Tax talk: Need clarity on tax on ESOPs of ex-employees

Clarity on taxation front begins to turn obscure when ESOPs are exercised and shares allotted, post cessation of employer-employee relationship. Questions surround the discharge of taxes post termination of the employer-employee relationship.

This may fasten TDS obligation on the former employer even where the individual exercising option is no longer its employee.
This may fasten TDS obligation on the former employer even where the individual exercising option is no longer its employee.

By Sandeep Jhunjhunwala

Income-tax laws lay out provisions for taxation of notional income on exercise of employee stock options (ESOPs) by characterising the differential between Fair Market Value (FMV) of shares allotted on exercise and strike price as perquisite. Taxation of such perquisites follows a similar course as for taxation of other salary components. Clarity on taxation front begins to turn obscure when ESOPs are exercised and shares allotted, post cessation of employer-employee relationship. Questions surround the discharge of taxes post termination of the employer-employee relationship.

Former employer’s TDS obligation
Definition of perquisite under I-T Act encompasses securities allotted or transferred, directly or indirectly, free of cost or at concessional rate by employer or former employer. This may fasten TDS obligation on the former employer even where the individual exercising option is no longer its employee. Though the characterisation as perquisite sounds beneficial for employees, as it comes with the perks of claiming deductions against salary income, this interpretation could cause practical difficulties for the ex- employer in discharging taxes as there could be no salary disbursements from which taxes could be withheld. Full and final settlement could be a recourse, if options are exercised prior to such disbursement. Whether that in itself would be commensurate to cover taxes is a situational aspect. Else, the former employer bears tax cost on behalf of its ex-employee unless the taxes paid are recovered from the employee.

Taxation as gift in the hands ofex-employee
If discharge of taxes by the former employer proves to be burdensome, a shift in obligation onto ex-employee is required, who would then have to budget additional tax liability while computing advance taxes. Allotment of shares on exercise of ESOPs post termination of employment could also be construed as a gift, i.e., property (shares) received without consideration or for consideration less than FMV, taxable as “other income” in hands of the ex-employee. Again, the delta between FMV and exercise price paid by the ex-employee (where difference is more than Rs 50,000) would become the taxable base for gift tax. Valuation rules to determine FMV, however, differ and are a factor of net book value of allottee company arrived at after applying prescribed I-T rules. Passing the mantle to the ex-employee has its own set of adversities, foremost being, cash flow issues as taxes are to be discharged on unrealised income at the time of receipt of shares.

The writer is partner, Nangia Andersen LLP. Inputs from Amita Jivrajani & Ankur Agarwal

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