SARs in India - The Hindu Business Line - July, 7, 2008

Stock appreciation rights

Stock appreciation schemes provide a form of deferred cash
compensation which is contingent upon financial performance of the
company.

H. P Ranina

Stock appreciation rights generally provide an employee with a cash
payment based on the increase in the value of a number of shares over a
specific period of time. Stock appreciation rights do not have a
settlement date.

The employees have the flexibility to decide the time for exercising
them, of course within a timeframe on the expiry of which the right
would lapse.

In effect, stock appreciation right schemes provide a form of
deferred cash compensation which is contingent upon financial
performance of the company.

Stock option

When a stock option is exercised, an employee has to pay the grant price and acquire the underlying security.

However, when a stock appreciation right is exercised, the employee does not have to pay to acquire the underlying security.

Instead, the employee would receive the appreciation value of the
underlying security, which would be equal to the current market value
less the grant price. In character, therefore, a stock appreciation
right is not the same thing as a typical stock option.

Unlike a stock option plan which aims at what can be termed as
employees’ participation in ownership, a stock appreciation right is a
scheme of bonus payment which is on the basis of financial performance
of the company.

This point was considered by a Special Bench of the Income-tax Appellate Tribunal (ITAT) in Sumit Bhattacharya vs CIT (300 ITR AT 347).
The facts in this case were that the assessee was employed as managing
director of PGI, which was part of a group of companies headed by PGU
of the US.

In January 1998, the assessee received $12,38,084.02, which was
equivalent to Rs 4,79,13,851.58, from PGU on account of redemption of
certain stock appreciation rights granted in October 1997, in
accordance with and subject to the terms of the PG Stock Plan. The
manner in which these stock appreciation rights worked was as follows.

A grantee was allotted stock appreciation rights in respect of a
specified number of shares in PGU. The agreed price of the shares which
normally reflected the market price as on the date of granting the
rights, was taken as the grant value. The grantee could exercise the
right to redeem the appreciation in value of these shares after one
year from the date of the grant.

The assessee had to use this redemption right within ten years from
the date of grant of these rights. On redemption of stock appreciation,
the grantee would get the excess of market price of the shares as on
the redemption date over the grant value of those shares.

No shares were actually allotted or given to the grantee. The rights
of the grantee were confined to claiming the appreciation in value in
respect of shares in question. The assessee claimed that this amount
was not taxable in his hands as income from “salaries” because the
assessee did not have any employer-employee relationship with PGU, that
is, the grantor of the stock appreciation rights and that the grant of
stock option was not liable to tax.

The assessee submitted that at best the stock appreciation rights
could be taxed at the point of time when they were granted but since
grant was at market value of shares, no advantage accrued to the
assessee. Those payments were, according to the assessing officer (AO),
profits of the assessee’s employment.

The view of the AO was confirmed in appeal, by the Commissioner (Appeals).

Tribunal’s view

On appeal, the Tribunal held that the amount received by the
assessee on redemption of share appreciation rights was in the nature
of consideration for services rendered by the assessee and nothing but
a deferred wage contingent upon performance of the company’s shares in
the market.

The very preamble to the Plan, under which share redemption rights
were given to the assessee, also stated that it was in the nature of
“deferred awards related to the increase in the price of the common
stock of the company”.

It was in consideration of the assessee agreeing not to leave
employment of PG and any of its subsidiary companies for a period of
one year, and not to engage in competitive business for three years
that the assessee got the stock appreciation rights.

The
assessee had no connection with PGU other than as an organisation
connected with the company with which he had entered into an employment
contract, The assessee’s receipts of whatever nature, in connection
with his employment, were to be taxable under the head “salaries”.

In
the case of stock appreciation rights, what the assessee actually
receives is a kind of cash bonus which is in the nature of deferred
wages and which is contingent upon the company doing well in financial
terms. There is no need, as in the case of stock options, in converting
the benefit into monetary terms because what is received by the
assessee is itself in monetary terms.

As the redemption amount
is dependent on the market price of shares which can move in any
direction at any time, the income arises only when the stock
appreciation rights are redeemed.

Taxability issue

According
to the Tribunal, grant of a stock appreciation right gives some benefit
to the assessee, and such a benefit is contingent upon the market
behaviour for the value of shares in question. An anticipated income
cannot be brought to tax until it actually accrues or unless there is a
specific provision to that effect. Therefore, the benefit on account of
stock appreciation rights cannot be taxed in the year of grant or
vesting, but only in the year of redemption.

The Special Bench of
the Tribunal concluded that even if the amount received by the assessee
on redemption of share appreciation rights was held to be not taxable
under the head “salaries”, this fact, by itself, would not take it
outside the ambit of taxable income, since, in such an eventuality the
amount would be taxable under the head “Income from other sources”.

Redemption
of stock appreciation rights was an employment-related benefit, in the
nature of deferred wages contingent upon the financial performance of
the ultimate employer, that is, the parent company of the company with
which the assessee had entered into an employment contract. In coming
to this conclusion, the court relied on the judgment of the Supreme
Court in Emil Webber vs CIT (200 ITR 483).

While the assessee may
appeal against this decision as a substantial question of law is
involved, it is unlikely that the Tribunal’s order will be reversed.

(The author is a Mumbai-based advocate.)