Comparison between Stock Appreciation Rights and Employee Stock Option Plans
Conceptually different from the Employee Stock Option Plan a.k.a ESOP, a household term in India, Stock Appreciation Rights, also known as SARs are a novel way of rewarding the employees of an organisation by granting them the right to benefit from any appreciation in the value of the common stock (shares) of a corporation. The subtle difference between ESOP and SAR is that, under the latter, no shares actually get allotted to the employees in the first instance. In other words, what the employees actually get is a right to take advantage of the appreciation in the stock value sans actually holding the same. Therefore, it appears more attractive to employees because they would not be required to incur any cash outflow to purchase the shares. At the time when the employees decide to exercise their rights, depending on the how the plan is structured, the appreciation could be conveyed to the employees either in cash (phantom stocks) or by giving shares to the employees, for a value equal to the value of the appreciation in the shares. As far as the corporation is concerned, it is an effective way of compensating the employees by deferring the payment of bonus to a future date, thereby achieving a twofold objective of postponing the cash outflow and at the same time incentivising the employees to stay in the organisation.
Issues in income taxes with respect to SARs
What makes this instrument an exciting one is the challenge that it poses to the tax authorities and the accountants. While accountants will have to decide on what should finally go as debit to the Profit and Loss account and how to account for the time spread of this benefit conferred on the employees, the challenge in taxes is multifold. The following pointers would guide in understanding the complexity surrounding the taxation of SARs.
- A parent company, say, located in the US decides to give SARs to the employees of its subsidiary in India, thereby granting them a right to gain from appreciation in the value of the US Corporation’s stock. The employee on whom such a right is conferred is not on the rolls of the US Corporation. Therefore, an employer employee relationship is absent.
- At the time of grant of SARs, nothing really accrues to the employee in monetary terms. He is merely given a right to benefit from the appreciation in the value of the common stock which right would be exercisable after a certain period when such rights actually vest in the hands of the employees. So, at the time of grant, would anything be taxed at all?
- Upon exercise of the right, if the compensation plan involves paying cash to the employee equal to the difference between stock value and the exercise price, then how should the sum be taxed in the hands of the recipient employee?
Arguments against taxation of benefits from SARs
It has been argued that in the absence of an employer-employee relationship between the parent corporation and the employees of the Indian subsidiary, the amounts received upon exercise of the SARs should not be taxable under the head ‘Income from Salaries’. Further, it has also been argued that the amounts should be construed as capital gains since SARs would constitute capital assets, the receipts upon their exercise would have been taxed under the head ‘Capital Gains’; however since the computation mechanism would fail (in the absence of a cost of acquisition), the same would not be eligible to taxation under the said head as well.
- The SARs are allotted to the employees by virtue of the employer-employee relationship that exists between the Indian company and the employee.
- Even though there is an absence of an employer-employee relationship in this case between the parent company and the Indian employees, it can be argued that the benefit stemming from SARs arises from the contract of employment and hence would be taxable under Section 17(1)(iv) of the Income Tax Act, 1961. The mere fact that the benefit is provided by the parent company would not alter the underlying obligation that necessitated such a conferment of benefit on the employee.
- The proposition of treating SARs as a capital asset could be far-fetched for the following reasons:
- SARs merely give a right to an employee to benefit from any appreciation in the value of the common stock of the Corporation.
- The said right solely vests with the employee and cannot be transferred by him to any other person.
- Any act by the employee to let the right lapse in a favourable scenario would not be compensated by the foreign parent which actually grants the SARs.
- While it is correct to say that in a scenario where the argument is accepted, the computation mechanism would fail, it is also interesting to note that the exercise of SARs per se would also fail to fit the definition of transfer as provided in Section 2(47) of the Income Tax Act, 1961. It would nevertheless be interesting to place this argument before the courts as the argument in itself is not completely fallacious.
- As regards the time of taxation, it is clear that no notional gains can be taxed in the hands of any person and hence at the time of grant of SARs, even though there could be a scenario where the commons stock of the corporation is traded above the exercise price of the SARs, nothing can be taxed in the hands of the employee.
- At the time of exercise, any difference between the stock’s market price and the exercise price which is monetised by the employees would be offered to tax.
To conclude, any gains arising out of SARs would be taxable under the head ‘Income from Salaries’ in India for the reason that while the form of the benefit is structured differently, it stems from the contract of employment between the Indian company and its employees. If any part of the monetisation of SARs has been taxed in the country of the parent company, the relief provisions in the respective DTAA or in the Indian Income Tax Act (in the absence of DTAA) would apply to the employee.
[The author is an Associate, Direct Tax Practice, Lakshmikumaran & Sridharan, Chennai]