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  • 1. 2007 Update on Granting Stock Options in India by fred m. greguras, s.r. gopalan and tahir j. naim This is an overview of some of the legal and strategic issues Effective with the publication on April 5, 2006 of RBI/2005- related to a U.S. parent company granting stock options to 06/253, the Reserve Bank of India (“RBI”) allows authorized employees of its Indian subsidiary, including consideration of foreign exchange dealers to handle remittances abroad for exchange controls, securities laws and tax burdens. acquiring shares under stock option plans, provided the dealer verifies: (i) the foreign issuer owns at least 51% of the strategy India subsidiary that employs the employees exercising the stock options; (ii) the shares are being offered by the foreign Before implementing a compensation scheme, a company issuer globally on a uniform basis (which we understand to must evaluate its likely effectiveness in incentivizing and mean that the stock option program in India should not have retaining employees. Options, to the extent they inspire terms that are different from the terms generally applicable loyalty and commitment and provide employees with a sense to employees elsewhere in the world) and (iii) the India of ownership, are an important compensation tool. Indian subsidiary files an annual return with the RBI disclosing the employees in the information technology and biotechnology remittances and the beneficiaries that is submitted to the RBI sectors generally are familiar with this type of compensation through an “Authorised Dealer” bank). The requirements for and at least higher level employees view options favorably. global uniformity and for filing of annual returns apply to all Lower level employees may prefer cash. employers in India. securities law considerations The RBI has also granted general permission to foreign companies to repurchase shares issued to their employees India’s securities laws do not impose any restrictions on in India under a stock option plan. Previously, such a the grant to employees in India of stock options by a U.S. repurchase required advance approval from the RBI. Now company. Companies may offer stock options to employees such approval is unnecessary if the following requirements of a subsidiary in India either directly or indirectly. U.S. are met: (i) issuance of the shares was in accordance with securities laws will not be an issue so long as the options are the exemptions above, (ii) the terms of the repurchase were granted under a plan which is either in compliance with Rule specified in the initial option agreement (and have not been 701 of the U.S. Securities and Exchange Commission (“SEC”) amended since); and (iii) the India subsidiary is current in and applicable state law or has been registered with the SEC filing its annual returns with the RBI providing details of on a Form S-8 registration statement. remittances/beneficiaries/etc. currency control considerations The general authorization for repurchase of shares appears India’s currency exchange controls applicable to option to be in addition to the existing general permission to the exercises by employees have been liberalized. There is optionees to sell their shares after exercise. A voluntary sale presently no limit on the amount that employees or directors by the employee (unlike an involuntary repurchase compelled are allowed to remit for this purpose so long as the U.S. by the employer in compliance with the above requirements) company owns at least 51% of the India subsidiary and is subject to the condition that the sale-proceeds are any proceeds from a sale of the shares is repatriated to immediately remitted to an account with an “Authorised an account in India. A purchase of U.S. company shares Dealer” bank in India (in any case not later than 90 days from by persons other than employees or directors of the India the date of such sale). 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. www.fenwick.com
  • 2. employment issues of 33.99% on the difference between the price paid for the shares and the fair market value of those shares on the date Like the United Kingdom, employees in India generally of exercise. FBT applies to any exercise of a compensatory have a written employment agreement. If the employment stock option by an employee that occurs after March 31, 2007, agreement expressly states that the grant of equity regardless of when the option was granted. The Indian tax compensation is entirely within the employer’s discretion, authorities have announced their view that employers based or makes no mention of equity compensation being part of outside India, even those with no permanent establishment the employee’s pay, then it is unlikely that an employee can in India, are nonetheless liable for payment of the FBT. claim any special or ongoing entitlement to additional equity compensation although there is no harm in expressly stating Since the application of FBT to stock options has been this in the stock option agreement. extended on such short notice, employers across India are still evaluating how to manage the additional impact on their data privacy bottom lines. An initial response is to provide in the stock option agreement that the employer can withhold from the Data privacy is a concern around the world now, no less employee’s exercise a number of shares equal to the FBT in India than in the U.S., so it is advisable to obtain the or the required amount of cash from the employee’s pay. employee’s consent to sharing personal information with This is similar to what is done by employers in the United persons outside India as part of the administration of the Kingdom with respect to a UK health insurance tax imposed stock option program. India’s close legal history with on employers when a stock option is exercised. This would the United Kingdom suggest it may eventually follow the be a prospective approach only, as currently outstanding European Union’s privacy practices to an even greater degree. stock options could not have this burden imposed without obtaining the optionholder’s consent. However, recovery tax consequences of FBT from the employee is taxable income to the employer Income Tax at a rate of 33.99%. Thus, for the employer to be indifferent As of April 1, 2007, when India’s 2007-2008 government to the imposition of FBT under this approach would require budget took effect, the exercise of a stock option by an the employee to reimburse the employer for this tax (and employee in India is no longer subject to income tax on the the tax on this additional reimbursement and so on). It difference between the price paid for the shares and the becomes apparent that this approach represents a significant fair market value of those shares on the date of exercise. diminishing return to the employee and is something of a Instead, the employer will pay a flat fringe benefits tax (“FBT”) mathematical headache for the employer. Therefore, the of 33.99% on the difference between the price paid for the employer either will: shares and the fair market value of those shares on the date of exercise. n Limit recovery of FBT from the employee to the amount of the original FBT, or Previously, the imposition of the employee’s liability for income tax on a stock option exercise could have been n Absorb the FBT as a cost of doing business (possibly by deferred to the date of sale of the shares, if the plan complied limiting the value of any option exercise in a given year in with certain tax guidelines and had been registered with proportion to the amount of FBT the employer will face as India’s Chief Commissioner–Income Tax of the state where a result), or the subsidiary is incorporated. The benefit from options granted under these plans is now mooted as income tax is n Cease granting stock options to employees in India. no longer imposed on the employee upon exercise. At the time the employee sells the shares the employee is subject Another approach that employers can use to mimic the to income tax on the difference between the amount realized effect of stock options is an award of cash-settled stock from the sale and the fair market value of those shares on the appreciation rights, as the payment is taxable income to the date of exercise (rules for how fair market value on the date of employee rather than subject to FBT paid by the employer. exercise is to be determined are still being developed). However, U.S. accounting rules will treat these awards as liabilities rather than equity. 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  007 update on granting stock options in india fenwick & west
  • 3. 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. conclusion 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. If you have any questions about this memorandum, please contact Fred M. Greguras (fgreguras@fenwick.com) or Tahir J. Naim (tnaim@fenwick.com) of Fenwick & West LLP (telephone: 650.988.8500) or S.R. Gopalan of Dawn Consulting in Bangalore, India (srg@dawnconsulting.com). ©2007 Fenwick & West LLP. All rights reserved. IRS circular 230 disclosure: to ensure compliance with requirements imposed by the irs, we inform you that any U.S. federal tax advice in this communication (including attachments) is not intended or written by Fenwick & West LLP to be used, and cannot be used, for the purpose of (i) avoiding penalties under the internal revenue code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.  007 update on granting stock options in india fenwick & west