The difference between the Fair Market Value (FMV) of the shares allocated upon exercise and the strike price is referred to as a perquisite under income-tax regulations, which include rules for taxing notional income upon execution of employee stock options (ESOPs). Similar rules apply to the taxes of these perquisites as they do to the taxation of other salary components.
When ESOPs are exercised and shares are awarded after the employer-employee connection ends, the tax situation becomes murky. The discharge of taxes following the end of the employer-employee relationship is a topic of debate.
Former employer liable to apply TDS
Under the Income Tax Act, securities given or transferred by an employer or former employer directly or indirectly at no cost or at a reduced rate are included in the definition of perquisite. Even if the person taking the option is no longer an employee of the former business, this could accelerate the former firm’s TDS due. Although classifying something as a perquisite as it comes with the benefits of taking deductions from salary income sounds advantageous for employees, this interpretation could actually make it more difficult for the ex-employer to pay taxes because there might not be any salary disbursements from which taxes could be withheld.
If options are exercised before such a payout, a full and final settlement can be an alternative. The question of whether that would be sufficient to pay taxes on its own depends on the circumstances. If the taxes paid aren’t reimbursed by the ex-employee(s), the former employer must pay them on behalf of the ex-employee(s).
ESOPs taxed as gifts in the hands of ex-employee
The weight of tax discharge by the former employer must be transferred to the ex-employee, who must budget for the higher tax obligations while calculating advance taxes. The distribution of shares upon the exercise of ESOPs upon employment termination may also be seen as a gift, meaning that the ex-employee must report the property (shares) acquired as “other income” if it was received for less than fair market value (FMV) or without payment at all. Once more, the difference of more than Rs 50,000 between FMV and the exercise price paid by the ex-employee will be the taxable base for gift tax.
However, the valuation guidelines used to calculate FMV vary and consider the allottee company’s net book value as determined by the use of the I-T guidelines. Giving over the reins to an ex-employee comes with its own set of challenges, the biggest of which being cash flow problems because taxes must be paid on the unrealized gain at the time shares are received.
(By BM Singh, ESOP Expert & Managing Partner, BMSA)