Mergers, ESOPs and their tax implications

Mergers have long been used to create larger businesses, become more competitive or just as a means of survival in today's dynamic environment. However, mergers bring with them a plethora of regulatory requirements and tax implications. Today I will analyse some of the important tax issues that are thrown up with respect to employee stock option plans ('ESOP' or "Plan') in the event of merger.

The ESOP tax System today;

ESOP is taxable in the employee's hands at two points.

1. The first point of taxation is when the employee exercises the options i.e. the shares of the company are transferred to him upon payment of the exercise price. The notional gain (quantified as the difference between the exercise price and the market price prevailing on date of exercise) is generally treated as salary income and taxed accordingly.
2. The second point of taxation is when the employee sells the shares. The gains, if any, is taxed as short term or long term capital gains depending on the period for which the shares are held after exercise.

Mergers involve extinguishment of one company's shares and stock options in lieu of the other company's shares and stock options respectively. In such a situation it is imperative that the people who exercised the ESOP, now will have some changes. Lets look at this below.

• Capital gains exemption: Exchange of capital assets will give rise to capital gains tax in India.  However, the tax laws provide a specific exemption from capital gains tax for any transfer of shares by a shareholder of an amalgamating company, in a scheme of amalgamation, in exchange for shares in an Indian amalgamated company. Exchange of shares under a scheme of merger satisfying this exemption provision will not be liable to tax in India.
• Unvested options: These are not taxed because only exercised options are liable for taxation as per Indian Taxation Act.

Merger of foreign companies

The exemption provided under Indian tax laws for exchange of assets in the event of merger is not available for shares held in such foreign companies. Consequently, in addition to the tax exposure on exchange of vested/unvested options, it appears that employees could be held liable for exchange of shares between foreign companies. This creates an inequitable situation between employees holding shares of an Indian company to an employees holding shares of a foreign company, so to counter this a proper mechanism is required to be framed.

So to conclude it could be said that it is not exactly clear when you could be taxed and when not. So there is a need of a proper well defined frame work which is missing till now.

If anyone could make these taxation principles much more clear, please do so for our readers.