Financial Reporting Alert 07-9: Accounting for Reimbursement of India’s FBT on Stock Option Compensation From Employees
December 17, 2007
In 2005, India introduced the fringe benefit tax (FBT), which requires an employer to pay taxes on certain benefits offered to employees. In May 2007, the scope of the FBT was extended to include compensation related to the exercise of employee stock options and to allow employers to unilaterally recover, directly from the employee, any FBT paid. However, this scope change did not eliminate the employer’s legal obligation to pay the tax.
What’s the Big Deal?
The change in scope of the FBT raises some interesting questions: If employers choose to recover the amount of the FBT from the employee, how should it be accounted for? Should the reimbursement be offset against the related taxes paid by the employer or should the reimbursement be considered part of the exercise price paid by the employee upon exercise of the related stock options?
Some believe a company should be able to simply offset the reimbursement from the employee for the FBT against the actual FBT paid by the employer. Unfortunately, the accounting supported by the authoritative literature is not that simple. Rather, because the reimbursement is directly linked to the exercise of the stock options, it should be considered a component of the exercise price. This conclusion is supported by Issue 15 of EITF Issue No. 00-23, “Issues Related to the Accounting for Stock Compensation Under APB Opinion No. 25 and FASB Interpretation No. 44.” Although nullified by FASB Statement No. 123(R), Share-Based Payment, the principle underlying Issue 00-23’s guidance is appropriate because of the absence of current literature on point. Issue 15 discusses the accounting consequences of an employee’s agreement to reimburse an employer’s tax liability (specifically the U.K. National Insurance Contributions Tax), noting that the exercise price would include amounts the employee is required to reimburse to the employer upon exercise of the stock option. In addition, Issue 00-23 refers to Question 20 of FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation, which clarified that amounts refunded by an employee that are contingent upon exercise of a stock option should be considered combined with the stock option and thus would result in a variable exercise price. Further, because the employer is obligated to pay the tax and is not required to recover the tax from the employee, the FBT would not be considered a minimum tax withholding, as discussed in paragraph 35 of Statement 123(R).
What’s the Impact?
Accounting for the FBT reimbursement from the employee as a component of the exercise price will affect a company’s books twice. First, a company will be required to include the expected reimbursement in its estimate of the grant-date fair value of the award. Because this assessment will actually increase the expected exercise price as of the grant date, the grant-date fair value of the stock option recognized over the requisite service period will be less for an option that provides for the recovery of the FBT. Moreover, since the estimate of the exercise price will require an assessment of the future tax required to be paid, companies will most likely be required to use a lattice model in determining the fair value of the award.
The second impact will occur when the employer actually pays the tax. In EITF Issue No. 00-16, “Recognition and Measurement of Employer Payroll Taxes on Employee Stock-Based Compensation,” the Task Force concluded that payroll taxes should be recognized when they are paid. At that point, the tax is recorded as an operating expense.
We understand that companies may be considering modifying outstanding awards to require reimbursement of the tax. This change in the terms of the awards would be considered a modification under Statement 123(R).
Companies should consult with their tax professionals regarding the complexities of applying the new tax law and determining the actual amounts and timing of the tax. If you believe this situation applies to your company, we encourage you to consult with your accounting professionals .