Archive for March, 2007

I must request you, sir, to relook at your proposal for Fringe Benefit Tax (FBT) on Employee Stock Options (ESOPs).

I have watched you mention, in a number of television interviews, that no one has yet asserted that ESOPs are NOT a fringe benefit. Perhaps the interviewers have missed this, but I would like to say this: ESOPs are a benefit, but they are NOT a fringe benefit.

Not that you need to be reminded, but let me ask you, sir, to look back at the time you introduced FBT. The idea was to tax the company as a whole, what you could not attribute to individual employees; that employees benefited from certain expenses like employee welfare expenditure, conference travel, telephone reimbursements, gifts etc. - and such expenses could NOT be attributed to individual employees (or it was too cumbersome to split the official expense from the personal one). You therefore said that a flat tax would apply to a percentage of such expenses assuming that the personal benefit was that fraction of the expense.

Yet, the underlying theme was that you could not attribute these expenses to the employee directly, and therefore could not tax the employee on this benefit. Unlike, I presume, monies paid directly to the employee such as salary, bonus etc. which are taxed in the hands of the employee since it is well known that the employee has received this amount as a benefit.

Now let me ask you sir, to look at employee stock options. Are they a benefit? Yes, if the stock price of the company is higher than the price the option is offered at.

But are ESOPS a "fringe" benefit? No, sir, they are not. There is no "official" and "personal" benefit differences in this regard, and the employee is fully and completely benefited from the gain in price. The gain can be fully attributed to the employee and there is no confusion about whether the ESOP is partly an official benefit and partly personal. If you want to tax this benefit, sir, you must tax it in the employee's hands, not in the company's.

The employee currently pays no tax (if STT has been paid) and a lower capital gains tax if STT has not. But that is on a capital investment - ESOPs are not capital investments, they are options! Only when exercised are they an investment (i.e. money is paid to purchase).

Therefore if we only apply capital gains tax to the difference in the exercise price and the market price at sale, and instead taxed in the employee's hands the difference between the grant price and that at exercise, it would be more equitable.

Sir, there is another reason I ask you not to tax companies this tax. Imagine that an entrepreneur starts a company today and grants all his employees stock options. In a few years, this company goes public; but the options are not exercised (or not even vested yet). Let us say the stock market likes this company and the share prices double, triple or even quadruple.

At this point sir, please do look at how the company must report its results. At every increase in stock price (which as you know, companies have little control over, and do not benefit from, once listed) there needs to be a provision made for the potential gains their employees will make through their stock options, and the FBT thereof! A company's stock may increase in price for reasons uncontrollable by the company, and the company does not benefit at all from such a price rise; yet, your new tax now penalises a company for this rise (through the FBT provision). Which means sir, that companies do not benefit from a rise, but have to pay tax on it.

Who does benefit? The employee. Why then should the company be bothered with this benefit? When the employee exercises the option, the company ensures that the taxes are paid - should that not be all the company is required to do?

Now should the pay tax on this gain? That is a matter of conjecture as you reward other people for long term capital gains - but if you feel that the "option" is not really a long term investment, please tax the difference between the option grant price and that at the time of exercise. But please do so in the employee's hands, not in the company's.

I understand that the laws have not been framed yet, but please consider my argument as a humble citizen before you do frame them. Please help our small entrepreneurs by allowing them to issue stock in lieu of salaries, and let this benefit be taxed in exactly the same way you tax salaries.

Yours sincerely,
Deepak Shenoy

Neutral: MAT applies
Minimum alternate tax of 11.33% will now be applicable to all tech companies. That is a minimum tax, which is not actual tax but can be set off against tax paid in later years (can carry it forward upto seven years). In 2009 the exemption given to STPI companies will go away and all tech companies will be absorbed into the tax bracket. MAT is a precursor to that.

While this may not impact companies much - expected margin hit is about 4% in reality - it will be a precursor of things to come. Eventually these companies have to live with paying a lot more tax. One view is that they have the pricing potential to increase rates, but we'll have to wait and see. Infy has said 1.5% of their margins will be hit, and that might impact the stock prices as well (and already has)

Negative: service tax on rent
Commercial rents are now going to be higher, with 12.36% service tax extra. The hit on companies will be less than 1% of margins, most likely, for the big tech companies. The smaller tech and BPO companies perhaps pay a greater percentage of their costs as rent or lease payments, and this will have a greater impact for them.

Negative: DDT is up
DDT is now 20% for mutual funds and 25% for liquid funds (for corporates). A number of tech companies used to place extra cash with liquid funds but with the new taxation some of the other income will reduce.

Let me use the Finance minister's examples. If you have an income of:
1) 110,000 to 150,000: Earlier tax was 5,100, now is 4,120 (save 980)
2) 150,000 to 250,000: Earlier tax was 25,500, now is 24,720 (save 780)
3) 250,000 to 500,000: Earlier tax was 102,000 now is 101970 (save 30)
4) 10,00,000: Earlier tax was 280,500, now is 282,117 (pay more 1617)

So it's not such a big deal actually; just balances things out. But the cess increase will affect everything else in our lives, from toothpaste to motor cars.

Negative: Increased dividend distribution tax
DDT is now 15% (from 12%) and specifically for money market and liquid funds, 25%. The former will not be huge - if dividends were taxed in your hands, you would end up paying a lot more for them. Liquid and money market funds are higher, because they were giving dividends paying DDT, which was 12% but fixed deposit returns, which are just as secure, will be taxed at your marginal rate (usually 20%, more likely 30%) - the arbitrage was too much. Now @ 25%, this difference has been evened out. Even so, it takes away one big option for investing.

Dividends from companies is going to reduce a little bit with this additional tax. With typical dividend yields being 2-3% you will not probably notice the difference.

Positive: Exemption from Service Tax upto 8 lakhs per year.
If you are a small service provider you may have had to pay service tax on your income last year, if your income was above Rs. 400,000. Now that limit has been doubled, to Rs. 800,000. This is good for micro businesses and for consultants - consulting income needs service tax paid, but if the income is less than Rs. 800,000 a year you can avoid having to pay it.

Negative: Portfolio Management Services by individuals taxed
Some high networth inviduals would hire portfolio managers to manage their money. Such managers were uptil now exempt from service tax, and could pocket their fees in full. Now such services need service tax paid, which means a lower return for the investors.

Positive: No tax surcharge for companies less than 1 cr. in turnover.
If you own a small business and are profitable, you would pay 33.66% of your profits as tax. The new bill reduces that to 30.9%, if your turnover is less than a crore.

Negative: ESOPs have FBT
Employee Stock Options will now be considered a fringe benefit and taxed to the company on exercise. For the employee this means potentially 6% of the gains may have to be given back to the company to offset the fringe benefit tax paid. Regulation is not yet clear on this, but this is a sure negative for employees with ESOPs.

Negative: Art is now under capital gains
If you were an investor in art, till now you could have sold art and have the tax department consider it "personal assets" which did not attract tax. From 2007-08, you will pay capital gains tax on gains made. But art will have only long term capital gains beyond 3 years of holding, and if you are an art investor, 3 years is way too short to make any serious gains anyways, so this is barely a negative practically speaking.

Minor Negative: Hike in Cess
Education cess is up to 3% from 2%. While this sounds like a 1% increase, the actual effect of this increase is going to be a lot lesser because cess is a tax on tax. That means income tax goes up to 33.99% from 33.66% (a change of 0.33%) and service tax goes up to 12.36% from 12.24% (increase of 0.12%). But the fact is that the education cess is going to help this very industry by bringing more educated employable people in about 10 years from now. If you don't want to wait that long, this stays a minor negative.

Negative: Commercial rents to attract service tax
Renting commercial space is now going to cost 12.36% more. This is a negative for most industry; nearly everyone rents space. This will affect IT and BPO companies a lot more since most of their large offices are rented; and most service companies too - like Banks, telecom companies and retail.

The impact will depend on what parts of costs are taken by rents. For tech companies, which are typically people intensive, a company uses up about 80-100 sq. ft. per person - for rented space, each sq. ft. would cost around Rs. 40 per sq. ft. per month. That means the rent per person would be about Rs. 4000 per month, which translates now to a cost of about Rs. 450 per month per person. For 1000 people, that's about 54 lakhs a year that will hit the bottom line.

Example: Going from Infy's annual report, the lease cost for 2008 is about 38 cr., which will translate to a service tax of Rs. 4.7 cr. Wipro's 84 cr lease spend translates to a 10 cr. liability. That is less than 1% of their profits, so it doesn't look too bad!

Positive: Customs duties cut
All customs duties for non-agri products are down to 10% from 12% peak. This is moving to ASEAN levels of 6%. This is good for industry that imports raw material, like CD manufacturers, chemical companies etc.

Most of the other impacts are sector specific and I will talk about them in individual posts.