ESOPs and leave encashment

T. Banusekar

This week, `Tax Talk' looks at the various aspects of employee stock options and taxation of leave encashment.

Query

My son is an NRI working in the US for an Indian company. The company's shares are listed in a stock exchange in India. The company offered him shares by way of employees stock option plan (ESOP). The offer was made at a price of Rs. 255 per share, while the market price on that day was Rs. 580. My son paid $5.90 per share, the equivalent of Rs. 255. For the total number of shares that was allotted by way of ESOP, my son paid a tax of $1118.11, the rupee equivalent of Rs. 48,336, as on that day.

This tax was levied on the basis of the difference between the market price and offer price of these shares. My son has now sold the shares in India, which has resulted in a

short-term capital gain. I am aware that short-term capital gain attracts tax at the normal rates. However, to calculate the tax due on capital gains I have two opinions.

Opinion 1: Tax paid in the US is to be added to the cost of acquisition, arriving at the short-term capital gain (see table).

Opinion 2: Tax paid in the US is not added to the cost of acquisition to arrive at capital gain. However, the tax paid in the US can be set off against the tax from short-term capital gain (see table). These opinions are illustrated in an example in the table. Kindly clarify which is the correct opinion.

Sankaranarayanan

Chennai

Reply

The gain from the transfer of shares or debentures of an Indian company initially acquired in convertible foreign exchange, shall be determined by converting and reconverting the cost of acquisition, expenses incurred wholly and exclusively, in connection with the transfer and the full value of consideration into the same foreign currency in which the asset was first acquired. This conversion and re-conversion is to be done in the following manner:

Cost of acquisition shall be converted at the average of the telegraphic transfer (T.T.) selling rate and buying rate as on the date of acquisition.

Expenses incurred wholly and exclusively in connection with the transfer and the sale consideration shall be converted at the average of the T.T. selling and buying rate, as on the date of transfer.

The capital gains so derived in foreign currency, by reducing from the sale consideration, the cost of acquisition and expenses, which are in foreign currency, shall be reconverted at the T.T. buying rate, as on the date of transfer.

This mode will be applicable only if the assessee is a non-resident in accordance with the Income Tax Act. It may also be remembered that the benefit of indexation will not be available, even in the case of a long-term capital asset. The reader seems fundamentally flawed in the manner of computation of the gain, irrespective of the option. As the requisite information is not available, it is not possible to compute the actual gain.

The reader may however compute the gain in the manner stated above. The next issue, which needs to be considered is whether the tax paid in the US can be added to the acquisition cost. There seems to be no merit in this contention. If this was possible, then tax paid in India on ESOPs could be added to the cost of acquisition. Therefore, this option needs to be rejected.

The second opinion also is not correct. The computation has to be done by reducing the fair market value as on the date of exercise of option, that is, Rs. 580, [refer section 49(2B)] from the sale consideration and not the offer price of Rs. 255. The question of reducing the tax paid in the US from the gain so arrived also does not arise.

This can be done only if the income is doubly taxed. One may refer to Article 25 of Double Taxation Avoidance Agreement between India and the US. It may also be mentioned here that expenses incurred wholly and exclusively for the purpose of transfer alone can be reduced in computing the gain and not expenses such as account opening charges.

It is presumed in answering this query that the assessee is a non-resident in accordance with the Income Tax Act.

Query

It is learnt there is a Supreme Court ruling that leave encashment is not to be treated as taxable income, but as capital receipts which are not to be considered as taxable. Kindly clarify.

C. Jacob

Kottarakara, Kerala

Reply

The Supreme Court, in Karamchari Union v UOI (2000) 243 ITR 143, clearly lays down that the term income under section 2(24) alone governs the taxability of the receipt of any amount or allowance. In this decision, the apex Court has also referred to section 17 which includes perquisites and profits in lieu of salary, and has held that any payment received by an employee by way of leave encashment will also fall within the scope of this section.

Unless such payment is specifically exempt under section 10, the same has to be taxable. There is no exemption of the leave encashment received while in service. However, at end of service, superannuation or otherwise, an exemption is available under Section 10(10AA) subject to certain limits. Thus, the entire leave encashment received while in service is taxable and the excess over the quantum exempt under Section 10(10AA) is taxable, in respect of leave encashment on quitting, on superannuation or otherwise.

(The author is a Chennai-based practising chartered accountant.)

Business Line invites queries on personal taxation issues to this column. They will be answered in the first Sunday's issue of Business Line every month. Queries may be addressed to Tax Talk, Business Line, Kasturi Buildings, 859, Anna Salai, Chennai 600 002, or by e-mail to rags@thehindu.co.in