pertaining to ESOPs like taxation of shares of overseas companies, tax treatment in the case of employees assigned/deputed to India who were granted stock options prior to arrival in India, tax treatment in the case of employees about to cease employment in India, gains realized by former employees after leaving India, double taxation treaty benefit and other relevant areas.