In today’s competitive job market, corporates are putting their best foot forward to position themselves as “employer of choice”. They are willing to invest significantly in policies that motivate, reward and retain the good performers. The equity-linked incentive plan is one such endeavour to instil a feeling of ownership among employees and encourage them to nurture long-term career aspirations with the employer.
Here, the benefit received by an employee can be in the form of either stock/ shares offered at a discount to the market value or cash equivalent of the differential between the market price and the exercise price payable by the employee.
As such benefits typically accrue to the employee after a gestation period, it encourages them to stay on with the organisation.
Equity incentive plans commonly include Employee Stock Option Plan (ESOP), Employee Stock Purchase Plan (ESPP), Restricted Stock Units/ Awards (RSU), and Stock Appreciation Right (SAR).
Generally, a company allots shares to its own employees or the employees of its subsidiary under ESOP, ESPP or RSU. The benefit under SAR could be either in cash or equivalent shares.
The lifecycle of a plain vanilla ESOP starts with grant of options, which have a vesting period governed by conditions such as years of service, performance, and so on. On expiry of the vesting period, the employee can exercise his right to buy the shares at the grant price, which may either be at a discounted market price or the fair market value (FMV). The shares are then allotted to the employee.
The taxability of equity-based incentive has changed over time. Initially the taxability was triggered on exercise. However, the employee benefit was exempt from taxation if the plan complied with Central Government guidelines. In 2005, benefit from equity-based incentives was brought under the Fringe Benefits Tax (FBT) regime.
Effective April 2009, with the abolition of FBT, the taxability of benefit from equity-based incentives was once again triggered.
Currently, taxation is triggered when a company allots shares to its employees or when the benefit is received in cash from the employer.
The taxable benefit in the case of share allotment is the difference between the FMV on the date of exercise and the grant price. The employer has to withhold tax on such benefits as part of the ‘salary’.
There are specific valuation rules under tax laws to calculate the FMV of shares. If the shares are listed on a recognised stock exchange in India, the FMV is determined as the average of the opening and closing prices of the share on the date of exercise; and if there is no trading on the exercise date, the closing price on the nearest date shall be the FMV.
In the case of companies (foreign or Indian) not listed in India, the FMV is determined by a Category I Merchant Banker registered with the Securities and Exchange Board of India. The valuation obtained on any date will apply for the next 180 days. If the exercise date falls within these 180 days, the value may be adopted.
Subsequently, the employee may face tax on the actual sale of shares. The employee should pay the tax on incremental gain, as this is not subject to tax withholding by the employer. The taxable incremental gain is the difference between the actual sale consideration and the aggregate of the FMV on the date of exercise and any cost of such transfer.
If the employee retains the shares for twelve months or more from allotment, the capital gain will qualify as long-term; a shorter holding period characterises it as short-term capital gain. Long-term capital gain is exempt from tax if it is a listed share that is transferred through a stock exchange (that is, subject to Securities Transaction Tax). In other cases, it attracts 20 per cent tax.
Short-term capital gain attracts 15 per cent tax in the case of listed shares transferred through stock exchange. Otherwise it is taxed according to the slab rates applicable. In both cases, surcharge and education cess apply.
While equity-based employee incentive schemes have emerged as a powerful HR tool, employers should be mindful of the tax withholding obligations and valuation rules involved.
(Divya Baweja is Senior Director, Deloitte Touche Tohmatsu India Pvt Ltd, Divya Agarwal is Manager, and Naren Kumar is Deputy Manager, Deloitte Haskins & Sells)