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A controversial issue has arisen recently, pertaining to stock options issued by a foreign parent company in favour of employees of its Indian subsidiary. Generally, a scheme is devised by the foreign company whereby the employees of the Indian subsidiary can opt for shares of the parent company at a pre-determined price. When the option is exercised by Indian employees, the shares are sold immediately at the prevailing market price, the profit being payable to Indian employees.
In other words, the shares of the foreign company are not physically taken possession of by Indian employees who exercise the option by a written intimation, on receipt of which the foreign company arranges for the shares to be sold. The difference between the prevailing market value of the shares and the price at which the Indian employees are offered the same is directly paid to Indian employees. The question of taxability of such profits has been considered by the Authority for Advance Rulings (AAR) (P. No. 15 of 1998). The factsin this case were that the employee of an Indian firm was given the option to subscribe for shares in the parent US firm. On exercising the option, the shares had to be sold immediately at the ruling market price.
"Profit made by Indian employee on sale of such shares taxable": AAR: The question before the AAR was whether the profit made by the Indian employee on sale of such shares was taxable under the head "salary" under section 15 of the Income-tax Act, 1961 and whether the US company was required to deduct tax at source under section 192 of the Act.
On a perusal of the provisions of sections 15 and 17, the AAR held that any benefit or amenity received by the employee including the benefit of purchase of shares of the American company at a concessional rate would have to be treated as perquisite under section 17(2)(iii). It was held that if the definition of salary as given in sections 15 and 17 was examined, it would be seen that any salary paid by an employer to an employee as well as salary paid"by or on behalf of an employer or a former employer" have been brought within the ambit of "salary" chargeable to tax under section 15.In this case, stock option was given to the employees of the Indian company. The American parent company was making this offer with a view to give an incentive to the employees of the Indian company. There would have been no problem had the stock option been offered by the Indian company. However, the position in law would not be different only because the stock option was offered not by the Indian company but by its parent company. If the "salary" was paid for or on behalf of the employer, that would also have to be included in "salary" income by virtue of section 15(b).
In respect of the stock option offered to the employees of the Indian company, if and when the option was exercised by the employee, shares would be allotted and thereafter sold. The resultant profit would be taxable in the hands of the employee. The amount that the employee would receive would come to himin addition to the salary which he would get from the Indian company. It was, therefore, something more than what was due to him under the contract of employment.
Additional amount is "salary": Hence, this additional amount came clearly within section 15(b) of the Income-tax Act. The stock option scheme had been devised to enable an employee to get additional remuneration. Roxburgh J., in the case of Bentley v. Evans (39 T.C. 132 (Ch D)), held that such payment should be held without hesitation as additional remuneration. However, the law in India is different. In view of the express provisions of the Act, such benefit given to employees would be additional remuneration. Salary has been defined in section 17(iv) to include, inter alia, perquisites or profits in lieu of or in addition to any salary or wages. The stock option scheme would enable employees to get something in addition to their remuneration. This addition would clearly come within the definition of the expression "salary". This has been madeclear by section 15(b) of the Act.The next question before the AAR was whether the amount was paid for or on behalf of the employer. The AAR observed that the offer was made to the employees of the Indian company which was a fully-owned arm, whose business was completely controlled by the parent company. The object of making such offer could only be the desire to give a benefit to the employees and, at the same time, to enhance their interest in the company.
The parent company had made such an offer to the employees of the subsidiary company, only because it regarded its subsidiary and itself as the same concern. Even if the subsidiary was treated as a separate juristic entity, the stock option offered by the American company was treated to have been made for on behalf of the Indian company. Moreover, in a case like this, it was held that the corporate veil would have to be lifted to see the real nature of the transaction.
There was no difficulty in law in recognising the reality of the transaction andtreating the benefit given to the Indian employees as one by the employer himself or by the American company for or on behalf of the employer. In any view of the matter, this additional remuneration or profit would have to be treated as income from "salary". The Supreme Court in the case of State of UP vs Renusagar Power Co. (70 Comp. Cas 127), observed that the doctrine of lifting the corporate veil was expanding in the context of modern jurisprudence.
Holding company and subsidiary treated as one: The court held on the facts of that case that "the holding company and the subsidiary were to be treated as one and the same because the subsidiary was created to generate and supply energy and power to the holding company in order to enable it to maintain its production commitments to the State and therefore, generation of power was considered for the purposes of excise to be the holding company's own source of supply and not supply from a separate company." In the instant case, the American company hadfloated an Indian subsidiary. It had devised a scheme to give encouragement and pecuniary incentive to the employees of the Indian company by offering them an option to purchase its own shares at a pre-determined price. This sort of transaction was not possible unless the parent company treated its own business and the business of the Indian company as one.
The next question considered by the AAR was whether there should be deduction of tax at source by the American company in respect of the income arising on account of the stock option. The gain made by an employee after exercise of the stock option may be taxable as salary. The American company had taken upon itself the responsibility of paying this salary. The provisions of section 192 of the Income-tax Act would, therefore, be clearly attracted. Hence, it would have to deduct tax at source before payment of any salary to the employees of the subsidiary firm. The AAR concluded that by devising the stock option scheme, the US firm had taken upon itselfthe responsibility for paying, what should be regarded as "salary" to the employees of the Indian firm. They were, therefore, under obligation under section 192 to deduct income tax of source on the amount payable to the employees.
It may be pointed out that if payment had been made by the broker directly to the Indian employee, the broker being an agent of the American company, the latter would be required to deduct tax at source. However, if a foreign broker is appointed by the Indian employee and not by the parent company, the broker would be an agent of the Indian employee. In that case, the question of tax deduction at source would not arise because the employer (even if the corporate veil is lifted and the foreign company is deemed to be so) would not be paying any amount by way of salary or perquisite as contemplated under section 192 of the Act.
The decision of the AAR has caused considerable flutter in corporate circles, as it is common practice for multinationals to provide incentives toemployees of foreign subsidiaries. However, if the administrative burden of deducting tax at source, depositing the amount with an Indian bank, issuing a certificate of tax deduction to employees and filing an annual return, are to be imposed on foreigners, there would be considerable resistance on the part of multinationals to make offers of stock options to Indian employees.
Hence, to protect their interest, the government should consider amending the law to provide that the provisions for deduction of tax at source under section 192 would not be applicable in such cases. There will be no loss of revenue because Indian employees would then be liable to pay advance tax in respect of the profit arising on sale of their stock option. Further, there is no likelihood of evasion of tax, as the amount is always received through official banking channels.
The author is an advocate with the Supreme Court of India
Copyright © 1999 Indian Express Newspapers (Bombay) Ltd.
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