Employee share based payments: Understanding the taxation aspects

By Rahul Maharshi (rahul@vinodkothari.com), (finserv@vinodkothari.com)

Introduction

Employee share based payments (ESBPs) are an effective way of incentivising employees. ESBPs work as a two way growth strategy for both company as well as the employees. On one hand, it helps the employees to participate in the growth of the entity and in turn reap out the benefits from it, on the other hand it helps the entity to boost the growth rate and align the vision of the employees with that of the company. The ESBPs work as a catalyst for the employee growth as well as the growth of the company.

The theme of this article revolves around the taxation aspects of different types of ESBPs, but before we proceed further, let us have a quick understanding about the different types of ESBPs.

Types of ESBPs

There are various types of ESBPs which an entity can offer to the employees. However, the choice of offering a specific type of ESBP depends upon various factors, such as growth strategy of the entity, degree of dependence on the performance of the entity, regulatory restrictions and tax implications.

Some of them are Employee stock option plans (ESOPs), Employee Stock Purchase Plans (ESPPs), Stock Appreciation Rights (SARs), sweat equity shares, Phantom Stock Plans explained below:

Employee Stock Option Plans (ESOPs): ESOPs are in form of contracts which gives employees a right, but not an obligation, to purchase or subscribe to a specified number of shares of the company at a fixed price, that is, the exercise price. The exercise price remains fixed even if the market price goes up in future.

One may compare an ESOP to a future contract, particularly to a call option, which entitles the holder of the option a right to buy securities on a future date at a predetermined price viz. the current market price on the date of granting the option.

However, there exist a primary difference between two, being the tradability of such option in the market. A future contract in the nature of a call option is traded in the stock market, but an ESOP is not traded in the market. Also, an ESOP is specifically offered to an employee and there exist a performance factor which helps in enhancing the wealth of the company, in turn making the option in the money.

Employee Stock Purchase Plans (ESPPs): ESPP is a plan under which the company offers shares to its employees at a discounted price as part of public issue or otherwise.  In comparison to an ESOP, ESPP provides immediate reward to the employee in the form of shares at discounted price.

Stock Appreciation Rights (SARs): SARs are rights that entitle the employees to receive cash or shares for an amount equivalent to the excess of market price on exercise date over a stated price. The SAR which is settled by way of shares of the company are referred to as equity settled SARs. The SAR which is settled by way of cash are known as cash settled SARs.

Sweat Equity Shares: Sweat equity shares are such equity shares which are issued by the company to its directors or employees at a discount or for consideration, other than cash for providing their know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called.

For a company, the determining factors to choose one of the above schemes may depend upon the preference of the company. For example, a company would go for an ESPP, if immediate increase in shareholding is required in place of an ESOP, where the shareholding changes after exercise. On the other hand if the company does not want any change in shareholding, it would go for an SAR.

External factors, such as regulatory restrictions and tax implications also affect the choice. In India, the choice primarily depends upon regulatory restrictions and tax implications.

Tax implication on ESOPs

Employee Perspective

ESOPs are a kind of fringe benefit over and above the employee’s salary. Post amendment to the Finance Act, 2009, ESOPs have been made taxable in the hands of the employees as Perquisite. Earlier they were taxable in the ambit of Fringe benefit tax.

To understand the tax implication on ESOPs, we first need to understand the process flow in case of an ESOP issuance.

The steps involved in an ESOP begins with granting of options to the eligible employees whereby the employees get a right to acquire shares of the company in future at a predetermined price. The right to acquire the shares are provided under a scheme and the option may be exercised after a certain number of years, known as vesting period. After the vesting period, the employees with the options are eligible to exercise them at the predetermined price, known as the exercise price (EP).

The incidence of income tax on the employees, in case of ESOP are at two events:

  1. At the time of exercise of the options (Allotment of shares to employees)
  2. At the time of sale of shares by the employees
At the time of exercise of the options (Allotment of shares):

As explained earlier, ESOPs were under the ambit of fringe benefit tax till the amendments vide Finance Act, 2009. Post the amendments, ESOPs have been made taxable in the hands of the employees as perquisites under section 17 of income tax act, 1961 (IT Act).

As per clause (vi) of sub-section 2 of section 17 of the IT Act:

(2) “perquisite” includes—

…………………..

(vi) the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at concessional rate to the assessee.

                ……………………

Explanation.—For the purposes of this sub-clause,—

  • “specified security” means the securities as defined in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and, where employees’ stock option has been granted under any plan or scheme therefor, includes the securities offered under such plan or scheme;

Therefore, at the time of exercise of the options by the employees, the difference in fair market value (FMV) of the shares allotted and the exercise price is treated as perquisite.

The guidance for determination of the FMV of the share(s) allotted is been given in the Income tax Rules, 1962 (IT Rules). As per sub-rule (8) of Rule 3 of the IT Rules, if the shares allotted are of a listed company, the FMV shall be the average of the opening price and closing price of the share on that date. In case of unlisted shares, the FMV shall be such value of shares in the company as determined by a Merchant Banker on the specified date.

The method of deduction of the said perquisite will be similar to deduction of tax from salary, in which the employer shall deduct TDS on the said perquisite value in addition to the TDS on salary u/s 192 of the IT Act.

At the time of sale of shares by the employees

Logically, an employee shall exercise the option when the same is in the money. Upon exercise of the option, the employee can either hold the share or it can sell off shares immediately and realise the gains. Realisation of gains will attract capital gains taxation.

The capital gain tax would be calculated as a difference between the sale consideration and the fair market value as on the date of exercise of the options.  As per section 2(42A) of IT Act, the period of holding such shares should be considered from the date of allotment of such shares.

The period of holding the shares shall determine whether they attract a tax on long term capital gains (LTCG) or short term capital gains (STCG).

At the time of sale of shares by the employee, companies whose shares are listed on any recognised stock exchange shall attract capital gains tax as follows:

  1. Shares held for a period less than or equal to 12 months to be considered Short term. As per section 111A of the IT Act, the tax on listed shares held as short term are to be taxed at a flat concessional rate of 15%.
  2. Shares held for a period of more than 12 months are to be considered long term. Prior to Finance Act, 2018, LTCG tax on listed shares were exempted vide section 10(38) of IT Act, provided the transaction of sale was chargeable to securities transaction tax (STT). The exemption was withdrawn vide Finance Act, 2018, correspondingly section 112A was introduced in the IT Act to impose an LTCG tax at a concessional rate of 10% on the gains in excess of Rs. 1 lakhs on transfers made on or after 1st April, 2018.

At the time of sale of shares by the employee, companies whose shares are not listed on any recognised stock exchange shall attract capital gains tax as follows:

  1. Shares held for a period of less than or equal to 24 months are to be considered short term. Tax on the same is treated similar to any other income and taxable as per applicable income tax slab rate on the employee.
  2. Shares held for a period of more than 24 months are to be considered long term. As per section 112 of the IT Act, LTCG tax on the same is to be charged at the rate of 20% with the benefits of indexation.

The treatment of ESOP in the hands of employee is diagrammatically represented below:

Employer Perspective

ESBPs are a way of incentivising the employees, there are income tax implications in the hands of employees, however, in case of the employer, there is an implication of whether the expense on ESOP be allowable or not. As the discount provided through the ESOP is a general expense, it is to be considered as a general provision under Section 37 of the IT Act.

The allowability of the expense has always been litigious and questionable. There have been decided judgments wherein the expense incurred by employer is treated allowable. Held in the case of CIT vs. Lemon tree Hotels Ltd., August, 2015[1], the disallowance of ESOP expenses of Rs. 1,28,19,169/- by the Assessing Officer (AO) was rejected  by the Delhi High Court and was allowed as an expense.  Also, held in case of CIT (A) vs. People Interactive India Pvt. Ltd., October, 2015[2] that the discount allowed under ESOP shall be treated as employee cost deductible over the vesting period.

Section 37(1) of the IT Act, which grants deduction for the expenses which are not particularly mentioned in Sections 30 and 36 are neither personal expenses nor capital expenditures of the assessee.

Tax Implications on ESPPs

Unlike ESOPs, ESPPs are a medium of providing incentive to the employees by offering shares at discounted price immediately. ESPP is a plan under which the company offers shares to its employees at a discounted price as part of public issue or otherwise.

ESPPs allow the employees to use their salary to purchase the shares of the company offered at a discounted price.  Generally, the consideration to be provided for ESPP are paid by the employees by way of monthly deduction from their salary.

Generally, there is a specific lock-in period of one year from the date of allotment, if the shares offered under ESPP have been issued at a discount.

Employee Perspective

In case of ESPPs, the incidence of tax, in hands of the employee, arises on the fact that the securities are issued at a discount, and hence, the difference between the discounted price, and the market price on the purchase date is to be considered as income.

The above income is taxed in the hands of the employee as “perquisites” under clause (vi) of sub-section (2) of section 17 of the IT Act.

Similar to the tax implication in case of ESOPs at the time of exercise of the option and allotment of the shares, the same requirement applies in case of ESPPs.

The only difference is, that in case of ESOPs the perquisite value is the difference in FMV and exercise price, in case ESPPs the perquisite value is the difference between FMV and the discounted price at which the shares are sold to the employees.

The guidance for determination of the FMV of the share allotted, given in the Income tax rules, 1962 (IT rules) as explained above, in case of ESOPs shall apply similarly to arrive at the FMV of the shares on the date of sale to the employees.

The treatment of ESPP in the hands of employee is diagrammatically represented below:

In case of ESPP, the employees allow the employer to withhold a certain portion of his monthly salary, the accumulated amount of which is utilized to acquire shares at a discounted value.

At the time of sale by the employee, the tax implications similar to that applying in case of ESOPs shall apply.

Employer Perspective

ESPPs generally allow the employees to purchase shares of the company through after-tax payroll deductions. ESPPs are provided to employees at a discounted price as part of public issue or otherwise and there is an immediate offer of shares. Hence, there does not arise a requirement of vesting, like in case of ESOPs.

ESPPs are generally  Unlike ESOPs, there does not arise a case of allowability of expenses are a way of incentivising the employees, there are income tax implications in the hands of employees, however, in case of the employer, there is an implication of whether the expense on ESOP be allowable or not. As the discount provided through the ESOP is a general expense, it is to be considered as a general provision under Section 37 of the IT Act.

Section 37(1) of the IT Act, which grants deduction for the expenses which are not particularly mentioned in Sections 30 and 36 are neither personal expenses nor capital expenditures of the assessee.

Tax Implications on SARs

As already discussed, SAR is a form of ESBP whereby the employees become entitled to a future cash payments or shares which is based on the increase in price of the shares from a specified level or a specified period. SARs are rights that entitle the employees to receive cash or shares for an amount equivalent to the excess of market price on exercise date over a stated price. Typically, SARs can be of two kinds: (a) Equity settled SARs; (b) Cash settled SARs.

Equity-settled SARs

In case of Equity settled SARs, the settlement amount, i.e. the amount based on the increase in price of the shares on the grant date, compared with the price on the exercise date, is provided in the form of shares of the company.

The equity-settled SARs are more or less similar to ESOPs since the settlement is in shares of the company. However, the major difference between the two is that in case of ESOP, at the time of exercise, the employee is required to pay the discounted price i.e. the exercise price to the company. But in case of SARs, the employee is not required to pay any amount, rather the employee receives shares of the amount of appreciation.

The tax implication of equity settled SAR is explained below:

Employee perspective

The incidence of income tax on the employees, in case of Equity settled SARs are at two events:

  1. At the time of exercise of the SARs (Allotment of shares of the appreciation value to employees)
  2. At the time of sale of shares by the employees
At the time of exercise of the SARs

On exercising the right, employee receives shares of the company of the amount of appreciation which the shares of the company has achieved.

For example, Mr. X, an employee of ABC Ltd. has been granted 1,000 SARs with a price of Rs. 10 per share, to be exercised at the end of 3 years from the date of grant. The price of the shares of ABC Ltd, at the end of 3 years appreciates to Rs. 100. Since the SARs are equity settled, Mr. X is eligible to get the appreciation in terms of shares of ABC Ltd. The appreciation being the difference in share price multiplied by no. of SARs granted and exercised [i.e. (100-10)*1000= Rs. 90,000].Therefore, Mr. X is eligible to get 900 shares of Rs. 100 each of ABC Ltd amounting to Rs. 90,000.

As per section 17(2)(vi) of the IT Act, at the time of exercise of the SARs by the employees, the difference in fair market value (FMV) of the shares allotted and the exercise price is to be treated as perquisite.

Since the appreciated value is given in shares to the employee, without any consideration taken from the employee, the said appreciation in the value of shares will become the value of perquisite.

Now, for the purpose of determining the perquisite value, the FMV of the shares are to be arrived at as per the guidance provided in the Income tax rules, 1962 (IT rules). As per Sub-rule (8) of Rule 3 of the IT rules, if the shares allotted are of a listed company, the FMV shall be the average of the opening price and closing price of the share on that date. In case of unlisted shares, the FMV shall be such value of shares in the company as determined by a merchant banker on the specified date.

At the time of sale of shares by the employees

When the employee sells such shares at a future date, the capital gain arising from such sale shall be taxable on the date of sale of such shares.

Capital gain, here, shall mean excess of ‘sales consideration of shares’ over the ‘cost of acquisition of shares. Sale consideration shall mean the amount actually received against sale of such shares. Cost of Acquisition shall mean the value of such shares as on date of exercise of SARs which was considered for perquisite tax determination i.e. the FMV arrived at the time of exercising the SARs.

The tax treatment of SARs in the hands of employee is diagrammatically represented below:

 

Cash-settled SARs

In case of Cash settled SARs, the employee is paid the difference in value of shares between the date of exercise of right and the date of grant of right. There is no actual transfer of shares in this case.

The tax implication of equity settled SAR is explained below:

Employee perspective

Since, in case of cash settled SAR, the amount of appreciation in value of shares is paid to the employee in cash, the said amount is directly treated as perquisites. The amount of appreciation in value of shares received by way of cash payment from the Company is subject to tax in the hands of the employee as perquisite. It is treated as part of salary and is accordingly taxed.

The treatment of ESPP in the hands of employee is diagrammatically represented below:

Employer perspective

The amount of appreciation paid by the Company to the employee in cash is allowed to be claimed as expenditure under Section 37 of Income Tax Act.

Also, as per section 192, the company is under the obligation to deduct tax at source, on such payment of compensation.

Conclusion

ESBPs are a way of incentivising the employees, there are income tax implications in the hands of employees, and still the medium of incentivising is lucrative and in turn beneficial for the growth of the company as a whole.

However, with recent changes brought in through Finance Act, 2018 and particularly through withdrawal of exemption under section 10 (38) the tax implication in hands of the employee has increased.

There has been a proposal by the Department for Promotion of Industry and Internal Trade (DPIIT) to the finance ministry for reviewing the taxation of employee stock ownership plans for addressing issues that curb their effectiveness as a compensation tool. Such review is not be confined to start-ups and would be holistic. The same may result in a substantial change in the way ESBPs are taxable.

Currently, In case of the employer, Ind AS implementation and applicability of Ind AS 102- Share Based Payments the requirement of fair valuation of the employee compensation expense has resulted in higher expense recognition in the initial years and trending to taper off in the later years. The same is to be seen whether the expense recognition will come in alignment with the allowance by the tax authorities.



[1]
http://itatonline.org/archives/wp-content/uploads/Lemon-Tree-ESOP.pdfThe treatment of ESPP in the hands of employee is diagrammatically represented below:

[2] https://indiankanoon.org/doc/154254860/

 

 

Project Rupee Raftaar: An Analysis

Notional income tax on issue of shares by closely held applicable not applicable under Sec.56(2) (vii a), clarifies CBDT

-Million dollar question: Can the same be extended to Sec. 56(2)(x) ?

By Yutika Lohia (yutika@vinodkothari.com)

The abolition of Gift Tax Act in the year 1998 paved way for one of the most dynamic sections of the Income Tax Act, 1961, – Section 56(2). Under this section all kinds of incomes and gains which were from sources other than the sources mentioned in the Act at that time was brought under the purview of Income Tax. Now, incomes and gains arising out of such transactions which were structured to pass on assets to some other party without any consideration or with inadequate consideration was subject to be taxed under this section.

While the Section 56(2) gave the authorities a tool to keep check on the transactions structured to merely launder unaccounted income, it also brought in many questions with itself. The CBDT has since been releasing clarification to address the questions as well as making changes to the section to cover all lose ends of laundering unaccounted incomes.

Recently Central Board of Direct Taxes (CBDT) in its circular dated 31st December, 2018 came up with a clarification to address the question –

Does the terms “receives” with regards to section 56 (2)(viia) include receiving shares of companies (where public are not substantially interested) by way of issues of shares by way of fresh issue/ bonus issue/ issue of rights shares/ transaction of similar nature?

Before we get to the clarification lets first analyse the sections – 56(2)(vii), 56(2)(viia) , 56(2)(viib) & 56(2)(x)

Analysis of Section 56(2)(vii) Section 56(2)(viia) Section 56(2)(viib) & Section 56(2)(x)

Section 56(2)(vii) Section 56(2)(viia) Section 56(2)(viib) Section

56(2)(x)

Applicable to Individual/ HUF Firm/ Company (closely held) Company (closely held) Person as per section 2(31) of the IT Act, 1961
Applicable on 1. Money

2. Immovable Property

3.Property other Immovable Property

Shares of closely held company 1.Issue of Shares 1. Money

2. Immovable Property

3.Property other Immovable Property

Applicable date From  1st October, 2009 to 31st March, 2017 From 1st June, 2010 to 31st March, 2017 From 1st April, 2013 From 1st April, 2017

 

Section 56(2)(viia) of the IT Act, 1961 was inserted by Finance Act, 2010. Referring to the memorandum of Finance Act, 2010[1] clause (viia) was incorporated in section 56 to prevent the practice of transferring unlisted shares at a price which was different from the fair market value (i.e no or inadequate consideration) of the shares and also include within its ambit transactions undertaken in shares of the company (not being a company in which public are substantially interested) either for inadequate consideration or without consideration where recipient is a firm or a company (not being a company in which public are substantially interested).

In a layman’s term the act of receiving means to receive something which was already in existence and the act of creation of the that particular thing.

Similarly receipt of shares of shares by way of fresh issue/ bonus issue/ issue of rights shares/ transaction of similar nature is an act of creation of the securities and not transfer of the same. The CBDT in its circular dated 31st December, 2018has clarified the same. section 56(2)(viia) is applicable to transactions involving subsequent transfer of the shares form the initial receiver to some third party, and not time of issuance of such shares.

It is palpable that the shares would be treated as goods only when it comes into existence and issuance of shares is the act of bringing the shares into existence. The word “receives” with respect to section 56(2)(viia) would not include issuance of shares within its ambit.

The intent of insertion of clause (viia) to section 56 was to apply anti-abuse provision i.e transfer of shares for no or inadequate consideration, it is hereby clarified by the CBDT circular that section 56(2)(viia) of the Act shall apply in cases where a company (not being a company in which public are substantially interested)  or a firm receives the shares  of the company (not being a company in which public are substantially interested) through transfer for no or inadequate consideration. Hence section 56(2)(viia) of the Act shall not be applicable on fresh issue of shares by the specified company.

Taxation of fresh issue of shares comes under the purview of section 56(2)(viib).

The Subhodh Menon case in context to Section 56

Recently the Income Tax Appellate Tribunal (ITAT) in the case of The Assistant Commissioner of Income Tax Vs. Shri Subhodh Menon[2], order dated 7th December, 2018 held that a shareholder cannot be taxed under section 56(2)(vii)(c) of the IT Act, 1961 so long as the shares are allotted to the holder on a proportionate basis (right shares), even if such shares are allotted at a value lower than the fair market value.

Drawing from the above case law, right shares issued at a value below the fair market value to individual/ HUF where allotment is disproportionate will not be taxable under section 56(2)(vii)(c) of the IT Act, 1961. Shares issued higher than proportion offered (based on shareholding) shall attract tax provisions.

Conclusion

The Union Budget 2017[3] introduced the section 56(2)(x) of the IT Act, 1961 widening the scope of Income from other sources and also clubbing section 56(2)(vii) & section 56(2)(viia).  Income Tax shall not be chargeable at normal rate for fresh issue of shares for closely held companies.

Since the offence that section 56(2)(viia) was trying to curb is the same as section 56(2)(x), the question still lies, whether the term “receives” clarified in the CBDT circular shall have the same analogy for Section 56(2)(x)? Simply put, whether section 56(2)(x) of the Act will also be limited to transfer of existing shares and not cover fresh issue of shares?


[1] https://www.indiabudget.gov.in/ub2010-11/mem/mem1.pdf

[2] http://itatonline.org/archives/wp-content/uploads/Subodh-Menon-shares.pdf

[3] https://www.indiabudget.gov.in/budget2017-2018/ub2017-18/memo/memo.pdf

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Introduction

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Genesis of the thin capitalization rules

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