The Indian budget proposal that includes the abolition of fringe benefit tax (FBT) and the institution of income tax on employee equity compensation has been approved. Although we can now be sure that the FBT tax will no longer be due by employers, and that employees will now be taxed on income from option exercises, RSU vests, and ESPP purchases, there are still several issues that companies will need to sort through.

The Impact of the 2009-2010 Budget

First, a quick summary of what we can be sure of based on the new budget:

• Employers must remit taxes on income from stock transactions on or after April 1, 2009 for both current and former employees.
• Employers are responsible for remitting the tax regardless of whether or not it was actually withheld from employees.
• The income amount will be based on the spread at the transaction date (exercise, vest, purchase).
• Late payment is subject to penalties of 1% per month.
• Employers who already paid the first installment of FBT for the financial year 2009-10 will need to apply for a refund.

Further Guidance Needed

The key element of the new taxation that is pending further guidance is how the fair market value of stock is to be determined. Under FBT, companies were required to enlist the services of a Merchant Bank to determine the fair value of stock. At this point, it looks like it is possible that the Indian government will accept the use of the actual market price of the shares. The most recent alert from Baker & McKenzie suggests that, until guidance is available, companies should be able to use the market value of shares to determine the appropriate tax amount.

Outstanding Issues

There are still a number of issues that companies will need to address.

Grant Agreements

First, companies will want to review their grant agreements. If companies intend to collect taxes from employees on equity compensation, hopefully they implemented sufficiently broad language in the grant documents to accommodate the new tax withholding requirement. Additionally, it will need to be made clear to employees what tax payment methods will be permitted.

Interim Tax Payments

Then there is the issue of the taxes that are due retroactively on transactions that have already taken place after April 1, 2009. Companies that did not remit their first FBT installment may use those funds to cover the taxes that are now due. However, if the company already submitted the first FBT installment, the funds can’t be “transferred over” to pay employees’ income taxes.

Companies can opt to go ahead and eat the cost of the taxes for the interim transactions (grossed-up to compensate for the additional income). If this isn’t a viable option, then companies may choose to withhold the tax amounts from future paychecks. This is possible for current employees, but poses a problem when it comes to employees who have had transactions after April 1, but are no longer with the company. Companies are required to remit this tax to the government, even though there is no viable way to collect it from former employees. Paying the taxes on behalf of former employees while forcing current employees to foot would, at the very least, be a difficult PR strategy.

Terminated Employees

If your company grants stock options to employees in India that have a post-termination exercise period, the issue of terminated employees is likely to haunt you down the road as well. In situations where terminated employees are exercising their options, companies will have no way to confirm the appropriate tax rate and no way to true-up the tax withholding through local payroll.

Employee Concerns?

I’ve already seen blog posts and articles from sources in India with employees concerned about the impact of the change. I found this interesting comparison from iTrust Financial Advisors that proposes the new tax on perquisites will negatively impact employees even if their employers were already passing the FBT through to them.

However, I suspect that companies who did pass the FBT tax through to employees will likely not encounter much resistance to the new tax on equity compensation going forward (even if employees are unhappy about the taxes on other benefits). Employers who were covering the FBT, on the other hand, may find that employees are unhappy about having to suddenly pay taxes on their equity compensation. This will be especially true for grants that were either granted under a tax-favorable plan prior to FBT or for grants that were awarded at a reduced size to account for the cost of the FBT. Companies will need to determine how best to address employees’ concerns and then roll out a well-orchestrated education campaign to get everyone on board.

The Million Dollar Question

So, what are companies doing about it, now? An informal poll taken by Elizabeth Dodge of Stock & Option Solutions showed a wide range of responses including: withholding taxes as soon as the proposed budget was announced, covering the taxes for employees on current grants with plans to increase the size of future grants, and the “wait and see” approach pending further guidance from the government.

-Rachel