The Indian IT revolution was just entering a stage in its evolution where it seemed that the Silicon Valley’s success story could be emulated with ease. But with the Central government imposing the Fringe Benefit Tax (FBT) on employee stock options (ESOPs), the picture has turned gloomy for the more than 5,500-odd small and medium IT companies now struggling to come to terms with the ramifications of this tax.
The primary reason so many entrepreneurs came out of the Silicon Valley was that they got rich with stock options before going ahead on their own. This is a trend that’s just beginning in India, and taxing stock options is bound to discourage it.
Due to the FBT on ESOPs, most companies might be rethinking decisions to offer this benefit to their employees. The negative impact is that this would directly affect their chances of attracting talent. The remuneration and the brand name offered by mid-cap and small-cap companies is weaker than that offered by the multinational giants. A better way of attracting talented employees is by giving them a share in the company. It gives the employee a chance to add value and gain from a company’s success, once it gets listed. And the company gains long-term employee commitment.
ESOPs are a great source of motivation. With ESOPs, the company’s ownership is well distributed amongst its employees. Employees with ESOPs display a greater sense of ownership producing striking results as these naturally encourage employees to deliver more than 100%. Indeed, ESOPs should be considered long-tem capital gain—patience, and a lot of hard work, are needed before these materialize.
For the Indian IT industry to create many more success stories, the right environment and the right people would be critical. Not only will companies require a huge local talent pool, they will also have to attract experienced NRI technocrats who have hands-on experience of working on highly sophisticated technologies abroad. ESOPs are a good tool to hold the interest of this set of technocrats but with FBT, a barrier gets in the way.
From an entrepreneurial view-point, when a start-up comes into existence, it does not have the wherewithal to attract good employees. The best way for start-ups to get good talent is to provide them with stock options. This is not only financially attractive but also makes them work harder for the company’s success. Taxing ESOPs is likely to impede the innovative activity such start-ups usually undertake.
In the case of SME IT companies, the tax outgo will start pinching net profits and impact the cash flow of these companies through reduced profits. Companies might try to counter the FBT issue by passing on the costs to employees, which again will be counterproductive and will adversely affect talent retention.
FBT on ESOPs also restricts Indian companies from climbing the value chain from pure IT to product companies. The additional cess of 1% and extension of FBT on ESOPs and the extension of MAT (minimum alternative tax) has raised the burden on most infotech corporates. This will put pressure on the post tax margins of all IT companies, especially those in the SME category.
The path beyond 2009, in terms of a level playing field with larger companies which will increasingly migrate to SEZs, has also not been facilitated by the finance minister.
Tax practitioners in other countries will probably agree that to put the stock option spread in the same basket as a company car or suit may somehow demean both. FBT will certainly cannibalize start-ups and hence, innovation.
Sudhir Naik is vice-president, international sales, at eInfochips, a chip and product design services company. Comments are welcome at email@example.com