CA Gourav Goyal
Brief about Employee Stock Option Plan (ESOP)
Employee Stock Option Plan (ESOP) is a frequently used incentive mechanism used by organizations. There are various reasons for which the employees of a company are given such stock options. The phenomena of stock options is more prevalent in start-up companies which cannot afford to pay huge salaries to its employees but are willing to share the future prosperity of the company. In such cases the employees are given the stock options as part of the compensation package.
It is a common practice among organizations to reward performing employees by giving ESOPs as a part of the salary and ensure long-term commitment of the employee. It aims at improving the performance of the company, increasing the value of the shares by involving stock holders, who are also the employees, in the working of the Company and further, ESOPs help in minimizing problems related to incentives. However, one must also analyze the tax implications of ESOPs for employee as well as the company.
The idea that employees should have an ownership stake in the company led to the emergence of concept of Employee Stock Option Plan (ESOP). Definition of “Employee Stock Option” was first incorporated by way of a clause (15A) in Section 2 of the Companies Act, 1956, based on the recommendations of Working Group. Section 62 of the Companies Act, 2013 further incorporates enabling provision for the issue of ESOPs subject to the sanction of special resolution and compliance with Rules (in case of unlisted public company) and SEBI Regulations (in case of listed companies). Let us discuss the compliances for an unlisted company in detail.
The Employee Stock Option Plan (ESOP) or Employee Stock Option Scheme (ESOS) is the option or a right which is being offered by a company to its employees to purchase its shares at a pre-determined price in the future. ESOP is not an obligation rather it is a right of the employee to purchase certain amount of share of the company at a pre decided price.
ESOP is basically a tool used by a company to retain its employees and get them awarded for being associated with the company. As a part of an employee’s compensation ESOP creates a sense of ownership in the mind of employees and their interest in the organization remains intact. ESOP plays a vital role to attract employees at the growing stage of the company.
Sec 2(37) of Companies Act, 2013 defines “employees stock option” which means, ‘the option given to the directors, officers or employees of the company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a pre-determined price.’ This provision needs to be read with Rule 12 of The Companies (Share Capital and Debentures) Rules, 2014.
The objective of issuing ESOP is to:
The effective date of exercise is the date on which the Company allots the shares.
Approval of shareholders
The issue of Employee Stock Option scheme shall be approved by the shareholders of the company, by passing a Special Resolution.
For the purpose of the Section 62(1)(b) and Rule 12, “Employee” means –
a. A permanent employee of the company who has been working in India or outside India; or
b. A director of the company, whether a whole time director or not but excluding an independent director; or
c. An employee as defined in clause (a) or (b) of a subsidiary, in India or outside India, or of a holding company of the company or of an associate company, but does not include-
i. An employee who is a promoter or a person belonging to the promoter group; or
ii. A director who either himself or through his relative or through any corporate, directly or indirectly, holds more than 10% of the outstanding equity shares of the company.
However, in order to promote startups, the Ministry of Corporate Affairs vide Notification dated 19.07.2016 issued the Companies (Share Capital and Debentures) Third Amendment Rules, 2016 wherein it was provided that Startups may issue the shares under ESOP to their promoters and directors who hold more than 10% for the first 5 years from the date of their incorporation. The restriction on issuing shares under ESOP to promoters and such directors continues for companies which does not fall under the category of startups.
The company shall make the following disclosures in the explanatory statement annexed to the notice for passing of the resolution:
The companies granting option to its employees pursuant to Employees Stock Option Scheme will have the freedom to determine the exercise price in conformity with the applicable accounting policies, if any.
The approval of shareholders by way of separate resolution shall be obtained by the company in case of:
The company may by special resolution, vary the terms of Employees Stock Option Scheme not yet exercised by the employees provided such variation is not prejudicial to the interests of the option holders. The notice for passing special resolution for variation of terms of Employees Stock Option Scheme shall disclose full details of the variation, the rationale therefore, and the details of the employees who are beneficiaries of such variation.
There shall be a minimum period of one year between the grant of options and vesting of option. In a case where options are granted by a company under its Employees Stock Option Scheme in lieu of options held by the same person under an Employees Stock Option Scheme in another company, which has merged or amalgamated with the first mentioned company, the period during which the options granted by the merging or amalgamating company were held by him shall be adjusted against the minimum vesting period required under this clause.
The company shall have the freedom to specify the lock-in period for the shares issued pursuant to exercise of option.
The Employees shall not have right to receive any dividend or to vote or in any manner enjoy the benefits of a shareholder in respect of option granted to them, till shares are issued on exercise of option.
The Board of directors, shall, inter alia, disclose in the Directors’ Report for the year, the following details of the Employees Stock Option Scheme:
(i) key managerial personnel;
(ii) any other employee who receives a grant of options in any one year of option amounting to five percent or more of options granted during that year.
(iii) identified employees who were granted option, during any one year, equal to or exceeding one percent of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant;
At the time of grant of option, valuation of fair value of shares shall be done by registered valuer. At the time of exercise of option, valuation shall be done by Merchant banker.
Fair value of shares at the time of “grant of Option” and “exercise of option” shall be done by registered valuer as per “Guidance note on accounting for employee share-based payment” (issued 2005). Income Tax Act, 1961 does not specify any method for computation of FMV of shares but Section 17 and Rule3(8) of the Act provides that for the purpose of perquisite valuation the FMV of ESOP shall be such value as determined by a merchant banker on the specified date.
“Specified Date” means the date of exercising of the option; or any date earlier than the date of the exercising of the option, not being a date which is more than 180 days earlier than the date of the exercising.
There are no cash outflows or taxation implications when the options are granted as and when the options are vested in the employee.
The Income Tax Act, 1961 has laid down the following two stages of taxation for employees in respect of shares allotted to them under an ESOP.
Today, employees in start-ups and unlisted companies are also allotted ESOPs. These shares will be considered short-term assets if held for less than 24 months from the exercise date and taxed according to the respective tax slab. If the shares are held for more than 24 months, and sold after this period, these are considered as long-term gains and taxed at 20% after indexation of cost.
In case the employee chooses to not exercise his option, there shall be no tax implication for the employee.
The Issuing Company can claim ESOP cost as deduction.
The discounts under the ESOP are an employee cost and should be allowed as a deduction over the vesting period, in the hands of the issuing company.
Furthermore, there may also be a situation when ESOP-shares are bought back by the Company.
When it comes to a buyback of shares of an unlisted company, then provisions under sections 10(34A) and 115QA of the Income Tax Act shall intervene.
As per section 10(34A), any income arising to a shareholder (including ESOP-shares) on account of buy back of unlisted shares by the company shall be exempt in the hands of such shareholder. Further, as per section 115QA, the tax @ 20% shall be paid by the unlisted company on the buyback of its shares.
Therefore, in the hands of the employees, the gain from the buyback of shares by an unlisted company shall be exempt and the company shall be liable to pay buyback distribution tax.
It is to be noted that if the employee sells ESOP-shcares to a third party instead of the company, then he shall be liable to pay capital gain tax and the company need not pay any taxes, as the transaction happened between an employee and the purchaser.
Undoubtedly, the ESOPs are a prevalent method used by companies to attract, motivate and retain employees. This tool of ESOPs have two fold benefit i.e. reducing cash outflow and retaining deserving employees for their growth. Employees also see this scheme as a long term investment for which they have to compensate with their cash perquisites and bonuses. Since many companies have now made ESOPs as part of the compensation for key employees, it is very important for an employee to be aware of its taxability. ESOPs are beneficial to both employees as well as Startups if implemented effectively. The sense of ownership acts as a motivation for the employees to work hard and diligently.
About the Author
Author is Gourav Goyal, FCA having expertise to develop high quality business strategies and plan ensuring alignment with short-term and long-term objectives of Foreign Companies. He has gained rich experience with expertise in the areas of Consultancy to Foreign companies, Non Resident Indians and Joint Ventures including work relating to FEMA matters, RBI and FIPB He is associated as “Director – India Entry Strategy” with Neeraj Bhagat & Co. Chartered Accountants, a Chartered Accountancy firm established in the year 1997 with its head office at New Delhi and can be reached at firstname.lastname@example.org.