INTRODUCTION

♣ ESOPs in India and globally have been used by businesses to encourage employees to buy shares and own a part of the company while aligning their performance and hard work to the same.

♣ ESOP has gained enough popularity after young start-ups struggle to attract suitable human capital.

♣ Start-ups start losing the workforce when they become unable to provide lucrative offers to retain and boost up their employees but are willing to share the future prosperity of the company.

♣ A solution to this problem could be solved by implementing ESOP in the company as part of the compensation package which does not only play a major role in liquidating capital but also motivates employees to perform better and helps in the growth of the company. 

OBJECTIVE OF ISSUING ESOP?

ESOPs are actively deployed by Start-ups to achieve the following objectives

A. A start-up requires funds and so, the capital requirement of the company can be increased by offering stocks of the company to employees, keeping them within the business.

B. ESOP turns out to be a perfect alternative for appealing, encouraging, and retaining employees instead.

C. It is similar to a profit-sharing plan. Employees being aware that they are shareholders and owners are bound to work with more enthusiasm and feel responsible for the growth of the company.

D. Provided with the limited marketability, it is better to utilize the scheme rather than listing shares on a stock exchange.

Thus, the emotional connection to the Start-up is much higher vis-a-vis full cash compensation.

WHAT IS ESOP?

The word ESOP is generally used in two contexts:

First, is the literal meaning which is the Employee Stock Option Plan, this is usually a plan or scheme under which options are given to the employees in a company

The second meaning is the Employee Stock Options. It’s important to note that options are NOT shares themselves. Rather this signifies the ‘option or right’ of the employee to purchase the shares of the company at a pre-determined price at a future date.

ESOP is given to the employee via a grant letter with grant date, vesting details, exercise price, etc clearly mentioned on it.

ESOPs, give the employee a right to purchase the share, but not an obligation, to buy a certain amount of shares in the company at a predetermined price for a certain number of years.

Therefore, if the shares of the company are valued at less than the option exercise price, then the employee need not excise the right to buy the shares of the company. 

REGULATORY FRAMEWORK

1. Companies Act,2013

2. Income-tax Act,1961

3. SEBI (Share-based Employee Benefits) Regulations,2014

4. ICDR (Amendment) Regulations,2021

5. FEMA, 1999

6. IFRS 2 and Ind AS 102 

STEPS FOR CREATING ESOPs

The steps required if your Start-up is registered in India are as follows:

1. The first step is to get an ESOP scheme prepared through a professional.

This scheme document covers various legal clauses governing -ESOP administration, pool size, grants, vesting, employee cessation, exercise period, etc.

2. The next step is to get the board approval for adopting this ESOP scheme

3. The ESOP scheme also needs to be approved through a special resolution at the shareholders’ meeting (EGM). You need to send out an EGM notice for the same and then finally conduct the EGM and pass the shareholder resolution.

Note that this needs to be a special resolution (votes in favor of the resolution at least three times than votes against) as compared to an ordinary resolution (simple majority).

4. The board resolution and EGM resolutions need to be filed with the Registrar of Companies (ROC) website using form MGT14. Your company secretary can do this. There is no other filing required with the ROC

Note that ESOPs are only options and not shares, therefore there is NO need to increase the authorized share capital of the company at the time of ESOP grants. It only needs to be done when an employee goes for exercise, which is usually much later.

5. Now, you are ready to formally grant ESOPs to your employees through a grant letter.

Note Many a time we come across founders trying to issue a grant letter to the employees backdated to an earlier date because the employee was promised these long before the ESOP scheme got approved by shareholders. This is not legal; the grant date must be greater than the ESOP shareholder resolution date.

PROCEDURE:

  • First stage: GRANT,

Share options are issued to eligible employees on a date called grant date.

  • Second stage: VESTING 

The option holder is given the right to apply for the shares of the company according to the rules laid out in the employee stock option scheme. The vesting period is referred to as the period from the date of grant till the date on which such option becomes a vested option, i.e. when the option holder is eligible to exercise the option. Vesting can be based on duration, milestones, or performance.

  • Third and final stage: EXERCISE

Once an option becomes vested, which means the relevant vesting period is over (or milestone is achieved), the employee has the right to exercise the option. The date on which the employee exercises his/her options is called the exercise date. Upon exercise of the option by the employee, the company allots the shares to the eligible employee in accordance with the employee stock option scheme. 

LEGAL DOCUMENTS REQUIRED:

1. Employment agreement: The employment agreement usually specifies that the board has the discretion to grant such options to the employees as it deems fit.

2. ESOP Plan: The ESOP Plan is the plan which lists out the features and the terms of the ESOP scheme.

3. Trust Deed (if the ESOP is administered by a trust): If the trust route is used for the ESOP Plan, a trust deed for the creation of a trust to hold the shares is required.

4. Letter of grant of options: Options are conferred by a letter to the employees furnished by the board of directors of the company.

5. Letter of acceptance by employees 

ESOPs – THE EMPLOYER OUTLOOK

A. Cost of Implementation of ESOP to Company:

Apart from dilution in the shareholding of promoters, the company should keep the following expenses in mind:

  • Fees payable to the Registered valuer and the Merchant Banker for Valuation of shares
  • Fees are payable to the consultant for implementation and supervision of ESOP.
  • Administration cost throughout its tenure

B. Taxation of ESOPs in the hands of Employer

There is no specific section that specifies whether it will be allowed as a deduction or not. It is allowed as business expenditure u/s 37 as other business. However, the deductibility of expenditure relating to ESOPS has frequently been the subject of litigation in India.

The discount (i.e., the difference between the market price of the shares as at the date of grant of the options and the allotment price) is a deductible business expense of the employer company.

The employer should be careful in calculating the deduction of ESOP expense every year and should keep in mind the guidance provided by the appellate.

ESOPs – THE EMPLOYEE OUTLOOK

ESOP valuation plays a vital role in the success of the ESOP Scheme. ESOP Valuation affects the EPS of the company and higher valuation may result in higher tax pay-out by employees as a perquisite and may turn ESOP scheme unattractive thus appropriate plan & scheme is required for success ESOP.

Employee Stock Options Plans are wealth creation plans that essentially give an employee the option to buy a certain amount of company shares either at market value or at a discounted price.

As per the stipulated time-frame defined in their ESOP scheme document, employees can actually buy the shares that were once provided to them as an option.

Post this, they can either monetize all or some of these shares when the company announces liquidity like a buyback or secondary sale or an IPO (Initial Public Offering).

This complete or partial monetization of ESOPs (if the start-up has done well and has considerable valuation) will far exceed the standard remuneration of the employee. In start-ups, ESOPs that are not exercised will lapse (after a stipulated period) and return to the ESOP POOL. In simple terms, ESOPs empower employees with a monetary edge.

Employee Stock Options for long have been undervalued in India but many success stories of employees creating wealth through ESOPs and eventually building their own start-ups have slowly started to build a strong culture of wealth creation among employees.”

While companies are leveraging ESOPs as a retention tool and growth-multiplier, employees are benefitting in the overall process. To summarise, ESOPs pave a way for employees to:

  • Boost personal wealth through equity ownership.
  • Grow professionally as primary contributors.
  • Improve job security and satisfaction
  • Actively participate in decision making

Taxation of ESOPs in the hands of Employee

Start-ups should mention tax implications to all new employees before giving them an option to get ESOPs as there will be considerable tax consequences for an employee.

There are many employees or individuals who wanted to become a part of a start-up but are not aware of the implications of tax.

Treatment of tax depends upon various factors such as:

1. Type of option issued

2. Event on which such option is granted or exercised

3. The time of resigning

ESOPs are taxed at 2 instances in the hands of employee –

1. At the time of exercise – as a perquisite.

2. At the time of sale by an employee – as a capital gain 

Exercise price <Perquisite> FMV on exercise date <capital gains>sale price

At the time of exercise – as a perquisite- when shares are allotted to the employee after he has exercised his option on completion of the vesting period

– When the employee has exercised the option — the difference between the FMV on exercise date and exercise price is taxed as perquisite employees as per Section 17 of the Income Tax Act, 1961.

– The employer (i.e., Start-up) is liable to deduct TDS on this perquisite depending on the tax bracket in which the employee falls, and deposit the same with the government before the 7th of the next month.

– This amount is shown in the employee’s Form 16 and included as part of the total income of Salary in the tax return.

At the time of sale by an employee – as a capital gain when the employee opts to sell the allotted shares under the ESOP. 

-When an employee sells his ‘exercised shares,’ he will have to pay capital gains tax on the profit that he makes from the share sale.

-The difference between the sale price and FMV on the exercise date is taxed as capital Gain.

Here capital gain would be the difference between sale consideration and cost of acquisition. Where “Cost of acquisition” would be a perquisite value plus amount actually paid by the employee.

Capital gains are of two types:

Tax implication on STCG: STCG arises when shares are sold within 24 months of exercising

Tax implication on LTCG: LTCG arises when shares are sold after 24 months of exercising. Rate of tax = 20% (after indexation of cost). Indexation cost is basically factoring in the Cost Inflation Index (CII)

Understanding ESOP Tax – An Example

Imagine Sakshi joined a start-up ‘Electro Solutions’ as one of the early employees in 2014. Upon joining, Sakshi was granted 10,000 ESOPs at an exercise price of INR60 per share. As per the policy, the option can be exercised at the end of 3 years i.e., in 2017 at an exercise price of INR60.

In 2017, Sakshi exercised her option.

The FMV of each share on the date of exercise is INR100

Further, in 2018, she decides to sell the shares @ 120 each.

Assume, she falls in the 30% tax bracket

Now, we will see how the ESOP Taxation will work:

The first level of taxation (when the option is exercised):

ESOPs would be taxed as perquisite, the value of which would be (on date of allotment) = (FMV per share – Exercise price per share) x number of shares allotted.

  • Perquisite = INR (100 – 60) X 10,000 = INR 400,000
  • TDS = 30% X Perquisite = INR 1.2 lakhs (applicable cess & surcharge will be extra)

The amount calculated above as perquisite value of ESOP i.e., INR4,00,000 shall form part of Sakshi’s salary and be taxable in the year of allotment of such shares. Employer (Start-up) is liable to deduct TDS on such amount.

The second level of taxation (when ESOPs are sold):

When Sakshi decides to sell the share in 2018, she would be liable to pay capital gain tax, which shall be calculated as follows:

Capital gains = Sale proceeds – FMV of shares at the time of allotment of shares

(120 – 100) x 10,000 = Rs. 200,000

Since the holding period of shares in the hands of Sakshi is less than 12 months (will be counted from the date of allotment), gains will be classified as Short-term Capital Gains and will be taxable as per the normal slab rates applicable on Sakshi.

India: Tax on ESOPs Deferred for Start-Ups: AMENDMENT MADE IN BUDGET 2020

The newly introduced deference of tax payment on ESOPs will help start-ups attract and retain high-quality employees.

In order to ease the burden of payment of taxes by the employees of the eligible start-ups or TDS by the start-up employer, Government deferred the payment of income tax on ESOPs from the time of exercise of ESOPs.

Now, the tax liability arises within 14 days from any of the following events, whichever is the earliest:

1. after the expiry of 48 months from the end of the relevant assessment year; or

2. from the date of the sale of such ESOP shares by the assessee; or

3. from the date of the taxpayer ceases to be an employee of the ESOP allotting employer.

Liability for deducting tax at source (TDS) on the start-up also stands deferred.

Eligible Startups (under Section 80-IAC) which satisfy these criteria cumulatively will be eligible for the deferred ESOP tax payment benefit.

The eligibility criteria are:

1. It is incorporated on or after the April 1st, 2016 but before April 1st, 2021

2. The total turnover of its business does not exceed twenty-five crore rupees in any of the previous years beginning on or after the April 1st, 2016 and ending on the March 31st, 2021

3. It holds a certificate of eligible business from the Inter-Ministerial Board of certification as notified in the Official Gazette by the Central Government.

The sore point however is that this benefit ceases when the employee decides to change jobs. This would mean that the employee has to pay from her pocket or allow the options to lapse. The problem remains for employees who decide to change jobs. But, overall, this is a welcome change.

WHEN TO ACCEPT ESOPs?

Few things to be kept in mind before accepting ESOPs from a start-up:

1. Understand the terms:

    • Number of Shares: The total number of options granted to an employee
    • Strike Price: The price the employee must pay to purchase each share at the time exercising the option
    • Vesting period: The period over when the options become wholly-owned and exercisable by the employee
    • Cliff Period: In this period vesting accrues, but the total effect of this vesting is realized after the cliff
    • Expiration Date: The last date on which the options may be exercised.

2. Scope of a start-up: To check on the viability of the idea, evaluate whether the company has a scope to stay in the market for a period of at least four years. It is important to know the scalability of the idea before accepting ESOPs from an early-stage start-up.

3. The uniqueness of its idea: To check if the Business Idea of the Start-up is validated and solves genuine problems.

4. Tax implications: These options are considered as a part of an employee’s perks and taxed accordingly

5. Awareness of Chances– Remember that you will be having ESOPs of a start-up and not a listed company. There are quite a few chances of cashing out till the company goes public. The acquisition would be beneficial, but that is again a chance-game. In case of acquisition, the stocks get transferred to the acquiring company and the ESOP holders will be allowed to encash a portion of their holdings.

6. Money matters: Although ESOPs aren’t really considered as a cost to the company (CTC), remember that you are sacrificing a part of your salary in the name of ESOP. Since you are not a direct owner, it is no harm to evaluate between the two options-a good CTC or CTC plus ESOPs. Take a step that you won’t repent for all the hard work you are going to offer.

7. Terms of employment: Read the terms carefully. When in doubt, clarify from a legal expert. Accepting ESOPs is like buying a lottery ticket. They are equal chances of both winning and losing. The excitement and scope that exists in a start-up job make it worth the risk.

Author Bio

Qualification: CA in Practice
Company: SAKSHI GOYALA & CO
Location: New Delhi, IN
Member Since: 10 Feb 2021 | Total Posts: 3

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