The ABC of stock options

Now that markets the world over are doing well, stock options have once again emerged as an employee compensation and retention tool. Earlier the domain of just software majors, corporates across industries now offer employee stock option plans (ESOPs) — not only to the top management but rank and file employees too in a bid to link rewards with value creation.

So what exactly are stock options? Why — and more importantly how — do companies offer them? Are employees guaranteed profits just on account of having stock options? What is meant by vesting period and how does it affect the employee? How are options taxed and what strategies should employees adopt to minimise the tax outgo?

Let’s begin with a simple definition. Stock options mean that — an option or a choice given by your employer to you to buy a specified number of the company’s shares during a specified time, at a specified price, which is usually at a discount to the current market price.

The concept of vesting

Note that getting stock options is not the same thing as getting shares of the stock. An option is the right but not the obligation to purchase the shares. You purchase the shares by exercising the options. Generally, this right to exercise is spread over a number of years. In other words, you must earn the right to purchase those shares, you need to become vested in those shares.

For example, say XYZ Ltd grants its employees options to buy 100 shares at Rs 200 per share. The employees can buy 25% of the shares in the first year, another 25% in the second year and so on over a four-year period. This means the shares are being vested one fourth every year.

The vesting schedule determines when the employee gets control over his options. Once vested, the employee still has to exercise the options at the exercise price during the exercise period in order to become the owner of the shares. The vesting schedule, exercise price and the exercise period are all specified in the stock option plan. (See table for details)

Tax incidence

Tax laws as regards stock options have undergone a change since they were first introduced. Till 1999-2000, there was a dual layered tax system. The first leg of taxation occurred upon the exercise of the options. Tax was payable on the difference between the market value of the shares and the price paid by the employee. Later on, when the shares were sold, the difference between the sale price and the market value on the date of grant was taxable as capital gains.

However, now, tax is payable only at the time shares are sold. In other words, there is no tax payable when the options are granted or when they become vested or when the employee exercises them. However, once the shares are sold, the difference between the sale price and the exercise price is taxed as capital gains.

All normal rules relating to capital gains tax apply. If the shares are sold on a recognised stock exchange after a holding period of one year, the gains are tax-free. Else 10% tax is applicable on the short-term gains.

Foreign ESOPs

Many employees, especially in the software field, are granted ESOPs of the foreign parent company. Here too, capital gains tax applies. The only difference is that since the transaction doesn’t take place on a domestic exchange, shares held over 12 months are taxed at 20% with indexation benefits and a lesser holding period attracts the full rate of tax at the slab rates applicable to the employee.

Taking care of a pitfall

More often than not, the exercise period for ESOPs matches the vesting schedule.

What happens is that, buying shares that have been vested over a period of time can mean a huge cash outgo on the part of the employee. Not everyone may have the liquidity to afford it. Thus, companies provide for a cashless transaction also known as flipping the option. In such cases, employees can exercise the option and then sell their shares in the same transaction. They are paid the profit, which is nothing but the difference between the sale price and the exercise price. However, the pitfall here is that such a transaction gives rise to short-term capital gains and, especially in case of shares listed abroad, the profit would be taxable at the highest rate, i.e, 30% or 33% as the case may be. In my experience, most employees who get ESOPs from their parent body listed abroad suffer from this drawback.

A bit of proactivity on the employee’s part can prevent this from happening. The employee should specify to the HR department that he would not be opting for a cashless exercise. Pay for the shares out of one’s pocket. In cases where liquidity is a hurdle, perhaps taking a loan is the answer. Remember, the loan doesn’t have to be for a period of more than one year. Of course, the cost benefit analysis of the tax saved vis-a-vis the interest paid on the loan will have to be done. However, in most cases, one would find that a cashless exercise proves to be more expensive.

To sum

There are many different ways that a company can draw up a stock option plan for its employees. But no matter what the plan, the basics don’t change. To take optimal advantage, the employee must study and understand the plan offered by the company in light of the interplay between the vesting period, exercise/grant price, the exercise period and the consequent tax incidence.

sandeep.shanbhag@gmail.com