An ESOP (Employee Stock Option Plan) is an option given to the employees to buy a certain number of shares of the company at a pre-determined price known as the Exercise Price on completion of the Vesting Period. It is a tool for employee retention, remuneration mechanism, etc.

Though the scheme sounds to be very attractive but while implementing ESOP it should be well kept in mind that the designing of the ESOP scheme, its documentation, exit mechanism, taxation, etc. should be very clear which requires consultation of experts.

The trickiest part is the taxation of ESOP.

Taxability

Any Stock Options granted under ESOP and exercised on or after 1^st April, 2009 shall be taxable in the hands of employee in accordance with the amended provisions of Section 17(2)(vi) and 49(2AA) of the Income Tax Act 1961.

Treatment in the hands of Employee

1. At the time of allotment of shares – It will be treated as a perquisite and will be taxable under the head Income from Salaries. Employees shall be liable to pay tax only at the time of exercise of options which shall be calculated and paid on the amount of difference between the Fair Market Value on the date of exercise and the Exercise Price, and such amount shall be taxed as a perquisite under Section 17 of the Income Tax Act 1961 in the hands of the employee.

This can be well explained by an example:

Say, Rohit has been granted an option on 01-Jan-2015 of buying 100 shares of his company at an Exercise Price of Rs.10/- saying that the shares will vest 100% after 1 year of service in the company which means on 01-Jan-2016, Rohit can exercise his option. On 15-Jan-2016, Rohit exercises his options and purchases the shares of his company at the exercise price of Rs.10/-. In this case, Rohit will pay (100*10) Rs.1000/- for purchasing 100 shares and further let us assume that on 15-Jan-2016, the Fair Market Value of each share is Rs.50/-. Therefore, the tax to be paid by Rohit will be calculated on the difference between the Fair Market Value on the date of exercise and the Exercise Price, i.e; Rs.(50-10)= Rs.40/-, (100*40)= Rs.4000/-. Considering, Rohit is in the highest tax bracket of 30%, Rohit will have to pay a tax of Rs.1200/- (surcharge has been ignored for simplicity).

2. At the time of transfer of shares – Employees shall be liable to pay tax under Income from Capital Gains at the time of transfer of shares under Section 49 of the Income Tax Act 1961. The tax shall be calculated on the amount of difference between the Fair Market Value of the shares at the time of transfer and the Price at which the shares were acquired.

Taking the above example further:

Let us consider that Rohit sells all his shares on 15-Feb-2016, at a price of Rs.60/- per share which is the Fair Market Value per share as on 15-Feb-2016, i.e; Rs.(100*60)= Rs.6000/-. In such case, the difference between the Price at which the shares were acquired and Fair Market Value of the shares shall be Rs(60-10)=Rs.50/- i.e; Rs(100*50)=Rs.5000/- shall be considered as his Short Term Capital Gain and Rohit will have to pay Short Term Capital Gain tax on Rs.5000/-.

Treatment in the hands of Employer

Section 37(1) of the income Tax Act 1961 grants deduction for expenses not specifically set out in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee, laid out or expended wholly and exclusively for the purposes of business or profession shall be allowed in computing the income chargeable under the head Profits and gains of business or profession. Therefore, discount on ESOP is a general expense not specified anywhere else and hence shall be covered by the general provision of section 37 of the Income Tax Act 1961.

There have been various decisions where it has been discussed at length whether ESOP cost should be allowed as an expense or not and there is no unanimity on the decisions pronounced. Certain judgements have been given where ESOP expenses was allowed. In a recent case of CIT vs. Lemon Tree Hotels Ltd. it was held by Delhi High Court that expenses incurred by the assessee (Employer) on account of issuance of ESOP is an allowable expense.

ESOP expense is called Compensation Cost because employee share-based payment involves grant of shares at a concessional price or a future cash payment based on the increase in the price of the shares from a specified level. Such payments are borne by the employers to compensate employees to compensate employees for their services and to provide incentive to the employees for remaining in the employment.

Compensation Cost is the difference between Fair Market Value on Grant and the price at which the company has offered the options to the employee, i.e; the Exercise Price.

Allowance of Compensation Cost

1. In case of Equity-settled Schemes – This is the scheme in which the employee gets the equity shares against exercise of options. In this case, the entire expense is calculated at the time of grant of options and then equally divided over a period within which the options will vest with the employees.

This can be well understood with the help of an example:

Options granted = 100

Fair Market Value on grant = Rs.50/-

Exercise Price = Rs.20/- per share

Compensation Cost = Rs.3000/- per share Rs.[100*(50-20)].

Let’s consider that the option will vest 100% at the end of 1^st year from the date of grant.

Therefore, the total compensation cost of Rs.3000/- has to be booked in the year of vesting by the company in its Profit & Loss account of the Company.

2. In case of Cash-settled Schemes – In this scheme, the employee gets the incremental value of Company’s shares over a period of time. The employer makes a provision equivalent to the amount to be paid by the employees in the year in which the payment is to be made.

Considering the above example again:

Options granted = 100

Fair Market Value on grant = Rs.50/-

Let’s consider that the option will vest 100% at the end of 1^st year from the date of grant.

Fair Market Value on redemption = Rs.100/-

Therefore, the provision to be made is Rs.5000/- [100*(100-50)]

Note: It is presumed that the payment for provision is made in the year of vesting.

 

Conclusion

 

As there is no clear law on allowance of Compensation Cost in the Income Tax Act 1961 what we really need is a specific provision in the Income Tax Act 1961 to deal with the issue of deductibility, and allowance of cost incurred in ESOP.

________________________________________________________________________________________