This is an overview of some of the legal and strategic issues related to a U.S. parent company granting stock options to employees of its Indian subsidiary, including consideration of exchange controls, securities laws and tax burdens.
Before implementing a compensation scheme, a company must evaluate its likely effectiveness in incentivizing and retaining employees. Options, to the extent they inspire loyalty and commitment and provide employees with a sense of ownership, are an important compensation tool. Indian employees in the information technology and biotechnology sectors generally are familiar with this type of compensation and at least higher level employees view options favorably. Lower level employees may prefer cash.
securities law considerations
India’s securities laws do not impose any restrictions on the grant to employees in India of stock options by a U.S. company. Companies may offer stock options to employees of a subsidiary in India either directly or indirectly. U.S. securities laws will not be an issue so long as the options are granted under a plan which is either in compliance with Rule 701 of the U.S. Securities and Exchange Commission (“SEC”) and applicable state law or has been registered with the SEC on a Form S-8 registration statement.
currency control considerations
India’s currency exchange controls applicable to option exercises by employees have been liberalized. There is presently no limit on the amount that employees or directors are allowed to remit for this purpose so long as the U.S. company owns at least 51% of the India subsidiary and any proceeds from a sale of the shares is repatriated to an account in India. A purchase of U.S. company shares by persons other than employees or directors of the India subsidiary, under an equity incentive plan or otherwise, remains subject to monetary limits (presently $50,000 per year per Indian resident) under India’s foreign exchange control regulations.
Effective with the publication on April 5, 2006 of RBI/2005- 06/253, the Reserve Bank of India (“RBI”) allows authorized foreign exchange dealers to handle remittances abroad for acquiring shares under stock option plans, provided the dealer verifies: (i) the foreign issuer owns at least 51% of the India subsidiary that employs the employees exercising the stock options; (ii) the shares are being offered by the foreign issuer globally on a uniform basis (which we understand to mean that the stock option program in India should not have terms that are different from the terms generally applicable to employees elsewhere in the world) and (iii) the India subsidiary files an annual return with the RBI disclosing the remittances and the beneficiaries that is submitted to the RBI through an “Authorised Dealer” bank). The requirements for global uniformity and for filing of annual returns apply to all employers in India.
The RBI has also granted general permission to foreign companies to repurchase shares issued to their employees in India under a stock option plan. Previously, such a repurchase required advance approval from the RBI. Now such approval is unnecessary if the following requirements are met: (i) issuance of the shares was in accordance with the exemptions above, (ii) the terms of the repurchase were specified in the initial option agreement (and have not been amended since); and (iii) the India subsidiary is current in filing its annual returns with the RBI providing details of remittances/beneficiaries/etc.
The general authorization for repurchase of shares appears to be in addition to the existing general permission to the optionees to sell their shares after exercise. A voluntary sale by the employee (unlike an involuntary repurchase compelled by the employer in compliance with the above requirements) is subject to the condition that the sale-proceeds are immediately remitted to an account with an “Authorised Dealer” bank in India (in any case not later than 90 days from the date of such sale).
Like the United Kingdom, employees in India generally have a written employment agreement. If the employment agreement expressly states that the grant of equity compensation is entirely within the employer’s discretion, or makes no mention of equity compensation being part of the employee’s pay, then it is unlikely that an employee can claim any special or ongoing entitlement to additional equity compensation although there is no harm in expressly stating this in the stock option agreement.
Data privacy is a concern around the world now, no less in India than in the U.S., so it is advisable to obtain the employee’s consent to sharing personal information with persons outside India as part of the administration of the stock option program. India’s close legal history with the United Kingdom suggest it may eventually follow the European Union’s privacy practices to an even greater degree. tax consequences
As of April 1, 2007, when India’s 2007-2008 government budget took effect, the exercise of a stock option by an employee in India is no longer subject to income tax on the difference between the price paid for the shares and the fair market value of those shares on the date of exercise. Instead, the employer will pay a flat fringe benefits tax (“FBT”) of 33.99% on the difference between the price paid for the shares and the fair market value of those shares on the date of exercise.
Previously, the imposition of the employee’s liability for income tax on a stock option exercise could have been deferred to the date of sale of the shares, if the plan complied with certain tax guidelines and had been registered with India’s Chief Commissioner–Income Tax of the state where the subsidiary is incorporated. The benefit from options granted under these plans is now mooted as income tax is no longer imposed on the employee upon exercise. At the time the employee sells the shares the employee is subject to income tax on the difference between the amount realized from the sale and the fair market value of those shares on the date of exercise (rules for how fair market value on the date of exercise is to be determined are still being developed).
Fringe Benefits Tax
As noted above, as of April 1, 2007, the exercise of a stock option by an employee in India subjects the employer to FBT of 33.99% on the difference between the price paid for the shares and the fair market value of those shares on the date of exercise. FBT applies to any exercise of a compensatory stock option by an employee that occurs after March 31, 2007, regardless of when the option was granted. The Indian tax authorities have announced their view that employers based outside India, even those with no permanent establishment in India, are nonetheless liable for payment of the FBT.
Since the application of FBT to stock options has been extended on such short notice, employers across India are still evaluating how to manage the additional impact on their bottom lines. An initial response is to provide in the stock option agreement that the employer can withhold from the employee’s exercise a number of shares equal to the FBT or the required amount of cash from the employee’s pay.
This is similar to what is done by employers in the United Kingdom with respect to a UK health insurance tax imposed on employers when a stock option is exercised. This would be a prospective approach only, as currently outstanding stock options could not have this burden imposed without obtaining the optionholder’s consent. However, recovery of FBT from the employee is taxable income to the employer at a rate of 33.99%. Thus, for the employer to be indifferent to the imposition of FBT under this approach would require the employee to reimburse the employer for this tax (and the tax on this additional reimbursement and so on). It becomes apparent that this approach represents a significant diminishing return to the employee and is something of a mathematical headache for the employer.
Therefore, the employer either will:
- Limit recovery of FBT from the employee to the amount of the original FBT, or
- Absorb the FBT as a cost of doing business (possibly by limiting the value of any option exercise in a given year in proportion to the amount of FBT the employer will face as a result), or
- Cease granting stock options to employees in India.
Another approach that employers can use to mimic the effect of stock options is an award of cash-settled stock appreciation rights, as the payment is taxable income to the employee rather than subject to FBT paid by the employer. However, U.S. accounting rules will treat these awards as liabilities rather than equity. It has been suggested by some, that it might be possible for the employer to avoid the FBT by classifying as a cash bonus by permitting option exercises to only occur through a “sell-all” program (whereby employees of publicly-traded companies instruct a stockbroker, retained by the issuing company, to sell a number of shares subject to the option into the market and use the sale proceeds to fund the exercise of the option with the remaining cash then delivered to the employee so the employee never has more than fleeting physical control of shares). However, we are informed that the Indian tax authorities view such an approach as subject to FBT.
Overall, India presents a welcome climate for investment, but the fact that this law applies to stock options granted prior to its taking effect will give many investors pause, as it signals the willingness of the Indian government to unexpectedly shift a tax liability to the employer, who provided the stock option to the employee at a time when the employer thought the tax burden was borne by the employee who stood to reap the taxable benefit.
Nonetheless, some employers may still believe it worthwhile to implement an equity-based compensation program in India, perhaps using restricted stock awards or limiting stock option exercises in such a way as to avoid more than a predictable amount of FBT in any given year (a potentially complicated exercise), in order to attract and retain employees. Such employers therefore, should consult with a chartered accountant or attorney in India to evaluate the best approach under the circumstances and with the knowledge that those circumstances may be subject to unexpected change.