TAXATION-OF-ESOPs-and-ESPSs-BENEFITS-IN-INDIA

Query 1:
Whether sweat equity benefit is taxable as income?

Our response:
Income in money's worth or equivalent of cash is also income.

Under the Act, income is defined u/s 2(24) to include a benefit or perquisite or concession  in certain situations. Accordingly, a benefit / perquisite arising in the course of  employment  is  taxable under the head ‘Salaries’ while the same arising from the exercise of a business or  profession is taxable as business income. As per section 2(24)(iv), a benefit or perquisite obtained from a company by a director or relative of director is also included as income.

Query 2:
How is sweat equity benefit taxable in the hands of an employee?

Our response:
Benefit received under as a sweat equity is taxed as a perquisite according to the provisions of section 17(2)(vi) of the Act.

Section 17(2)(vi) provides that 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 shall be treated as perquisite.

Thus, taxation arises at the time when the specified security is allotted or transferred to the employee.

The important aspects of section 17(2)(vi) are briefly analyzed as under:

  • Value means the fair market value (FMV) of specified securities on the  exercise date less  any amount actually paid or recovered from the employee for such specified securities. The mechanism for determining FMV has been prescribed under Rule 3(8) & 3(9) of the Income tax Rules, 1962 (the Rules).
  • Specified security means securities as defined in section 2(h) of the Securities Contracts (Regulation) Act, 1956 (SCRA). Where stock options are granted under any plan or scheme, then the securities offered under such plan or scheme i.e. the resultant securities arising on exercise of such options is included therein. The resultant securities could be shares, debentures or any other securities.
  • Allotted or transferred – specified security must be allotted or transferred. Allotment signifies primary issue by the Company while transfer would include secondary transaction by way of purchase from the Trust / other entity.
  •  Directly or indirectly – wide enough to cover options granted through a trust especially when the trust is settled or controlled by the Company or its parent company.
  • By the employer or former employer – For sweat equity benefits to be taxed, the grant / benefit should flow from the employer or former employer. Interesting issue arises where the sweat equity benefits are granted by the holding company or by a promoter.

Query 3:
What is the valuation mechanism to determine the Fair Market Value (FMV) as per the Rules?

Our response:
Rule 3(8) & 3(9) – Determination of FMV

In case of unlisted equity shares or securities other than equity shares, the FMV shall be the value   as determined by Category 1 Merchant Banker (registered with SEBI).

The FMV shall be determined either on the exercise date or any earlier  date not more than 180  days prior to the exercise date. The date of report of the merchant banker is not relevant but what   is relevant is the valuation date as of which the merchant banker determines the underlying valuation of the share. Thus, a valuation report once obtained will be valid for 180 days.

In case of shares issued by parent company, being a foreign trust / company with no presence in India, the mechanism for valuation of shares is not clearly specified under the Act. In such  situations, we are of opinion that the price determined by external appraiser based on internationally acceptable valuation practices / standard should be acceptable approach.

Query 4:
Are ESOPs offered by Holding Co. to the employees of Subsidiary Co. taxable as salary?

Our response:
In the case of Microsoft Corporation USA [(P. No. 15 of 1998) [1999] 235 ITR 565 (AAR)], the Authority for Advance Rulings (‘AAR’) held that the benefit arising to the employee of Indian subsidiary from stock option granted by its US parent company was taxable in the hands of Indian employee as ‘salary’. The AAR, by lifting the corporate veil, held that ‘the parent company has made such offer    to the employees of the subsidiary company only because it regards its subsidiary and itself as the same concern’.

In another decision in case - Sumit Bhattacharya v. ACIT [2008] 112 ITD  1  (Mum)(SB),  the  Tribunal (Special Bench – Mumbai) relying on the decision of the Supreme Court in case - Justice Deoki Nandan Agarwal v. Union of India [1997] 237 ITR 872 (SC), held that employer-employee relationship is not necessary for an income to be taxed under the head ‘Salaries’. It is enough if the sum earned is a reward for services rendered by the employee. Similar view has also been taken in other cases viz., ACIT v. Chittaranjan A. Dasannacharya [2014] 64 SOT 226 (Bangalore - Trib.).
 
In most such cases, the parent company may be recovering the benefit so provided by way of cross charge from the subsidiary. Further the obligation to deduct rightful taxes on the salaries paid to employees will be on the employer company. Keeping all these aspects in mind, in most cases, the benefit received is accordingly treated as taxable under the head ‘salaries’ and appropriate TDS is   to be done.

Query 5:
Is the Employer Company required to withhold any taxes on account of  perquisite element under  an ESOP?

Our response:
The employer shall be liable to deduct taxes at source on the perquisite under an ESOP. The perquisite u/s 17(2)(vi) is taxable at the time when the shares are allotted or transferred. Under Rule 3(8), the underlying FMV of the shares is to be determined as on the date of exercise. Nevertheless, the  perquisite arises only at the time of allotment or transfer of shares and hence,   the TDS obligation will also arise at the time of such allotment or transfer and not on the date of exercise, as held in Bharat Financial Inclusion Ltd. v. DCIT (TDS) [2018] 172 ITD 198 (Hyderabad- Trib.)

Query 6:
How are gains arising on subsequent sale of shares taxed?

Our response:
Gains arising on subsequent sale of shares shall be taxable as ‘capital gains’ - long term or short term, depending upon the period of holding of such shares. The period of holding shall  be  computed from the date of allotment of such shares as per section 2(42A). As per section 49(2AA), the FMV as per Rule 3(8) considered for determining the perquisite value u/s 17(2)(vi) shall be taken as cost of acquisition. This ensures that the employee does not suffer double taxation on the perquisite value already taxed as salaries.