Chapter 12: Taxation of other Products

ESOPs are provided to employees to retain top talent and acknowledge their contribution to the company. It allows employees to purchase securities of the employer company at a discounted price. ESOPs act as a motivational tool for the employees, as they feel responsible for the performance of the company after owning a stake in it.

Here are some key points related to ESOP taxation:

1. ESOPs are taxed as perquisites in the hands of employees at the time of exercise of options.
2. The difference between the fair market value of the shares on the date of exercise of options and the exercise price paid by the employee is taxable as a perquisite.
3. The employer has to deduct tax at source (TDS) at the time of exercise of options.
4. The tax rate applicable on ESOPs depends on the period between grant of options and exercise of options:

• If options are exercised after 24 months from the date of grant and after 12 months from the date of vesting, then the gain from the exercise of options is treated as long-term capital gains (LTCG). LTCG tax rate is 20% with indexation benefits.
• If options are exercised before the above-mentioned period, then the gain from the exercise of options is treated as short-term capital gains (STCG). STCG tax rate is the applicable income tax slab rate of the employee.

5. In case of sale of shares acquired under ESOP, the gain from the sale is treated as LTCG or STCG, as the case may be, depending on the period of holding of shares.

ESOPs are particularly popular amongst start-ups and emerging companies as it allows them to attract and retain top talent with the promise of future returns on the company’s success.

ESOPs and Tax Implications:

ESOPs (Employee Stock Option Plans) are a form of employee compensation where the employer offers employees an option to buy shares at a predetermined price after a certain lock-in period.

Vesting date refers to the date on which an employee becomes entitled to exercise the right to acquire the shares, while exercise date is the date on which the employees exercise the option to buy the shares.

Employees are not required to exercise ESOPs and may choose to let the option lapse.

Taxation of ESOPs occurs in two instances: at the time of allotment of shares and at the time of exercise of options.

The difference between the Fair Market Value (FMV) of the shares on the date the option is exercised and the amount paid by the employee for such shares is taxable as perquisite.

FMV is determined based on different scenarios, such as whether the shares are listed on one or more stock exchanges or not listed at all.

To calculate the value of perquisite arising from ESOP, determine FMV on the date of exercise of options, subtract the predetermined value of shares paid by the employee, and multiply by the number of shares exercised.

The deferment of tax on perquisite value of ESOPs in case of start-ups:

ESOPs are a significant component in the compensation of employees of start-ups. The taxability of ESOPs arises in the hands of the employee at two stages. To reduce the burden of taxes, the Finance Act, 2020 amended several sections to defer the deduction and payment of tax on income in the nature of perquisites arising from ESOPs for eligible start-ups as referred to in section 80-IAC.

Section 192 provides that an eligible start-up as referred to in section 80-IAC shall deduct tax from income arising in the nature of perquisites from ESOPs within 14 days from the happening of any of the following events: (i) On the expiry of 48 months from the end of Assessment year in which shares are allotted under ESOPs; (ii) From the date the assessee ceases to be the employee of the organization; or (iii) From the date of sale of shares allotted under ESOP.

For this purpose, the tax shall be deducted on the basis of rates in force for the financial year in which shares are allotted or transferred under ESOPs. A similar amendment has been made to sections 191 and 156 to provide that if an employer does not deduct tax on perquisite arising from ESOPs then tax shall be payable by the employee directly within the period mentioned above either voluntarily or in response to a notice of demand.

Only an eligible start-up as referred to in Section 80-IAC and its employees would get the benefit of deferment of TDS and tax payment on perquisite arising from ESOPs. An eligible start-up can only be a company or limited liability partnership (LLP) engaged in innovation, development or improvement of products or processes or services or a scalable business model with a high potential of employment generation or wealth creation. The entity should be incorporated between 01-04-2016 and 31-03-2021, hold a certificate of eligible business from the Inter-Ministerial Board of Certification, and its turnover should not exceed Rs. 100 crore for any of the financial years since incorporation/registration.

Sovereign Gold Bonds (SGBs):

Tax Implications on Sovereign Gold Bonds (SGBs)

The table below summarizes the tax implications on SGBs in India:

Note: SGBs have a tenor of 8 years, and Section 47 of the Income-tax Act provides that redemption of SGBs by an individual will not be regarded as ‘transfer.’

Example: Mr. X purchased 100 SGBs at a nominal value of Rs. 425,000 on 28-04-2019 with an interest rate of 2.5% per annum. The tax implications for Mr. X in different scenarios are:

1. If he holds SGBs till maturity, the interest income received will be taxed as per his applicable tax rates. Upon redemption, the capital gains will not be taxable for him as he is an individual.
2. If he transfers SGBs in the secondary market on 01-04-2020 for Rs. 450,000, the resulting capital gain of Rs. 25,000 (i.e., 450,000 – 425,000) will be treated as a short-term capital gain and will be taxed as per his normal tax rates.
3. If he transfers SGBs in the secondary market on 29-10-2020 for Rs. 470,000, the resulting capital gain of Rs. 45,000 (i.e., 470,000 – 425,000) will be treated as a long-term capital gain. If he chooses to take the benefit of indexation while computing the capital gain, he will be taxed at the rate of 20%. Otherwise, he will be taxed at the rate of 10%.

National Pension System (NPS) and its two types of accounts, Tier I and Tier II:

Tax treatment of contributions to NPS:

Example 1:

• XYZ Ltd. contributed Rs. 9 lakhs to NPS account of its employee Mr. A. Annual salary of Mr. A was Rs. 50 lakhs.
• Tax implications in the hands of Mr. A:
  • Amount taxable under the head salary: Rs. 50,00,000 + Rs. 9,00,000 = Rs. 59,00,000
  • Deduction under Section 80CCD(2): Rs. 50,00,000 * 10% = Rs. 5,00,000
  • Taxable income: Rs. 54,00,000

The Tax Treatment of sum received from NPS:

Real Estate investment Trusts (REITs)-

Real Estate Investment Trusts (REITs) are investment vehicles that allow investors to invest in large-scale portfolios of income-producing real estate. They were first introduced in the US in the 1960s and have since been introduced in over 30 countries, including India in 2014.

REITs invest in various types of real estate properties, such as offices, apartments, warehouses, retail centers, medical facilities, and hotels. Most REITs focus on a particular property type, but some hold multiple types of properties in their portfolios.

REITs are structured like mutual funds, with sponsors setting them up to collect money from the general public for investing in income-generating real estate properties. The investment is made in real estate properties either directly or through a Special Purpose Vehicle (SPV).

The structure of a REIT includes a sponsor, SPV, REIT, and unit-holders. The sponsor sets up the REIT and holds a collective holding of 25% for at least 3 years from the date of listing of units and 15% thereafter. The SPV is a company or LLP in which the REIT holds 50% or more of the equity share capital or interest, and it is formed for holding and developing real estate property. The REIT is the trust registered under SEBI (Real Estate Investment Trusts) Regulations, 2014. Unit-holders are the investors who make investments in the REIT and receive units of the REITs in return.

Real estate properties refer to land and any permanently attached improvements to it, including buildings, sheds, garages, fences, fixtures, warehouses, car parks, etc. However, assets falling under the preview of “Infrastructure” are not considered real estate property, except for hotels, hospitals, and convention centers forming part of composite real estate projects and common infrastructure for composite real estate projects, industrial parks, and SEZ.

Table: Tax implications on various types of income earned by REITs and distributed to unit-holders

Note: DTAA refers to Double Taxation Avoidance Agreement.

Tax implications on transfer of units of REITs by the unit-holder:

In addition, for units of business trust acquired on or before 31-01-2018, the cost of acquisition is determined based on the higher of the actual cost or the lower of fair market value as of 31-01-2018 or full value of consideration received upon transfer. If units were not listed on a recognized stock exchange on 31-01-2018, the net asset value on that date is considered as cost of acquisition.

Taxability in the hands of sponsor

Key points:

• Section 47(xvii) of the Income-tax Act exempts the transfer of shares by a sponsor to a business trust in exchange for units of such trust from being considered a transfer.
• No tax liability arises on such transfer of shares under this provision.
• If there is any notional gain or loss on such transfer, it should be adjusted while calculating the book profit for the purpose of the Minimum Alternate Tax (MAT), if applicable.

Example: Mr. X, who holds 30% shares in an SPV, transfers those shares to a REIT in exchange for 25% units of the REIT. This transfer is exempt from tax under Section 47(xvii) of the Income-tax Act.

Table: Summary of Taxability of REITs

Table: Summary of taxability of capital gain arising to unit-holder from the transfer of units

Applicability of TDS in the context of SPV to REIT and REIT to unit-holder is as follows:

SPV to REIT:

• TDS is not applicable when REIT receives interest income on loans/investment in listed debt securities of the SPV or income by way of renting or leasing or letting out any real estate asset owned directly by the REIT.
• TDS is applicable when the REIT receives interest income on unlisted debt securities, and the SPV is liable to withhold taxes at the rates in force as applicable to the REIT.
• Dividend received or receivable by a REIT from an SPV is exempt from tax under Section 10(23FC). Thus, no tax is required to be deducted from dividend credited or paid by an SPV to a business trust.

REIT to unit-holder:

• Rental income, dividend income received from SPV, and interest income received from SPV distributed by REIT to unit-holders are chargeable to tax in the hands of the unit-holders.
• REITs are required to deduct tax under section 194LBA while distributing the said incomes to the unit-holders.
• The tax rates for TDS are as follows: 10% for resident unit-holders and non-resident unit-holders for rental income and dividend income received from SPV, and 10% for resident unit-holders and 5% for non-resident unit-holders for interest income received from SPV. However, if the provisions of the Double Taxation Avoidance Agreement (DTAA) are more beneficial, the tax shall be deducted as per DTAA.

Infrastructure Investment Trusts (InVITs):

• InVITs invest in infrastructure projects such as roads, bridges, ports, airports, electricity generation, transmission or distribution, telecommunication services, telecommunication towers, special economic zones, etc.
• InVITs are registered with SEBI under SEBI (Infrastructure Investment Trusts) Regulations, 2014.
• The structure of InVITs is similar to that of a REIT (Real Estate Investment Trust).
• The tax implications are the same for InVITs and REITs, except for the pass-through status relating to rental income.
• The rental income of REITs is chargeable to tax in the hands of the unit-holders, but in the case of InVITs, rental income is chargeable to tax in its own hands and not in the hands of unit-holders.

AIF- Alternative Investment Funds (AIFs)-

Table: Taxation of Category-I and Category-II AIFs

Notes:

• AIF means any fund established or incorporated in India, as a privately pooled investment vehicle, to collect funds from sophisticated investors.
• AIF is mandatory to obtain registration from SEBI as per SEBI (Alternative Investment Funds) Regulations, 2012.
• Taxation of Category-I and Category-II AIFs is governed by Section 115UB of the Income- tax Act which provides pass-through status to such funds.
• Business income is chargeable to tax in the hands of AIF itself.
• Any other income shall be taxable in the hands of the unit-holder and it shall be exempt in the hands of the Investment Fund under Section 10(23FBA).
• Set-off and carry forward of losses is allowed for losses arising in the hands of the investment fund under the head ‘Profits and gains arising from business or profession’.
• Any losses, other than the business losses, accumulated at the level of investment fund as on 31-03-2019, shall be deemed to be the loss of the unit-holder who held the units as on that date.

Table: Taxation of Category-III AIFs

Conditions for Capital Gain Exemption:

• SEBI approved AIF located in any IFSC.
• All units held by non-residents except sponsor or manager.
• Transaction carried out on a recognised stock exchange located in any IFSC.
• Consideration paid or payable in convertible foreign exchange.

Example:

In the above example, Mr. X holds 30% units of a Category-I AIF, registered as a trust. The AIF has credited the entire income to the accounts of its investors except for income in the nature of other sources.

Taxability:

• Taxable in the hands of AIF: Business income of Rs. 20 lakhs is chargeable to tax at the maximum marginal rate (MMR) of 42.744%.
• Taxable in the hands of Mr. X: Income credited by the AIF under the head capital gains and income deemed to be credited is Rs. 4.5 lakhs. Income from other sources is Rs. 1.5 lakhs. Total income taxable in the hands of Mr. X is Rs. 6 lakhs. Income received by the unit holder from AIF in the nature of income from business or profession shall be exempt under section 10(23FBB).

Exchange Traded Funds (ETFs)

In summary, ETFs are like Mutual Funds that track an index or a commodity and are listed on the exchange. Gold ETFs invest primarily in gold or gold-related instruments, while Index ETFs invest in securities in the same proportion as an index of securities. For long-term capital gains, Gold ETFs are taxed at 20% with indexation, while Index ETFs are taxed at 10% with indexation (above Rs. 1 Lakh). Short-term capital gains on Index ETFs are taxable at 15%, while for Gold ETFs, it’s taxable at the normal tax rate.

As an example, if Mr. A (resident in India) acquired 10,000 units of Gold ETF at Rs. 30 per unit on 01-03-2018 and sold such units on 25-03-2021 at Rs. 50 per unit, the long-term capital gain would be Rs. 1,68,015 and the tax rate would be 20%. If Mr. A acquired 5,000 units of an Index ETF on 01-05-2019 at Rs. 200 per unit and sold the units on 01-06-2020 at Rs. 300 per unit through the recognized exchange and paid STT on such a transaction, the long-term capital gain would be Rs. 5,00,000, and the tax rate would be 10%.

Tax Aspects of Life Insurance Products

Notes:

• The tax treatment above applies to all types of life insurance policies.
• Premiums payable are allowed as deduction under section 80C, with a total deduction limit of Rs. 150,000.
• Deduction is available for policies issued in the name of an individual, spouse, or children, or in the name of any member of a HUF.
• Deduction is restricted to 20% or 10% of sum assured depending on the policy issuance date, except for policies taken on or after 1 Apr 2013 in the name of a person suffering from disability or severe disability referred to in section 80U or suffering from disease or ailment as given in section 80DDB, where the limit is 15% of capital sum assured.
• Various policies need to be held for a minimum period of 2 years for life insurance policies and 5 years for ULIPs of UTI or LIC. If policies are terminated before the minimum holding period, any deduction allowed in earlier years will be taxed as income of the year in which such policy got terminated.
• Finance Act 2021 made amendments in respect of high-value ULIPs issued on or after 1 Feb 2021, with specific provisions for capital gains calculation, long-term period, and tax rates for equity-oriented funds within high premium ULIPs.
• Any sum received on death of a person is exempt from tax, and the same applies to policies covered by the above amendments. However, for other policies where the conditions of section 10(10D) are not satisfied, it remains an open issue as to whether maturity proceeds of such policies will be treated as capital gains or income from other sources.

Tax Aspects of Reverse Mortgage