Last week while I was thinking about the ongoing issues for companies with equity compensation in India, the Federation of Indian Chambers of Commerce & Industry (FICCI) was considering the ongoing issues for employees. This week, FICCI issued a letter to the finance ministry asking that the taxation of ESOPs (Employee Stock Option Plans) be amended (See the press release here.).
In the proposal, FICCI asks that the discount value at grant, as opposed to the spread at exercise, be taxed as income. FICCI argues that only the discount provided by the company at grant represents the consideration given to the employee by the company; any increase in value after that is more like investment income. FICCI maintains that taxing the spread at exercise as a perquisite is counter to the SEBI guidelines for stock options.
The press release focuses on the section of the SEBI guidelines that stipulates the fair value of an option should not be adjusted for “changes in the price of the underlying stock, volatility, the life of the options, dividends on the underlying stock, or the risk-free interest rate.” Although the FICCI proposal does mention that SEBI guidelines define the FMV of an option as the market price prevalent on the grant date, it fails to mention that this “market price” referenced in the guidelines is actually the trading value of the option, or estimated trading value based on a valuation model (e.g., a Black-Scholes valuation). At any rate, this is merely a request to the finance ministry at this point. It remains to be seen whether or not the finance ministry will even entertain the idea. Because it would probably result in a decrease in tax revenue, my gut tells me no…but stranger things have happened!
Ads by Google: Or, “An ESOP by Any Other Name”
While reading an article on the FICCI proposal, Google ads saw a great acronym and gave me a targeted add for the ESOP Association. Because of that, I learned that October is Employee Ownership Month, which, I must admit, caught me by surprise. Although employee ownership is a foundation for most equity compensation, Employee Stock Ownership Programs (ESOPs) in the United States are specific programs under which shares of company stock are placed in a trust. Shares in the trust are allocated to employees based on whatever parameters have been set up by the company. The allocated shares typically vest over time, but vested shares are not actually issued to the employee until termination.
October has been Employee Ownership Month for more than 20 years; it’s a month set aside to educate the public (not just employees) about the benefits of employee ownership (i.e., ESOPs). According to the ESOP Association, “…companies celebrate with picnics to honor their employee owners, hold roundtable discussions with local public officials and organizations to spread the word about employee ownership, and some hold awards ceremonies to honor outstanding employees.”
So, I searched and searched, but I couldn’t find anyone that celebrates an “Equity Compensation Month.” With the cyclical nature of bad press on equity compensation, I certainly think we could benefit from one. Wouldn’t it be great if companies everywhere celebrated equity compensation at the same time?
We are about half-way through the first tax year in which employers have known the income reporting, tax withholding, and valuation requirements for employees in India. Last year (2009/2010) was quite a scramble, with retroactive updates and guidance being provided late into 2009.
Valuations
One issue that companies continue to work with is the calculation of FMV, as a Category 1 Merchant Banker valuation is still required for companies not listed on a recognized exchange (Neither NASDAQ nor NYSE are recognized exchanges.). There were several months where it was unclear whether or not Merchant Banker valuations would be required. If your company reported and withheld based on the market value of your stock during the 2009/2010 tax year, you should have adjusted your reporting at this point.
Frequency
When it comes to Merchant Banker valuations, frequency is still a key consideration (and one that will remain so long as these valuations are required). The regulations state that valuations are only required every 180 days, so it is possible to only value your company’s shares two times a year. However, this may not right for your company, especially if the trading value of the shares has decreased significantly since the most recent valuation.
Double Standard
The difference between the Merchant Banker valuation and the trading value of the stock will remain an ongoing issue regardless of how often your company has a valuation performed. If your stock plan administration software does not permit more than one FMV on a trading date, you may have to provide custom employee communications to accommodate the FMV that was used to calculate income.
Australia
Reporting Obligations
Generally speaking, most options and RSU grants in Australia awarded after July 1, 2009 are taxable at vest. There is no withholding obligation for employers, but there is a reporting obligation of Employee Share Scheme (ESS) statements to both the employee and the Australian Tax Office (ATO). They are not unlike the U.S. Section 6039 information statements in theory; presumably they will help employees better understand how to complete their own tax returns and will help the tax authorities determine if income is being properly reported on tax returns, which they will be auditing (See this alert from Deloitte.)
Valuation
For RSUs, the trading value of the shares at vest may be the FMV for income calculation. However, options are considered an “unlisted right” and might require a valuation method (e.g.; Black Scholes) to determine the market value of the shares on date of the taxable event.
30 Day Rule
One tricky piece of determining the FMV on the taxable date in Australia is the 30 day rule. If an employee sells shares from an RSU vest or option exercise within 30 days of the original taxable event date, then the sale date might be considered the taxable event, provided the company is aware of the sale.
Employees
Individual tax returns for the 2009/2010 tax year are due by October 31, 2010. Employees may still be trying to understand the ESS statements provided to them by the company.
Taking Action
Many companies appear to have moved away from granting options in Australia as a result of the reporting obligations. We completed a Quick Survey on this in September; only 20% of respondents were continuing to grant options in Australia, 38% were not granting options to begin with, and a significant 42% were moving to share grants (like RSUs) or some type of cash compensation.
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.
When the Finance Bill 2007 extended India’s Fringe Benefit Tax (FBT) to include equity compensation, companies scrambled to respond. The Finance Bill uprooted tax-favorable plans, changed the valuation method, and required employers to pay the tax. Companies had to determine how to accommodate the new tax (many passed the tax through to employees) and make the estimated tax payments.
Now, all that may be turned upside down. India’s Finance Minister has proposed to abolish the FBT beginning retroactively as of April 1, 2009; and not just for equity compensation, but for all FBT items.
What we do know this means is:
Equity compensation will be treated as perquisite income, valued at exercise for options, purchase for ESPP, and at vest for restricted stock.
Employers will be required to withhold income tax on equity transactions, but social insurance contributions most likely will not be required.
The further sale of shares will be subject to capital gains tax.
The questions this leaves unanswered are:
What valuation method will be acceptable; will companies still be required to use a merchant bank valuation?
Will there be any tax-favorable plans like those that existed prior to FBT on equity compensation?
Since the abolition of FBT is retroactive to April 1, 2009, how should transactions that have taken place since then be handled?
What also remains to be seen is whether or this will ultimately be easier or more difficult to administer than FBT. Employers who have already accommodated the FBT will once more need to confirm that grant agreements are adequate and make tax payments to the government. Employers who were not passing the FBT through to employees will now need to implement tax withholding on equity compensation. However, if the proposal eliminates the need to use merchant bank valuations, streamlining valuations to be more consistent with other country methodology, it would certainly make things easier! Stay tuned for more updates as clarifications become available.
The abolition of FBT in India may be a welcomed change, but the proposed updates to taxation of equity compensation in Australia have been met with overwhelming opposition. This upset proposal in the 2009/2010 Australian Federal Budget was to tax options at grant. Recently, we have heard that the proposal has been modified to allow a deferral of taxes until there is no longer a risk of forfeiture and there are no longer disposal restrictions attached to the shares. This, like the FBT change, will be a retroactive change to taxation of equity grants.
Belgium, in an effort to provide some relief in these difficult economic times, has proposed an opportunity for companies to extend the term of underwater options for up to five years without incurring additional individual income taxes due for the option-holder. Outside of this opportunity, extending the term of an option would constitute the grant of a new option; options are taxable at grant in Belgium. Options eligible for this treatment must have a grant date from January 1, 2003 through August 31, 2009. U.S. companies willing to take the expense hit for such an extension should keep an eye out for the final version of the Belgian Economic Recovery Act.
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Last year, the Indian Ministry of Finance surprised us by changing the taxation of equity compensation income by introducing the Fringe Benefit Tax (FBT). Although the annual FBT return is due on October 31st, and the next advance payment installment must be made by December 15th, companies are still struggling with what FBT will mean for them.
The introduction of FBT on stock income abolished the use of tax favorable stock plans in India. All equity awards are now exempt from income tax to employees. Instead, the Ministry of Finance will tax the employer at 33.99% on the ‘value’ of the grants when they vest. I use quotation marks for the word value because the definition of the value of shares on the vest date is unique to India. Only companies that are publicly traded in India may use the market value to determine the gain at vest. All others, including U.S. public companies, must employ a qualified Category 1 Merchant Bank to determine the appropriate fair value. This valuation is good for 180 days; technically a company could obtain a valuation twice per year and satisfy the valuation requirements. This causes some issues with the value taxed vs. value received, especially for employees of companies that are passing the FBT cost on to participants.
Some U.S. companies have chosen to pass the FBT on to their employees. Recovering the FBT from employees creates some unique issues for the employer. Because this is an employer tax, the reimbursement of FBT creates what is essentially a variable strike price and actually decreases the expense valuation of the grant. Basically, the recovered FBT is added back to the award as if it were part of the exercise or purchase price. This means that the employee pays more for the grant, reducing the valuation. Companies should be using a Lattice or Monte Carlo valuation method for these awards. Note that this also means that option grants are more likely to be underwater in a way that your stock plan administration software may not be able to track. According to the Practical Solutions for Stock Plans in India session from our conference this year, we are seeing an even split between U.S. companies that are choosing to pass FBT on to employees for new grants vs. those who are not. Curiously, a gentleman attending the session said that most India companies are passing the cost on to employees.
Another troublesome feature of FBT is that it is charged to the India subsidiary, but does not qualify for a company tax deduction (likewise, the recovery of FBT from employees does not increase the company’s income). This means that if the company does not choose to recover the FBT from employees, it will directly reduce the income of the sub without any cost recovery. To compensate for this, some companies are choosing to reduce the size of grants to Indian employees (which would not help the sub directly if the company is not recharging the award cost). Another option is for employers to turn to a cash-settled incentive, which would not be subject to FBT.
Finally, there is the subject of the estimated FBT payments due by the company on June 15th (15% of estimated FBT), September 15th (45% of estimated FBT, reduced by any actual amounts paid ytd), December 15th (75% less any payments made), and March 15th (100%). These advance payments were a topic of bitter conversation at the convention. Advance payment is pretty straight-forward for restricted stock, especially because the fair value might only be determined twice per year. The more difficult estimate is the option exercises. Even though the value of the FBT is determined using the grant date, it is not payable until the exercise date using a first-in-first-out (FIFO) method. Listening to these conversations, the issue that stood out the most to me is the recovery of over-payment of FBT. Underpayment of advance payments is only subject to a simple 1% interest charge. Overpayment, however, is not recovered by reducing the next year’s payment, but rather by applying for a reimbursement (which could take a considerable amount of time). This means that many companies are taking a hard look at how they estimate those payment as the cost for overpayment is significantly higher than the cost for underpayment.
If you haven’t already, take a look at our India page in the Global Stock Plans portal. There are a number of alerts posted specifically about the FBT tax. Sign up to receive the latest alerts here. You may also find additional details in the India Country Guide by the Jones Day Associate Firm, P&A Law Offices. There have been quite a few questions about India FBT in our Discussion Forum. Don’t hesitate to bring yours up. We have a great team of top international plan experts who are ready to help!