Infosys Technologies Ltd had allotted warrants to its Employee Welfare Trust under an Employee Stock Option Plan (ESOP).
The trust was to hold the warrants and subsequently transfer the same to the employees of the company. During the assessment years 1997-98, 1998-99 and 1999-2000, the trust issued the warrants to the employees.
The warrants were to be retained for a minimum period of one year. Afterwards, the employee was entitled to exercise his right and get shares at any time after one year but before expiry of five years. The shares were subject to lock-in period of five years and were non-transferable during this period. The employee had to remain in service for five years else he lost the right to shares.
The tax authorities ignored the lock-in period and contested that once the employee exercised the shares, the benefit arising to the employeethe difference between the market value and the price paid by the employeewas taxable as perquisite. Further, they contested that the employer was liable to withhold tax on the same.
It is pertinent to note that a new provision, taxing the benefit arising under an ESOP at the time of exercise was introduced for the first time with effect from April 1, 2000. This provision laid out the mechanism as to how the benefit is to be computed and accordingly the terms value and cost were specified. This provision was subsequently deleted from the very next year (April 1, 2001).
The apex court has drawn reference to its earlier decision in the case of Govind Saran Ganga Saran (Sales Tax), wherein it had laid down four important components of tax, which should be present before any benefit could be taxed. These are the character of the imposition, the person on whom the levy is imposed, the rate at which tax is imposed and the value to which the rate is applied for computing the tax liability. If there is any ambiguity in any of the four concepts, then levy would fail.
The apex court held that, unless a benefit/receipt is in the nature of income or specifically included by the legislature, as part of the income, the same is not taxable.
In the instant case, in the absence of a legislative mandate a potential benefit could not be considered as income of the employee. Also, the shares allotted to the employee had no realisable sale value on the day when he exercised his option, as there was no cash inflow to the employee. Further, the same was subject to lock-in period of five years during which these shares were non-transferable.
The term cost that is critical for determining the taxable value of the benefit under ESOP, was explained for the first time when the new provision was introduced.
The Memorandum to the Finance Act, 1999, however, did not specify that this provision or for that matter the meaning of cost was applicable retrospectively.
Therefore, the apex court, applying the principles laid down by it in the case of B C Srinivasa Setty, held that in absence of the definition of the cost, the value of the options was not ascertainable (the computation mechanism failed, hence it was not taxable).
Currently, the benefit arising under an ESOP is taxable as Fringe Benefit Tax (FBT) on the date on which the options vest with the employee. The FBT is payable by the employer at the time of allotment or transfer of shares to the employee. Further, the employer has been given an option to recover the FBT from the employee.
Nevertheless, the above decision highlights/ reiterates few fundamental principles of taxation and provides guidance as to the basis of taxation of any benefit provided to an employee by his employer. The principles laid down in this decision are equally applicable in case of other business transactions.
Vasal is is executive director, KPMG