From ESOPs to GSOPs

You must have heard of sweat equity or ESOPs (employees stock options plans). Infotech companies use these to pay employees in kind, in the form of options to buy company shares at a very low price. These are typically phased over several years with a lock-in period to induce employees to stay on in the company. Since infotech share values can rise a thousand-fold, they represent huge potential gains for employees, who are leaving secure, salaried jobs in droves to rush into an area where four-fifths of all new ventures are likely to fail.

The FM, facing a big fiscal deficit, is taxing ESOPs as perquisites. After all, stock options represent payment in kind, no less than the use of a company house or car. But the infotech industry is up in arms complaining of unfair taxation that can strangle India’s fastest- growing industry.

The solution, I think, is to have GSOPs–government stock options plans. Whenever employees get stock options, 20 per cent of these should be allotted to the government on identical terms. This will represent a flat 20 per cent tax. Since the maximum income-tax rate is 34.5 per cent, this is by no means a high rate of taxation. It will eliminate all sorts of hassles and wrangles, and bring in plenty of revenue too.

The infotech industry and various chambers of commerce say it is unfair to tax ESOPs when they are exercised, and that these should be taxed only when the employee sells his shares and realises the profit.

They give at least three reasons for this. First, the cash benefit to the employee comes only when he sells his shares. Second, the perquisite value of stock options can be very high, so employees often do not have the cash to pay the tax demanded, and will be forced to sell their options. For this reason some employees prefer to defer taking up stock options, for want of cash to pay taxes.

The third objection is that you often cannot put a fair value on stock options. If the market price of a share is Rs 1,000 and the employee gets it for Rs 100, it may seem that he has obtained a perquisite of Rs 900. But often there is a lock-in period during which he cannot sell. This reduces the value of his stock options, and there can be interminable wrangles on how much the reduction should be. Besides, many promising companies will ultimately fail. If so, employees would have paid a huge tax when they got stock options, yet may end up with zero wealth.

Moreover, many ESOPs are given by companies which are not listed on stock exchanges and have no transparent market price. It is difficult to place a fair taxable value on these ESOPs.

The FM has, rightly, rejected the first argument. Any ordinary tax- payer first pays tax on his income, uses the balance to buy shares, and then pays a capital gains tax when he sells the shares at a profit later. The infotech industry wants a system where their employees are taxed only capital gains, not on income. The fact that they get payment in kind is no reason for them to escape I-T.

The second and third objections of the infotech industry have more weight. Employees may often lack the cash to pay tax dues. And major disputes can arise about the valuation of ESOPs, especially for unlisted companies.

I think there is a simple way out. We just have to revert to the tax system used by kings in past centuries. Peasants were supposed to pay a tax, but there were problems in putting a cash value on their produce, as most produce was self-consumed and little was marketed. So the king collected the tax itself in kind. Instead of trying to assess peasant income, he assessed production of grain, and took a fixed share of the grain itself as tax. The problem of valuing income- in-kind was solved by having tax-in-kind.

The same principle can be used for ESOPs. If 20 per cent of all ESOPs are handed over to the government as tax, there are no problems of valuation. If a company fails, the value of GSOPs will also be zero, so the employee in question will not have paid tax on worthless shares. If the shares zoom in price, the government will share in the joy. GSOPs will create a way for the government to get a share of wealth creation on stock markets as well as income generation.

A GSOP should subject the government to same terms and lock-in period as any employee. That will provide a level field. Companies should not have to worry about the government becoming a substantial shareholder. And the FM himself needs cash to cut the fiscal deficit, not paper assets. So the government should be obliged to sell its shares/stock options within three months of the end of any lock-in period by public auction.

Skeptics will complain of possible rigging and leakages in public auctions. Maybe so. But surely the leakages will be far less than in the ordinary I-T system.

Employees of infotech companies, who view ESOPs as the pot of gold at the end of the rainbow, may think 20 per cent of this is being stolen. Venture capitalists will worry that such a tax will kill the goose that lays the golden eggs.

We probably need a public debate on this. I welcome other views. But it seems to me that a 20 per cent GSOP represents a lower level of taxation than the current system, where ESOPs are taxed in full as perquisites. Far from killing the goose, it may induce the laying of more golden eggs.

What do you think?