ESOP's Future

ESOPs : Is the Party Over?

The move to bring ESOPs into the FBT net may not only act as a spoilsport to retain the best talent but may also signal the end of the ESOPs era.

The inclusion of ESOPs under FBT will add to the challenges being faced by employers in knowledge-intensive industries in attracting and retaining world-class talent.

- Ashank Desai,
Non-Executive Chairman,
Mastek Ltd.

In this new millennium, knowledge plays a vital role in the progress of the organizations. Hence, it becomes imperative for corporations to recruit and retain a pool of knowledgeable employees. Nonetheless, this poses a great challenge to the organizations given the backdrop of the increasing rate of attrition. Factors such as shortage of skilled manpower and increasingly competitive business landscape have compelled organizations to look out for innovative ways to retain competent employees. Against this backdrop, Employee Stock Option Plan (ESOP) has emerged as an effective tool, in recent years, to motivate and retain talented employees.

Nevertheless, the concept of ESOP, which has become the corporate mantra for employee retention, may soon lose its charm once the proposal for the imposition of Fringe Benefit Tax (FBT) on ESOPs becomes a reality. In the Union Budget 2007-08, the Finance Minister of India, P Chidambaram, has announced that ESOPs will come under the tax ambit as he intends to further stretch the FBT net to ESOPs. Hence, the ultimate victims of this proposal, the employers, who are destined to bear the brunt, are likely to disapprove the issuing of ESOPs. In other words, the move may signal the end of the golden era of the ESOPs as analysts predict that the corporate world may embark on more viable motivational tools to retain their best talent.

The `two' options

ESOPs are typically tax qualified, contribution defined, employee benefit plans intended to provide employees with an ownership stake in the company that they work for. ESOPs, governed by the Employee Retirement Income Security Act (ERISA), were given a specific legislative framework in 1974. As per the framework, they can avail themselves of the tax benefits, provided they abide by certain rules. Among many other requirements, ERISA mandates that ESOP assets should be held in trust, and also imposes fiduciary norms on those who manage and administer the assets. To abide by these norms, the company has to set up a trust which holds the stock to be purchased by the company. Later, it appoints an individual or an institution as a trustee.

The company, however, can proceed with one of the two forms of ESOPs, such as leveraged and non-leveraged. Nevertheless, the most popular form is leveraged ESOP, which facilitates borrowing of money from the bank or any other commercial lender. Either the company or the trust can borrow the money and loan the proceeds to the ESOP. If the trust borrows the funds directly, it entails for the guarantee from the company. To facilitate the repayment of the loan amount, the company makes periodic cash contributions to the trust which enables regular loan repayments which due to the lenders. These payments are usually tax deductible in the hands of the company and should be within the prescribed limits.

The introduction of FBT on ESOPs in the hands of employers will make it more expensive for employers to retain skilled employees. The Union Budget 2007-08 has come up with the proposal that ESOP will be placed in the hands of the employers as it is considered a fringe benefit. What difference does this make to the employer as well as the employee vis-à-vis the earlier procedure? Akil Hirani: Currently, if shares under an ESOP scheme are offered to employees in conformity with the Income Tax rules, and the ESOP scheme is filed with the income tax authorities, the difference between the fair market value of the shares on the date of allotment/exercise and the exercise price of the shares will not be treated as a perquisite in the hands of the employee, and will not be taxable as income under the head of 'Salary'. However, if the ESOP scheme is not filed with the income tax authorities, the foregoing benefit is not available and the ESOPs are taxed in the hands of the employee at the time of exercise. The proposal to consider an ESOP as a fringe benefit will per se change the tax incidence vis-à-vis an ESOP. With effect from April 1, 2008, it is proposed to amend Section 115WB of the Income Tax Act, 1961 and bring the issuing company (the 'employer') under the Fringe Benefit Tax (FBT) net in respect of ESOPs at the time they are exercised. Further, the method to calculate the FBT has not as yet been prescribed. Introducing this provision will increase the tax liability of the employer, and in a way helps the government do away with the current tax exemption, i.e., an ESOP not being regarded as a perquisite in respect of a scheme that is filed with the tax authorities. Additionally, this will result in double taxation: the FBT, and in the form of capital gains tax on the sale of the shares by the employee. In my opinion, most employers will pass on the FBT burden to their employees. Deepak Ghaisas: A typical ESOP passes through three stages: In stage one, an employer grants an option that is exercisable at a predetermined price before its expiry by the employee. The second stage is the employee, exercising the option by paying in money and becoming a shareholder. The third stage is employee selling the share and paying capital gains tax depending on the holding period. As against this provision, the finance bill 2007-08 taxes ESOPs. When the employee exercises his option at the stage two under FBT through the employer. In other words, even if the employee holds the share for over 12 months, his ESOP gets subjected to an element of tax at the corporate rate, which of course, the employer can pass on to the employee. Secondly, what if the employee is no longer working with the firm at the time of exercising the option the current provision becomes complex. What are the implications of the move in general? Akil Hirani: ESOP is a very effective retention tool, and in an economy that is currently facing talent crunch, ESOPs are very essential. The introduction of FBT on ESOPs in the hands of employers will make it more expensive for employers to retain skilled employees. Further, unlisted companies will have to attribute a notional market price to calculate FBT, and this may be inconsistent with their overall valuation. Deepak Ghaisas: FBT on ESOPs may breed unfair practices. Unlisted companies may issue options at jacked up valuations to minimize the difference on which tax will be levied. Some companies are not yet clear who will bear the brunt of FBT on ESOPs: the employer or the employee? Either way, FBT is going to hurt the industry. Which sectors would be hard hit by this move? Akil Hirani: The sectors that will be worst hit by this move will be the BPO, IT, pharmaceutical, and financial services sectors. The attrition rates in these sectors have always been high requiring employers to use ESOPs as a retention tool. Deepak Ghaisas: Small and Medium Enterprise IT companies, new media companies, and generally new knowledge-based industry would be worst hit. They already are reeling under staff crunch and thwarting employee-defection to established players. FBT on ESOPs is also going to hit mid-cap and small-cap IT companies. Thanks to a severe shortage of skilled personnel, several sectors ranging from aviation to yarn makers have chosen the ESOP route to empower their employees. But now, it will not work. Insurance sector will also be affected. There is a serious contention from the industry people that a tax on ESOPs would affect their ability to retain talent. Does the imposition of FBT on ESOPs blur the future of ESOPs as a critical retention tool? Akil Hirani: Due to the imposition of FBT, employers will have second thoughts about offering ESOPs to employees. In some cases, they may try to pass on the burden to employees. Either way, it will impact the competitiveness of employers in marketplace, and employers may be forced to create alternative products in lieu of ESOPs. Deepak Ghaisas: ESOPs have been used as an HR tool to attract and retain top talent in a company and has been quite successful. Mid-cap and small-cap IT companies cannot pay as much as MNC giants do. They cannot offer brand value, as well. The only way they can attract talented employees is by giving a share in the company and showing them a dream of becoming a millionaire in two years once the company goes in for listing. But FBT may take that away, as well. The current scenario ignores the fact that many companies in their early stages often give stock options to hire and retain talent because they do not have the ability to pay large cash wages. Now, they have to pay the tax on something they could not afford to pay before. The tax outgo will flow out of net profits and impact the cash flow of the company and reduce the profits. We have to see if we can counter this by passing on the costs to employees, which again will be an unpopular move and affect retention of the staff. With the recent move, companies and HR personnel are worried that ESOPs can no longer be used as a way of negotiating with prospective candidates. Employees and prospective candidates will now obviously ask for a 50% hike in salaries than go for ESOPs. Any other comments? Deepak Ghaisas: Thinking up new ways of taxing people and corporations, while claiming that you have not increased the tax rate, may sound convincing to those who voice it but does not fool anyone anymore. - Akil Hirani Managing Partner, Majmudar & Co., International Lawyers, India - Deepak Ghaisas CEO- India Operations and CFO of i-flex solutions ltd., India

Akin to the way that regular pension fund contributions are made by the company, the non-leveraged ESOPs also make periodic contributions to the trust on behalf of the employees. The company may choose to contribute either shares which do not require initial outlay or cash which would, in turn, be utilized to purchase shares. Whichever is the form of issuing ESOPs, soon after the purchase of shares from the existing shareholders, they are allocated among individual accounts maintained by the trust for each participating employee.

ESOPs are distinct from other qualified benefit plans in several respects. Unlike most defined contribution retirement plans, which are required to be invested in a diversified portfolio, ESOPs are intended to be invested primarily in company stock. In addition, ESOPs can borrow money to purchase a large block of company stock and pay for it over time through tax-deductible corporate contributions. ESOPs also enjoy substantial tax advantages, including corporate tax deductions for principal and interest payments on ESOP loans, a deferral or total avoidance of capital gains for stock sold to an ESOP by owners of privately-held companies, and tax deductions for dividends paid on ESOP stock.

India's pick

The concept of ESOP was pioneered in India by the leading IT major, Infosys Technologies, in 1994. However, the broad guidelines to issue stock options were laid down only in 1999 by the stock market regulator. The then Union Budget has contended that ESOPs would be taxed as a perquisite at the time of exercise of the option and subsequently as capital gains at the time of the sale of security. Interestingly, after a while, two senior officials at Zee Telefilms filed a suit contending that ESOPs, being a perquisite, cannot be taxed at the time of exercise. Hence, for five years, only capital gains tax has been levied on the employee at the point of sale of the ESOPs.

During these years, ESOPs have gained huge popularity and emerged as a critical retention tool for many organizations. ESOPs typically work on the philosophy of sharing wealth with the employees by fostering a sense of ownership among them. It has been instrumental in motivating employees to perform better and to retain the talent during times when employee turnover is a norm rather than an exception. In India, its popularity has not only been widespread in IT sector but also in non-IT sectors like media, communications, etc. Unlike other countries where companies primarily use ESOPs to their advantage, in India, they are perceived more as a part of employee expectations, particularly in knowledge-intensive industries.

Spoilsport

Nevertheless, the proposal made in the Union Budget 2007-08 by Chidambaram to levy FBT on ESOPs can act as a dampener to withholding the best talent of the organizations. The new levy is proposed to come into effect from the accounting year April 1, 2007 to the assessment year 2008-09. The issue of taxing ESOPs has always generated problems. All along, it was debated that ESOPs should be taxed in the hands of the employee only as he is the principal beneficiary.

Though the employer did not fall into the tax ambit of ESOPs in the last 5-6 years, all that is set to change now if the recent proposal is accepted. When the proposal comes into effect, it is expected that the difference between the prevailing fair market value of the shares at the time of exercise and the amount actually paid by the employee (exercise price of the option) will be considered as a fringe benefit. Subsequently, the calculated fringe benefit is taxed in the hands of the employee at the proposed rate of 33.99% which is inclusive of corporate tax, surcharge, and the cess. "The tax outgo will flow out of net profits and impact the cash flow of the company and reduce the profits. We have to see if we can counter this by passing on the costs to employees, which again will be an unpopular move," avers Anil Bakht, CMD of ESS.

Losing sheen

Bringing ESOPs under the purview of FBT has been criticized in many ways. As the employers have to bear the brunt of FBT, it will obviously dampen their net profits. The fact that FBT payable would not tax deductible expenses further aggravates the effective cost of 45.54% post-tax to the employer. Hence, they may be reluctant to issue more number of ESOPs, which may badly impinge on talent retention.

Besides, the implied higher tax outflows for employers, the proposal has also been criticized on the grounds of double taxation. Cross-border taxation issues, especially in the case of globally-mobile staff, may arise. Though the employer pays the FBT in India, the employee working overseas may be entitled to personal taxation subject to the concerned jurisdiction norms. This will certainly lead to economic double taxation.

Moreover, industry experts see that small and medium-sized companies will be most hurt as they can offer neither competitive packages nor brand value. The only way out for them to lure skilled employees is by way of giving a share in their company through ESOPs. "Mid-cap and small-cap IT companies cannot pay as much as MNC giants. They cannot offer brand value, as well. The only way they can attract talented employees is by giving a share in the company and showing them a dream of becoming a millionaire in two years once the company goes in for listing. But FBT may take that away as well," says SL Ananthanarayan, CFO, Birlasoft.

Due to the net increase in cost due to imposition of FBT, even start-up companies with great ideas cannot afford to issue ESOPs to their employees any longer. This will, in turn, hamper the company's innovation and entrepreneurship. Nikhil Bhatia, Partner of BSR & Co., worries, "Until the Budget 2007, ESOPs had great appeal, and the Finance Minister has probably hit where it hurts the most as far as ESOPs are concerned. Software companies, which generally face a shortage of talent, have been effectively using ESOPs for retention and reward. But that sheen may be a thing of the past."

In fact, the early success of ESOPs in the western countries can be greatly attributed to the dual benefits that the structure offers. In the US, ESOPs are both tax deductible in the hands of employer and are also tax-free for employees. As many analysts in India fear, the move to bring ESOPs in the FBT net can have a sabotage impact on ESOPs, and the corporate world is raising concerns on this issue. Rahul Mulay, General Manager, Operations and HR Head at Harbinger says, "ESOPs have so far performed well as a motivation tool in the IT industry. This move is not a very good idea. It might be detrimental as companies would mull looking at other alternatives." Thus, it is most likely that the move may prove to be detrimental to the future of the hitherto effective motivational tool.n

- Y Bala Bharathi