U.S. citizens working in India who receive equity compensation from their employers should be aware of the U.S. income tax implications associated with taxes paid to India in connection with such compensation. Unlike the United States (which normally would tax the employee on the value of employer-provided benefits), India levies a tax on the employer based on the value of certain fringe benefits provided to its employees. Where this tax cost is contractually transferred to the employee (as permitted under the Indian tax rules), there may be complex issues that need to be addressed by the employee when determining his or her U.S. tax liability attributable to this compensation.
The Indian Fringe Benefit Tax (FBT) imposes a tax liability on employers based on the value of any privileged service facility or amenity directly or indirectly provided by the employer to its employees and former employees by reason of their employment either by reimbursement or otherwise. The FBT applies to a wide range of benefits, including, for example, transportation expenses for travel by the employee and his or her family members, costs related to the use of mobile telephones, the use of health club facilities, club membership dues, corporate gifts and scholarships. In addition, as a result of a change in Indian tax laws, certain types of equity-based compensation have also come to be treated as fringe benefits under the FBT.
Where equity-based compensation is provided to employees (e.g., grants of restricted stock or grants of stock options), the employer will be responsible for payment of the FBT on this "fringe benefit." Because the equity is treated as a fringe benefit subject to FBT, the employee is not directly responsible for any income tax liability to India (as would normally be the case for compensation paid as regular salary or cash bonuses). FBT liability is based on the value of the equity determined at the time the employee becomes vested. The FBT, however, is not imposed on the vesting date if the relevant securities have not actually been transferred to the employee. For example, where a stock option is granted entitling the employee to purchase shares of stock in his or her employer at a fixed price (normally, the fair market value of the shares determined as of the date the option was granted), no FBT is imposed unless and until the option is actually exercised and the shares are purchased and transferred by the employer to the employee. The amount of the FBT is, however, determined on the basis of the intrinsic value of the stock option determined as of the date the option becomes vested (i.e., becomes exercisable, even if not yet actually exercised). The calculation of the FBT liability on an option can be complex and is not linked to the amount of the built-in gain when exercised (which is the amount of compensation normally taken into account for U.S. income tax purposes). In addition to a difference in the time as of which the value is determined, the valuation of the underlying securities may also vary from what is used for U.S. income tax purposes.
When determining the value of employer equity securities transferred as compensation to an employee for purposes of the FBT, the market value of the equity securities can be used but only if the securities are traded on an Indian securities exchange. If the equity securities in question are traded on a public market but not on an Indian stock exchange, the valuation process is somewhat more cumbersome. Value is required to be determined by engaging the services of a registered investment banker in India. While the registered investment banker will take into account the value of the equity on the market in which it is traded as well as the exchange rate to determine value in Indian rupees, these services must be provided by such a banker and the employer cannot conduct this valuation on its own.
In the case of stock options, employers subject to the FBT are required to pay approximately 30 percent on the taxable value of the options. There are also fees and surcharges applied that can make the total FBT cost significantly higher.1Employers are permitted to require the employees who receive the equity compensation to reimburse the employer for the FBT paid so that the economic burden of the FBT is, in effect, transferred from the employer (who is legally responsible for the FBT payment) to the employee (who receives the economic benefit of the equity compensation). In connection with compensatory transfers of equity to an employee, for U.S. income tax purposes, any recovery of the FBT liability from the employee arguably should be included in the employee's cost basis of property received.
In India, the FBT is considered to be an income tax, but compared to basic principles of U.S. tax law, it is actually more like a payroll tax imposed on employers than an income tax imposed on compensation provided to employees. This will require careful treatment when it comes to reporting U.S. income tax liabilities for employees in this situation. Although the economic burden of the FBT may have been contractually transferred from the employer to the employee, the U.S. Internal Revenue Code will not treat this as a payment of tax by the employee, so no foreign tax credit will be permitted for the payment of the FBT by the employee when calculating personal U.S. income tax liabilities. For U.S. federal income tax purposes, the payment to the employer by the employee of the amount of the FBT (which is legally the liability of the employer to pay to the Indian tax authorities) will most likely be considered not as payment to the employee's tax liability but rather as an additional payment required to exercise the option. This may then be taken into account to offset the income otherwise required to be recognized by the employee on the option exercise (which is normally the excess of the value of the equity acquired in excess of the strike price paid under the terms of the option).
The United States, unlike most other countries in the world, taxes its citizens and permanent resident aliens on their worldwide income. Consequently, income earned by a U.S. citizen or permanent resident while working abroad for a business is subject to federal income tax in the United States. For example, a U.S. citizen who is resident and employed in India would need to file a U.S. tax return and report the income earned while employed in India on his or her U.S. tax return and pay the tax liability on that income as determined under the U.S. tax code. This U.S. federal income tax obligation is in addition to any tax liability the employee has to India's taxing authority. In contrast, most other jurisdictions limit their income tax imposed on their citizens to income actually earned while residing within that jurisdiction.
The U.S. federal income tax rules do, however, permit U.S. taxpayers to take a credit against their U.S. income tax liabilities for income taxes paid to foreign taxing authorities and also currently provides for up to an $87,500 exemption of a certain level of income for those U.S. citizens who do not reside in the United States. The availability of this exemption, however, is subject to rules that specify how long the U.S. citizen must remain abroad and limit the periods of visitation to the United States, often making this exemption unavailable. Credit for income taxes paid to a foreign jurisdiction may also be problematic.
In the context of the FBT imposed under the Indian tax laws, and where the employer contractually transfers the economic burden of that tax to the employee, a key limitation on the ability of the employee to tax a foreign tax credit is the requirement that the foreign levy be considered a tax, and more importantly, be considered an income tax that is "similar" to income taxes imposed in the United States. To be considered a tax in the United States, a foreign levy must require a compulsory payment pursuant to applicable law. Because India's FBT is imposed upon the employer and not the employee, a U.S. citizen receiving a stock option in India may be liable to his employer for the amount of the FBT but is not liable to the Indian tax authority. Therefore, the foreign tax credit against U.S. income tax liability is not likely available for the amount of the FBT paid by the employee. U.S. citizens whose compensation in India includes fringe benefits, such as stock options, and are required by their employer to pay the FBT may still, however, have a legal basis to take into account the amount paid as a reimbursement to the employer for the FBT due. Section 83 of the Internal Revenue Code governs the taxation of compensatory transfers of property (e.g., as in the case of an exercise of an employee option). Under these rules, the excess of the fair market value of the property transferred (i.e., the stock) over the amount paid for that property by the employee (all determined on the date of the option exercise) is included in the employee's gross income as compensation. If the employee is required to pay both the option strike price and the amount of the employer's FBT liability, the amount paid for the property should be equal to the sum of those two amounts (effectively providing a direct offset to the income that would otherwise be recognized on the option exercise based on the amount paid by the employee to reimburse the employer for the FBT payable with respect to the option).
U.S. citizens who are required to pay for the FBT on the transfer of shares received in the form of equity compensation should take care to consider how the FBT will be recovered by the employer. Although there is no guarantee, efforts to include the FBT in the price paid for the option seem to provide an adequate substitute for the unavailable use of a tax credit for foreign income taxes paid. Employers should also pay close attention to the Indian tax rules regarding imposition of the FBT on equity-based compensation. This is a very different tax regime from what U.S. employers normally confront. Alternatives that may be simpler to administer and less disruptive to the normal employer/employee compensation and tax arrangements may be considered in this context, such as limiting or eliminating actual equity grants and substituting increased base or bonus cash compensation or substituting phantom equity grants settled in cash that may avoid the FBT and should be taxed under Indian tax rules much like any other cash compensation paid to India resident employees. 1 Actual rates may change .
William Wright is a Partner in WolfBlock's Employee Benefits and Employment Services Practice Groups. Warren Fusfeld is Chair of WolfBlock's Employee Benefits Practice Group and is also a member of the firm's Employment Services and Tax Practice Groups.