Judgment clarifies tax rules for stock options

An employee stock ownership plan (ESOP) is an employee benefit plan with a defined contribution. It allows employees to become owners of stock in the company they work for. It is an equity-based deferred compensation plan.

ESOPs have several features that make them distinct from other employee benefit plans. First, only an ESOP is required by law to invest primarily in the securities of the sponsoring employer. Second, ESOPs allow borrowing and, as a result, “leveraged ESOPs” may be used as a tool of corporate finance.

The nuances of ESOPs came to the forefront on 4 January 2008 when the Supreme Court issued a judgment on the taxability of ESOPs in the case of the Commissioner of Income Tax v Infosys Technologies Ltd (Civil Appeal no. 3725 of 2007).

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The case presented a number of interesting features.

To implement the ESOP, Infosys had created a trust to deal with a buy-back problem. It allotted 750,000 warrants at Rs1 each to the trust. Each warrant entitled the holder to apply for and be allotted one equity share with a face value of Rs10 for total consideration of Rs100.

The trust offered the warrants to eligible employees at Rs10 each and every warrant had to be held for a minimum period of one year, after which the employee was entitled to elect and obtain shares allotted to him on payment of the balance of Rs99. The option could be exercised at any time after 12 months but before the expiry of a period of five years.

The allotted shares were subject to a lock-in period of five years, during which the custody of the shares remained with the trust and the shares were non-transferable.

An employee had to remain with the company for the five years. If he resigned or his employment was terminated, his rights under the scheme were lost and the shares were re-transferred to the trust at Rs100 per share.

When assessing the progamme for tax purposes, the assessing officer held that the “perquisite value” of the plan was the difference between the market value and the price paid by the employees to exercise the option. He opined that a tax deduction at source (TDS) of 30% was to be charged on this perquisite value. The assessee was held a defaulter for not making the TDS.

However, the Supreme Court observed that a warrant is a right without obligation to buy. So, in this case, perquisite value cannot be said to accrue when the warrants were granted.

The position would be the same with options vested on the employees after the lapse of 12 months.

Further, the employees had the option of not availing themselves of the benefit and there was no certainty that the option would be exercised. Further, the shares were not transferable for five years and if an employee resigned or was terminated during the lock-in period the shares had to be re-transferred.

During the lock-in period, the possession of the shares, an important ingredient, remained with the trust.

The stock exchange was duly notified about non-transferability of the shares during the lock-in period and the shares were stamped as “non-transferable”.

It was not open to the employees to hypothecate or pledge the shares during the lock-in period – during which the shares had no realizable value.
As a result, there was no cash inflow to the employees that exercised the options.

The Supreme Court also noted that when the options were exercised, it was not possible for the employees to foresee the future market value of the shares. Therefore, any benefit that arose when the option was exercised was only notional and without ascertainable value.

Therefore, it judged that treating the difference between the market value of shares on the date of exercise of option and the total amount paid by the employees consequent upon exercise of the said options as the perquisite value, was a mistake.

The Supreme Court held that the shares could not be obtained by the employees until the lock-in period was over and, in the absence of legislative mandate, a potential benefit could not be considered as “income” under the head “salaries”.

It is important to bear in mind that if the shares allotted to the employee had no realizable sale value on the day when he exercised his option, then there was no cash flow to the employee. At the same time, it was not possible to know – at the time of exercising the option – the future value of the shares allotted.

Therefore, treating the respondent as an assessee in default for not deducting the TDS at the statutory 30% was a mistake.

This was not a case of tax evasion. The assessee had floated the trust because of the buy-back problems, which were genuine when employees were dismissed, removed or resigned and were obliged to return their share allotments.

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Sumes Dewan is a partner at KR Chawla & Co Advocates & Legal Consultants. The firm is headquartered in New Delhi and has offices in Chennai and Bangalore as well as a representative office in Singapore.