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NEWS AND VIEWS

NV # 01/2004September-December, 2003
Discussion Paper on Taxation of STOCK OPTIONS
by Faisal Ahad, Advocate
Back ground
Employee stock option plans (ESOP) are one of the most versatile financing tools available to business owners. It provides a partnership among shareholders, management and employees by creating a Trust Vehicle through which employees can hold equity in the company through purchase of shares. Stock option has a leading edge over cash bonuses and other incentives that are being offered to employees in common practice as it provides a sense of ownership amongst employees through their investment in the shares of the company. As a result of this self-ownership the employee's performance can grow many folds. Another underlying objective of providing stock options is to retain employees.

Initially offer of stock options to employees was practiced in the United States in early 70's and due to its far reaching results it was widely adopted by the leading corporations in the United States. In a short span of time it was also used by the European business owners as a motivational tool for their employees. Now it is also practiced in Japan, China, Far East and other developed countries. In Pakistan ESOP are practiced in a few multinational organizations where the stock options are offered through their parent companies based abroad.
Governing Legislation

As you aware, the basic law in respect of companies is the Companies Ordinance, 1984 (the Companies Ordinance) which governs incorporation of companies, their management, issue of share capital and several other usual corporate actions and events. The provisions of the Company Ordinance are also supplemented by other related legislations. You may recall that Section 86 of the Companies Ordinance, 1984 before the amendment made in 1999 restricted the issuance of further shares (in the form of right or bonus) to the existing shareholders of the Company. However, through Finance Act, 1999 proviso was introduced whereby public company was allowed to reserve a certain percentage of further issue for its employee under ESOS. However, at that point of time there was no specific law, which dealt with the schemes of stock options. As such the stock options are not applied in the local Pakistani Companies. Further, the government in May 2001 has introduced the (Employees Stock Option Scheme) Rules, 2001. The salient features of the Rules are as below: -

(a) The Rules is applicable to Public Companies only.

(b) Only regular employees are eligible to participate in the Scheme. Executive director and Chief       Executive who are on the payroll of the Company are also entitled for the Scheme.

(c) The Company has to constitute compensation committee for administration and supervision he      Scheme, formulate the detailed terms and conditions of the Scheme.

(d) The Scheme, before offer to the employees, is to be approved by the shareholders of the Company      by passing a special resolution in the general meeting. The Scheme is also to be approved by the      SECP.

(e) Approval of shareholders by way of a separate resolution is to be obtained in case of -

         (i) grant of option to employees of a subsidiary or holding company; and

         (ii) grant of option to identified employees subject to certain conditions.

(f) The Company shall have the freedom to determine the " exercise price".

(g) There shall be a minimum period of one year between the grant of option and vesting of option.

(h) Under the cashless system of exercise, the Company may itself found the payment of exercise price,      which shall be, adjusted against the sale proceeds of some or all the shares.

(i) An option granted to employee shall not be transferable to any other person except to the entitled     employee of the Company.

As a result of promulgation of the above Rules and the second proviso to section 86 of the Companies Ordinance, which authorizes the director of the public company to issue share for its employees under ESOS it is now possible for the management/ business owners of the public companies to offer stock options for their employees in order to obtain the benefits of further future growth of the company.
Tax Treatment of Stock Options
Prior to the promulgation of the Income Tax Ordinance, 2001 there was no specific provision dealing with taxability of stock options. However, under the Income Tax Ordinance, 2001 the taxability has been specifically dealt with. For your convenience we give below a brief summary with regard to the tax treatment of stock options to be offered to employees of the company.
Event   Tax treatment
When the award is made  
Awarding of subscription rights would not give rise to an income chargeable to tax in Pakistan.
When the option vests  
Eligibility itself would not give rise to an income chargeable to tax in Pakistan.
   
(i) Exercise of share option will give rise to an income to the employee and     is chargeable under the head of "income from salary". The difference     between the market price of shares and the payment made by the     employee to acquire those shares shall be treated as his salary income.
   
(ii) Income tax would be charged on the above income at the individual's      marginal tax rate. Maximum marginal income tax rate is 35%.
When the employee sells the option or right  
The sale of option/ right would give raise to an income to the employee and is chargeable under the head "income from salary". The difference between the consideration received for the disposal of right/ option and the cost in respect of availing the option/ right shall be treated as his salary income.
When employee sells the shares  
The sale of shares would give rise to capital gain/loss which would have a special tax treatment. Where sale is effected within a period of one year of acquisition, the gain would be subjected to tax at the normal tax rates as applicable to all other incomes of that individual. Where sale is effected after a period of one year of acquisition, only 75% of the gain will be subjected to tax at the individual marginal tax rate.
The Members Assistance Sub-committee claims no responsibility to the correctness of the contents published. The information provided is non-exhaustive and readers are advised to refer to the respective taxation laws, documents/case laws cited for understanding the issue involved.
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