This section states that a person is taxable in India in respect of salaries earned, if the services rendered in India.

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1 Tax issues in inter country ESOPs Date: July 08,2013 Mr. Simachal Mohanty, Director (Taxation), Dr. Reddy's Laboratories Limited The deepest principle of human nature is the craving to be appreciated. * Appreciation for an employee comes as a pat in back accompanied by a bucket of pecuniary recognition as a true example that can be measured. Lets take it a step forward. Yes. make them part of ownership of the organization and seldom they will look back while delivering their best. In earlier days, the retention remunerations used to be in form of year end bonuses and giftswhich slowly paved its way to Employee Stock Option Plan (ESOP) to reward the employee for their performances and at the same time, retain them for a longer future. The advantage are many fold so are the complications in accounting and tax treatment. Primary advantage of allotting ESOP is that it installs a sense of ownership in employees while the company does not shell out anything out of its cash coffer. In fact, Narayan Murthy, co-founder of Infosys went on record saying that Every Indian employee at every level who joined the company on or before March 2010 is a stakeholder of Infosys. How does it work : ESOP s life cycle of a listed share spans into four stages; so designed to retain employees for a longer period. Initially employees are granted the right to purchase (grant of options) a certain number of shares in the company at a predetermined price. Upon expiry of a certain time period from the date of grant, shares are vested with the employees(vesting) when employee gets unconditional right to receive the shares. Once such options are vested with the employee, he gets right to exercise the options(exercise).company allots the shares to the employees (allotment) upon exercise of the shares by the employee. In India, ESOPs are granted as per SEBI (Employee Stock Option Schemes and Employee Purchase Scheme) Guidelines Companies grant ESOPs not only to employees but also to directors of the company, linked on their performances. Taxation of ESOP : Taxation in hands of employee : Universally, taxation of ESOP benefits in the hands of employees has been perennially complex in design. Normally ESOPs are granted by parent entity to the employees of the group. But taxation challenges surface when such employee migrates from the parent organization in one country to a subsidiaries in another country by way of deputation. Typically the country of service at the time of grant of ESOP may be different from country where the vesting and exercise happens thereby giving rise to conflict for apportionment of taxing rights between the countries. Following tax provisions and guidelines in brief to remember while ascertaining ESOP taxability. Residential Status : The first step is to ascertain the residential status of an employee for a particular year. In case the employees becomes resident of more than one country in a particular year, then the ultimate residential status needs to be examined by applying tie-breaker test as per tax treaty. Sec.9(1)(ii) of Indian Income Tax Act : This section states that a person is taxable in India in respect of salaries earned, if the services rendered in India. OECD commentary on Article 15. Paragraph 1 establishes the general rule as to the taxation of income of employment (other than pensions), namely that such income is taxable in the State,where the employment is actually exercised. Employment is exercised in the place where the employee is physically present when performing the activities for which employment income is paid. In other words ESOP perquisites is taxable in a country on the basis of number of days services rendered in the country. Page 1 of 5

2 Taxation in a Foreign Jurisdiction: Generally the perquisite income is taxable upon exercise of the options in most of the foreign jurisdiction. Lets take an example and analyse the issues in seriatim. A Ltd(Indian Parent) grants 150 ESOP Rs.100 to the employee on 1 st May 2013 at Rs.100, with a condition that such options would vest with the employee over three years i.e. 1 st May 2014,1 st May 2015,1 st May 2016 (per year 50 options) provided the employee is in service with any entity in the group. Employee gets deputed to a foreign subsidiary on 1 Jan 2015.Now lets analyse the taxability of ESOP perquisites in respect of the second vesting i.e. 1 st May 2015 (assume date of exercise : 1 st May 2015). Basic Facts : - Relevant Tax years (considering vesting & exercise date is 1 st May 2015) : India -> Tax year 2016 (April 15 to March 2016). Foreign subsidiary -> Tax year 2015 (Jan 2015 to Dec 2015) - Fair Market Value (FMV) : FMV of the shares on the 1 st May 2015 is Rs Perquisite amounts to Rs.1000 (i.e.fmv Rs.1100 minus Option price Rs.100). Taxability of ESOP perquisites :. India : Tax and Perk Value [1/4/15-31/3/16] Tax : Rs.12,910(30.9% on Perk value of Rs.41,781) Calculation basis :Rs.41,781 = (50,000/730 daysx610 days). [Date of grant 1 st May 13 to Date of departure 1 st Jan 15 : 610 days] Tax Rate : 30.9% assumed Foreign Subsidiary Tax [1/1/15-31/12/15] Tax : 2,959(Federal tax 36% on Perk value of Rs.8,219) Calculation basis :Rs. 8,219 = (50,000/730 daysx120 days). [Date of arrival: 1 st Jan 15 to Date of vesting/exercise : 120 days] Tax Rate : 36% assumed Global Tax [1/1/15-31/12/15] Tax : Rs.18,000. (Less) Tax credit : ( Rs.12,910) of India Tax (*) Net Tax payable : Rs.5,090 Ultimate Tax Outflow : Rs (*) subject to tax treaty provision and domestic tax law provision. ESOP taxation controversies Employees on Deputation Divergence in tax treatment There is considerably divergent laws in different parts of world with regard to ESOP taxation. One needs to respect such diversity while designing a ESOP plan for employees across the globe. Globally, either of following two types scenarios is envisaged while arriving at proportionate perquisite allocation: a) ESOP granted in country A and exercised in country B : Perquisite is apportioned on the basis of the no of days service rendered in respective countries during the period of grant and vesting and taxed accordingly. b) ESOP granted in country A and exercised in country B : Perquisite is apportioned on the basis of the no of days service rendered in respective countries during the period of grant and vesting. However, country B does not tax its portion on premise that ESOP is not granted in contemplation of duties in country B if sufficient time has elapsed between the date of departure from country A and date of exercise in country B. Page 2 of 5

3 While USA follows the scenario (a), countries like UK follows scenario (b). Inconsistent Tax Principles : OECD provides for the above allocation principles and Sec.9(1)(ii) of Indian Income Tax supports this. However, there has been divergent judgments by Indian judiciary authorities on this allocation principles. Delhi has clearly laid down the principles of proportionate taxing rights in case of ACIT v. Robert Arthur Keltz, ITA No.3452/ Del/ 2011 dated 24 May 2013.In this case employee of an USA registered company was on deputation to India to Indian liaison office of such company in The employees was granted stock option in 2004 which got vested in This option was exercised by the employee in 2007.AO taxed the entire perquisite value of stock option pertaining to year 2004 to However, CIT(A) held that only the portion attributable to the service in India should be taxable in India accordingly the perquisite attributable to the period 2006 to 2007 only is held to be taxable in India. However, in a similar circumstances, Hyderabad in case of Makrand Garde vs ACIT Circle 12(1) held that parent company in USA issuing ESOPs to its employees subsequently deputed to the Indian subsidiary will trigger tax liability on entire perquisite value in India including USA service portion. This is on the ground that USA parent had obtained an AAR ruling on this subject which stated that parent company issued shares to the employees of the subsidiary since it treated the business of subsidiary and of parent as one and hence ESOPs are granted in contemplation of duties in India. Double Taxation. In a situation where an employee of an Indian parent exercises shares while in India, pays perquisites tax in India on the difference between Fair Market value and option price. Subsequently, the employee gets deputed to the subsidiary abroad and then sells such shares while serving abroad in the subsidiary. The employee would have become a tax resident in the foreign company in the year of sale of share and is liable to offer tax on the global income including capital gain on sale of shares. While calculating such capital gain, ideally the FMV should be adopted as cost of shares. However, foreign states normally recognize option price paid as cost and not FMV due to the fact that perquisite tax is remitted in India. Foreign tax authorities need to be convinced about the FMV as appropriate cost for calculating capital gain. Otherwise employee would end up paying tax twice on the portion of difference between FMV and option price paid. Cash Flow. Sometimes employee of parent company goes on deputation to the foreign subsidiary. Upon allotment of the shares, employee pays perquisite tax partly in India and partly abroad depending on the number of days service rendered in respective countries. But in this case, liability arises while the employee is abroad. He faces substantial challenge for remitting Indian tax liability in INR to the parent company since he would ceased to get INR salary and also would have closed his bank account in India. It is advisable to plan for such event and have sufficient money at disposal in India to meet tax liability when one works abroad. Tax Equalisation. A deputed employee from an Indian parent to a foreign subsidiary is liable to pay tax partly in India and partly abroad if he has rendered service to parent as well as to subsidiary during period of grant and period of vesting. Assume Indian tax rate applicable to the employee is 30% and applicable foreign tax rate is 36%. If the employee is a tax resident of the foreign subsidiary in the year of exercise, then he has to pay 36% on the global income and take tax credit of India 30%. In other words, his entire income including India portion is 36%. Employers need to take this aspect into consideration to ensure employee does not lose out anything on account of higher tax. Timing of exercise. Timing of exercise hold key in terms of determining the perquisite value and also the period of tax recovery. Indian employees are in a more advantageous position since the tax withholding by the employer in India staggers over the remaining months in a financial year starting from month of exercise till year end. In countries like UK, employers are mandated to recover the withholding tax from the employee within 90 days of exercise of the product. ESOP taxation controversies Deductibility as business expenditure ESOP cost i.e. FMV minus grant price amortised over period of life of ESOP grant to vesting is recorded as ESOP cost in the Page 3 of 5

4 books of accounts. Deductibility of this amount has been subject to perennial litigation between tax payer and the tax department. Judgment /Adv Citation Court Judgment SSI Ltd vs DCIT Ranbaxy Laboratories Limited Adv 85 TTJ Dt.03/12/2004 ITA No 1855 & Dt.12/06/2009 Chennai Delhi ESOP granted in pursuance to SEBI approved scheme and hence the liability is ascertained one and should be allowed as a cost incurred towards employee retention. ESOP cost is notional in nature in absence of pay out by company and hence not allowable. Accenture India Pvt Ltd vs DCIT. VIP Industries Ltd CIT III vs PVP Venture Limited Spray Engg Devices Ltd vs Addl IT Adv ITA Mumbai No.4540/M/08. (2010) 2010-TIOL- 654(2010) Mumbai In this case, parent company s shares were granted to employees of subsidiary company and subsidiary claimed ESOP cost as business expenditure, held that ESOP cost is incurred towards employee retention and hence allowable Same verdict as in case of Ranbaxy ESOP granted as per SEBI guidelines to induce employees to work in TCA No 1023 Dt-19/06/2012 Madras HC interest of organization Hence as ascertained liability and allowable in nature ITA No-701 Dt-22/06/2012 Chandigarh Allowed in favour of appellant as an ascertained liability Above controversies have arisen only due to the fact there has been no specific guidance or provision in Indian Income Tax Act to allow ESOP cost as business expenditure. In USA, this cost is allowed in the tax computation of the assessee as soon as the employee has paid perquisite tax. Such a provision would have helped to avoid all these litigations. Tax department argument has always been on a single front that ESOP cost is an unascertained liability, a notional cost and hence not allowable. Assessee has been arguing that the liability is an ascertained one,since it has been accounted as per SEBI guidelines and also the expenditure is incurred towards retention of employees of the company. Lets examine this issue holistically and come to a conclusion: It is a fact that employer does not incur any cash cost for ESOP. By issuing ESOP, the value of existing shareholders goes down due to issue of additional shares. But undoubtedly, this cost accounted by the company is towards retention of the employees. ESOP cost so accounted by the company cannot be treated as unascertained one since ESOP cost is accounted in a systematic manner taking into consideration the amortised portion of difference between FMV and option price as per SEBI guidelines. ESOP Cost is not covered under purview of Sec.43B of Indian Income Tax Act, so it would be far fetched to argue that expenditure should be disallowed only cash is not paid. If one analyses the ground of the tax department that ESOP cost is a notional or unascertained,it appears to be incohesive since the same stand is not taken for MAT purpose at any point of time. It is an accepted fact employee pays the tax on the difference between FMV and option price. It is the same cost which gets stands scrutiny by tax department for its allowability time and again. Since this part of transaction has already suffered tax once, this should be allowed as deduction in the books of the company. Considering the increased number of companies issuing ESOPs to employees across the globe and also the taxes are paid Page 4 of 5

5 the employees on the perquisite value, a favorable amendment in Income Tax legislation clarifying the position,would be welcome by one and all. The views expressed are personal The deepest principle of human nature is the craving to be appreciated. Quote by James Williams. Page 5 of 5