This article has been authored by Shefali Agarwal, a fifth year student at National Law University Odisha.
Employee Stock Option Plans(ESOP) are incentive schemes formed by the company under which the company allows its employees to purchase a specified number of shares at a later date but at a price which is pre-fixed. Stock Appreciation Rights(SARs) are a variant of ESOP which is based on the performance of the company. The basic difference between ESOP and SAR is that, in ESOP actual shares are allotted and voting rights are vested with the employee unlike in SARs.
SARs are globally recognised ‘stock based compensation’ instruments which are now gaining fame in India, visible from SEBI Regulations. The SEBI(Share Based Employee Benefits) Regulations, 2014 applies to SARs. The Regulation gives the definitions of various terms associated with the SARs: Appreciation, Exercise, Grant, Vesting, and SAR. As per regulation ze, SAR means a right of the employee (who has been granted SARs), which entitles him to receive appreciation which is settled by way of cash (Cash-settled SAR (CSAR)) or shares (Equity-settled SAR (ESAR)). In SARs, the employee in actual scenario doesn’t hold any shares in the company; it is only a scheme of incentive or stock option given by employers.
STAGES OF SARs AND its TAXATION
A Compensation Committee is constituted under Regulation 5 which formulates the terms and conditions of the administration of ESOPs or SARs Schemes. SARs like stock option schemes have four stages: Grant; Vesting; Exercise; Sale
Grant is the scheme under which the option of benefits or SARs is given by the company to the employee. Vesting entitles the employee to receive the benefit so granted. By way of exercise, the employee makes an application to the company for the issue of the “shares or appreciation” against the vested benefits. The minimum vesting period is of one year. During the grant and vesting of SARs, there is no tax liability that arises in the hands of the employee. But during the next two stages the tax liability has to be calculated differently. For the SARs issued up to 2008-2009, SARs as taxable only as capital gains on the event of sale with the cost of acquisition being the value at time of vesting.
FAIR MARKET VALUE per share (-) EXERCISE PRICE per share * Number of shares allotted.
(Fair market value is the price of the share prevalent as on the date of exercise and exercise price being the price at which rights were exercised by the employee.)
The employer is duty bound to deduct tax at source on the said event along with the disclosures. The fair market valueof shares varies according to whether they belong to the companies listed in recognised stock exchanges or not. Besides that, unlisted shares are taxable in both situations be it short-term or long-term capital gain. For short-term capital gain the normal slab rates are imposed whereas in long-term gains the rate of tax is 20%.
The sale of SARs is taxable under the head of capital gains, which may be a short-term gain or a long-term gain. The long term capital gains are exempt from tax under section 10 whereas the short term capital gains are taxable at 15%. Since there were arguments for not taxing SARs as ‘Capital Gains’ because it did not involve any amount of money to acquire the capital asset, it was clarified that value of shares on the date of exercise will be taken as ‘Cost of Acquisition.’ The amount of capital gain is equal to
SALE AMOUNT (-) COST OF ACQUISITION
(Cost of acquisition being the fair market value for perquisites.)
RESIDENTIAL STATUS AND ITS IMPORTANCE
The residential status of the employee becomes important for the computation of taxes on ESOPs or SARs to be specific because of the difference in liability to tax. By virtue of section 5 of the Income Tax Act, 1961 an ordinary resident is charged tax on his global income irrespective of the source through which the income is receivable. But under section 6 for “not ordinarily resident” and “non-resident” only Indian income is taxable.
In case of employees having different countries where the SARs are granted and where they are exercised, taxation issues drive up. The amount calculated above is wholly and directly taxable for ordinary residents under section 17(2)(vi). For “not ordinarily resident” and “non-resident” the taxable value is the proportion of days the employee gave his services in India from the time of Grant to Vest. The employee can claim foreign tax credit with respect to taxes paid in foreign country on ESOP under section 90 supported with section 9(ii).
i. Under IT Act
Under the Act, section 17(2)(vi) can cover SARs. It was amended by the Finance Act, 2009 which erased the Fringe Benefit Taxing and rather explained that any employee stock option comes under this clause of perquisites. Earlier the provision which mainly covered the Employee Stock Options was sub-section (iiia) of section 17(2) which was inserted by Finance Act, 1999. This was made effective from 1st April 2000 to bring stock options in the purview of Income Tax under Perquisites. The recent judgement by the Supreme Court has been a landmark for SARs which are covered under the un-amended sub-section.
2. Additional Commissioner of Income Tax v. Bharat V Patal (AIR 2018 SC 2681)
The facts stated briefly, the respondent filed his returns at Rs. 40,13,820 and the Assessing Officer determined it at Rs. 7,23,11,013. The difference in amount as per Assessing Officer was redemption of SARs which was to be taxable as capital gains. The question that arose was to determine whether the SARs should be taxed as “Perquisites” or “Capital Gains.” The important point here was the issue was for the period 1991-1996. Thus the case falls outside the effect of 2000 amendment act. The Supreme Court ruled that the redemption is taxable as “Capital Gains” only. The SC has led down that, SARs are to be taxed under the provision which taxes share-based rewards.
ii. Under SEBI
As per the definition of SAR, it includes both CSAR and SSAR but, are they regulated by SEBI? When companies have approached SEBI for advice on their specific employee benefit schemes, SEBI has denied the application of the regulation on CSAR. It has advised that as per regulation 1(4)(ii) a scheme involving dealing in or subscribing to or purchasing securities of the company, directly or indirectly is regulated and since in CSAR there is no actual involvement of shares, it does not come under the Regulation. If we trace it back to the time when ESOS Guidelineswere reviewed, it can be seen that SEBI had no intentions of regulating schemes which didn’t involve actual securities but the final text does not maintain the difference between the cash and equity settled stock appreciation rights. Conceptually, both CSAR and ESAR benefit the employee from appreciation in the value of shares and do not involve direct security. So the uncertainty as to non-regulation of CSAR under SEBI or under any other regulation lacks a proper rationale. Since the provision uses the term indirectly and the definition includes CSAR, there remains to see why SEBI hasn’t yet come up with a clarification or an amendment with respect to CSAR.
The concept of SARs is relevantly new in India and not many cases have come up for decisions to establish firmly on the taxability of the SARs. SEBI Regulations do give a way ahead to regulate SARs and minimise unfair pricing practices, it does not regulate cash settled SARs. This leads to a lot of confusion and in our opinion since SARs have the potential to grow and impact the market, it should be regulated clearly.
The regulations do not penalise non-compliance by the companies and more so since CSAR is not governed under any regulation, there is no check on the companies. Careful planning of the schemes is necessary in order to specify the eligibility, time period, performance criteria for the employees to be covered under these schemes. The companies should assure funds for payments in future and not just make promises. The situation of absence of employer-employee relationship should also be considered before the execution of the scheme. Clarifications in regard to residential status of individuals covered under the scheme and the scope of SBEB Regulation should be decided upon for a better compliance.