The first major surprise results for the second quarter was announced by Dr Reddy's which buckled the trend in the pharmaceutical industry. The company posted a negative bottom line growth of 29 per cent in the second quarter, down from Rs 16.85 crore to Rs 11.96 crore. However, the company has been able to post a marginal growth in its top line, which increased from Rs 109.48 crore to Rs 113.57 crore.

Downtrend in the company's performance was visible from its first quarter results. Though the company had reported a 10 per cent growth in turnover, bottom line was affected as a result of poor performance in exports of formulations. This trend has continued in the second quarter. Formulation exports during the second quarter has dropped by 16 per cent from Rs 12.78 crore to Rs 11.37 crore. The drop, however, is much lower than that witnessed in the first quarter when the exports plummeted from Rs 23.09 crore to Rs 12.91 crore. This drop was mainly on account of exports to CIS countries which dropped from Rs 20.3 crore to Rs 8.86 crore. The company has made a conscious decision by cutting down on exports to CIS countries as can be seen from the second quarter sales which stood at Rs 6.34 crore. Further, provision for bad-debts, towards losses arising from exports to these countries have no longer been provided in the second quarter.

Overall formulations sales during the second quarter improved by 26 per cent from Rs 59.94 crore to Rs 75.33 crore, while for the first half it improved by 16 per cent from Rs 12.84 crore to Rs 14.86 crore. Domestic formulations were the main reason for growth which improved by 36 per cent. The company has improved its position in the retail segment as can be gathered from the increase in its market share in August 1999 which improved to 1.9 per cent as compared to 1.5 per cent for the same month in 1998.

However, all benefits of growth in formulations have been taken away by bulk drugs. During the second quarter, the company's bulk drug sales dropped by 21 per cent from Rs 45.41 crore to Rs 35.92 crore. In this segment, both the domestic as well as exports have performed poorly. For the half year, the company has posted a negative growth rate of 2 per cent in bulk drugs, thanks largely to a strong first quarter performance. Lower growth in bulk drug has been in line with the management decision of cutting down on reliance from this division as a result of lower realisations. Diagnostics sales continue to record pathetic performance with a drop of 44 per cent in the second quarter from Rs 4.1 crore to Rs 2.3 crore.

The poor performance of the company has, however, not been reflected in the share price which has shot up from Rs 850 in April to a high of Rs 1,600 recently. Rather than the current performance, it is the benefits likely to be accrued as a result of the company's research and developments efforts that seems to be discounted. Reports say that milestone payments on account of its drugs are expected to be higher than income from operations. However, a merger with group company Cheminor Drugs, could change the scenario, especially in the exports market. Industry sources say that the company could sell of its diagnostic division considering its poor performance. Thus though the company has reported poor results, there is little reason to worry about.

ESOP

Reportedly, Income Tax department has served a notice on Infosys for failure to deduct TDS on ESOPs. In a related development, the ministry of finance has refused to see the reason and do away with the requirement of TDS at the time of exercising of option by the employees. A controversial issue is, if the trust route is opted for (an employee trust is funded by the company and the trust issues shares to the employees) does it result in an employer-employee relationship?

Consider the problems related to TDS being deductible on the exercise of the option by an employee. The difference between the fair market value and the cost of acquiring the securities i.e. the grant price, is to be taxed as a perquisite. The employee's salary may not be enough (in cases of software majors for example) to cover the TDS.

For example, company A issues warrants to the employees convertible at Rs 100 per share. On the date of exercise of the option, the market price of share of the company is Rs 5,000. The perquisite will be Rs 4,900 per share. Alson ex-employees are eligible to retain all the vested options. How does the company deduct TDS in such cases? The first stage of taxing should not be at the time of exercise at all. Else, the employee will be forced to sell the underlying securities immediately to pay the TDS.

Here, the second problem comes up which is on lock-in period, which in India is one year. The lock in period nowhere in the world is one year. Granted Income Tax is tax on income and not on cash-flows but that does not justify this ridiculous requirement.

The problems raised by AAR's (Authority for Advance Ruling) ruling in the case of Microsoft's wholly-owned subsidiary still persist. The authority had ruled that the stock options granted by the holding company to the employees of the subsidiary, should be treated as perquisite and TDS should be deducted. It clearly ignored the fact that no employer-employee relationship exists between the concerned employees and the holding company. Now, how does a holding company deduct the TDS for the employees of the subsidiary company or vice-versa? In the above mentioned ruling, AAR claimed that the problem needs to be solved by the concerned management. Since SEBI guidelines permit stock options to the employees of holding/subsidiary company, the problem of TDS persists.

The accounting and tax treatment at the time of granting the option is another problem area. Deferred employee compensation expense (calculated by multiplying the number of options granted with the discount to market price) is required to be charged to the revenue account at the time of granting the option but the expense may be admissible u/s 37 of Income Tax Act only when the option is exercised. CBDT has in its wisdom decided not to clarify the issue.

What happens in the US-the founding country for Employee Share Ownership Plans (ESOPs)? An employee is converted into shareholder through tax deductible contributions made by the company to an ESOP Trust which holds the shares for the benefit of the employees. ESOPs are basically tax-driven tool of corporate finance in the US. Employer establishes tax-exempt ESOP trusts to acquire stake in the company. The trusts are either funded by employer through tax-deductible contributions or the ESOP trust borrows commercially. The borrowings are guaranteed by the employer company to acquire company securities. Such ESOPs are leveraged ESOPs. The employer can make a tax deductible contribution of upto 25 per cent of payroll to the trust which uses it to repay the loans. The ceiling of 25 per cent can be exceeded (and will be tax deductible) if the trust uses the funds to repay the ESOP loans. Around 50 per cent of interest earned by banks and other lending institutions by lending to ESOPs is exempt from tax. Taxdeductions are also allowed for dividends paid on employer stock held in ESOP. An individual selling employer stock to ESOP may be able to defer recognition of any gain realised on the sale if the sale proceeds are invested in securities of other corporation. In India, subject to amendment to Sec 40A(9), (10), (11) of the Income-Tax Act, 1961, it is possible to do the same (Source: Paper presented by RM Chitale at BCA Golden Jubilee Conference) but probably the revenue requirement does not permit it.

-- EMCEE (with contributions from Shishir Asthana & Urmik Chhaya)