Monday, March 12, 2007

The ESOP workaround

For entrepreneurs this budget - Budget 2007 - has one dissapointing element. Employee Stock Option Plans (ESOPs) are now classified as a Fringe Benefit, and one needs to pay Fringe Benefit Tax (FBT) on them. In essense, this means 33.99% of the difference between the price at exercise and price of grant is borne by the company.

A startup usually offers part compensation in stock, and the grant price will be abysmally low, like Rs. 10 or so. The employee can't buy stock at grant, because the options will vest over a few years. Even at vesting, the employee needn't buy stock - indeed, buying it will be of no use when the company is not public. And if the company goes public or gets sold, the company has to pay a ton of money as FBT for the options exercised.

Even if an option is exercised before the company goes public, the Income tax department will value the shares at the time of exercise (based on a valuation method that involves net worth per share) and tax the company on the difference.

Now a company may choose to recover this tax from the employee. I don't know how, though - what will the accounting entry say? "Received money to pay FBT"? Will that not classify as "other income" and get taxed in the company's hands? But that's a petty problem which I'm sure smart accountants will solve using fantastic words and phrases that will light up the room with their very presence. I'm not too worried about that.

What I'm worried about is that the government takes away a chunk of your employees' profits when it comes to a liquidity event (IPO or sale). I think I have a workaround to this, though I'm not yet sure it's totally fool proof.

If you're starting a company, start a "trust" which will hold shares that you have allocated for ESOPs. This trust is a separate entity (you could even have a different "not for profit" company) unrelated to the company, and will own the pool of shares you have set aside for employees. Ensure that the company does not own the trust - though promoters may do so.

Run your ESOPs the usual way, X shares every month for N months etc. But if the employee wishes to exercise, have the trust sell her the shares instead of issuing fresh stock (which is what happens with stock options).

The difference here is that the company is not involved - there is a third party transaction that transfers stock from the trust to the employee. If the "market value" of the share is much higher than the value it has been sold at, the trust takes the loss. The trust is a not-for-profit entity anyhow, and does not have a tax liability, so the loss is neutral for the income tax department.

The Income tax department may of course take a different view and disallow the loss. It could term the transaction a "deemed profit" for the employee and add it to the income of the employee. The idea here being that the trust intentionally sold the shares at a loss so that the employee must profit. But this can be fought in court, if you have an agreement between the employee and the trust on an earlier date that fixes the price of the share for later purchase. Such "call" options are common and legal, and in fact the very basis for convertible debentures.

Problem: If you get Venture capital and they want you to augment the number of shares given as ESOPs, you will need to issue more shares to the trust. Obviously this is going to be at a lower price than the VC price, which means the tax department will say it's a "deemed profit". That phrase again. But if the trust is created as a non-profit, you can avoid tax liability on such deemed profits too.

But such an arrangement will have to be stopped after the company goes public. Obviously, ESOP grants can't be transferred to a trust at a lower price after a company is subject to pricing laws when it is public. But as a public company, it may simply be better to use RSUs (Restricted Stock Units) instead.

What do you think?

4 comments:

Just Mohit said...

Hmmm...Looks like you gave quite a bit of thought to this one! This just might work. Will apply my accountant brain to it, and respond later.

Arun said...

Hi Deepak

If this is a viable loophole, the logical next step would be to see if this workaround is something that can be ***Standardised***. If not, then there are problems -
1) Explaining a complicated concept like this to potential employees who will be scared away and may not believe you
2) Founders need to spend time and money understanding and setting up these financial vehicles
3) This could becomes a money spinner only for the accountants and lawyers who might create complex and unique cases for each company
4) Major discouragement factor against the concept of starting up

If it can indeed be standardised (and also approved by the tax pple), then kudos. You might want to explore more and actually start a company to provide these services.

The best standardisation, that I would think, of some very complex legal issue is along the lines of MBS securitisation using trusts. SO much so that many of these mortgage firms were veritable sausage factories in the US housing boom :))

Anonymous said...

From the May 4th announcement, it seems like the FBT is applicable only to the difference between FMV (at _time_of_grant) and the exercise price (which is set at time of grant). If options are priced at fair market value at time of grant, then FBT will be zero. Am I wrong?

I found 2 sources that interpret it that way, and one (the hindu) that says it is at time of vesting (which would mean you need to calculate fmv every month. yikes!)

SOURCES
http://inhome.rediff.com/money/2007/may/04cement.htm
Providing marginal relief to companies issuing employee stock options, the finance minister also said that the fringe benefit tax on ESOPs would be calculated on their value at the time of issue of the option and not at the time of exercise of the option, as proposed in the Budget.

http://www.business-standard.com/common/storypage.php?autono=283397&leftnm=3&subLeft=0&chkFlg
proposal to impose fringe benefit tax on ESOPs would be based on the fair market value at the time of issuing the option and not at the time of allotment or exercise of the option as proposed in the Budget.

http://www.hindu.com/thehindu/holnus/006200705042048.htm
That FBT will now be payable by the employer company on the difference between the FMV on the date the option vests in the employees as reduced by the exercise price. Earlier, the value to be considered was on the date of exercise, which is a date subsequent to vesting. Therefore, the FBT blow may be reduced to some extent, especially in start up companies, as the value on the date of vesting would be lower than the date of exercise.

http://www.hindu.com/thehindu/holnus/006200705042048.htm
That FBT will now be payable by the employer company on the difference between the FMV on the date the option vests in the employees as reduced by the exercise price. Earlier, the value to be considered was on the date of exercise, which is a date subsequent to vesting. Therefore, the FBT blow may be reduced to some extent, especially in start up companies, as the value on the date of vesting would be lower than the date of exercise.

Deepak Shenoy said...

anon: The FM said, "The fair market value of the ESOP for taxation will be reckoned on the date of vesting the option and not the date of allotment or transfer of the shares.".

That pretty much means vesting time, not at the time of grant. Grant when you sign up for the ESOP, when you are not necessarily vested. vesting time is when the shares are available for you to buy.

The FM has said "The liability to tax will be attracted on the date of allotment or transfer of the shares and the period of holding of the ESOP will also be reckoned from the date of such allotment or transfer,". In this context "allotment" means when you vest and can purchase the shares.

TEchnically this is the "yikes" part of your comment - FMV needs to be calculated at all vesting dates. If a private company has a monthly vesting policy, it has to value shares every month. Yikes all right...