Employee Stock Option Plans, popularly known as ESOPs, is a concept introduced in India. It is used by companies as a scheme of selling shares to the employees by which they become a shareholder in the company and thus hold a certain small level in the ownership of the company.

ESOPs are given by the companies to the employees thereby, giving them the following rights:

• Right to purchase a certain number of shares in the company-at a pre-determined price after a predetermined period.
• It helps the employer to retain the company and assure a good level of performance in the work.

ESOPs serving a 2-fold purpose for both the company & the employee

ESOPs are generally awarded for performance or tenure of the employee with the company thus, it serves a two-fold purpose for both the company and the employees.

1. It acts as a tool of motivation for the employees for a basic reason that once they own a stock they feel responsible for performance of the company, as it determines the value of the stocks of the company. If the company performs well, the value of the stocks rises and vice-versa.
2.  It helps the employer to retain the company and assure a good level of performance in the work.

Employee stock option plans serving as a motivational tool for employees

These ESOPs are offered by the companies in parts and as per a schedule.

For instance, today an employee might get 4000 shares given in sets of 1000 or 500 shares over a period of time. A time period is given to the employee for exercising their right to purchase the shares. This time period of waiting is called a vesting period. The offer lapses if not exercised within the vesting period. This period is also known as the lock-in period.

Who Are Using ESOPs?

The scheme is mostly used by IT companies who were actually the first one to jump into the bandwagon when the concept was introduced in India. But now, other sectors including the core sectors, such as steel have realized the potential that ESOPs hold.

As per a survey,

• While around 43% of the IT companies have given ESOPs to more than 90% of the employees, only 17% of the Non-IT companies have done so.
•  More than 75% of the Non-IT companies offer ESOPs only to the senior and middle management employees.

As per this survey of 2001, it is however revealed that-

Within the IT companies, while only 23% of the large companies offer ESOPs to more than 90% of the employees, the number is as high as 60% in case of smaller companies.

• A significant 54% of the large IT companies offer ESOPs to less than 25% of their employees.

Advantages of ESOPs

ESOPs provide advantages like:

• Aligning the interest of the managers with those of the owners.
• It is a non-cash compensation tool to compete for the best human resources.
• It gives an opportunity to corporate to pay without a reduction in book profits [ accounting advantage].
• Sense of Ownership and Belongingness amongst the Employees.
• Lower Attrition Rates.
• Boosted Morale of Employees.
• Greater Effort on the Part of Employees.
• More Equitable Distribution of Profits.

Basic Features and Types of ESOPs

The conventional stock option plans give the employees a choice or option to a fixed proportion of shares in the company or their employer.

However, it must be understood that- the employees are under no obligation to buy these fixed number of shares and they are free to reject the offer if they wish to.

These offers vest over a period to an employee subject to fulfillment of certain conditions such as-

• continued employment for a specified period or
• there can be performance based plans wherein the employee has to meet certain level of performance as laid down by the Company.

When it comes to classifying the ESOPs, it can be divided under two categories, namely:

• Non-Compensatory Plan
• Compensatory Plan

Non-Compensatory Plan

It is the one under which the employees do not get compensation. The basic purpose of such plan is to either diversify ownership to include the employees or to raise additional capital for the Company.

Under a non-compensatory plan the shares can be in future at the market price on the date of exercise/vesting.

Compensatory Plan

Under this category, the employees are compensated. In other words, services rendered by the employees are partially compensated for the issuance of shares of a certain value.

Companies use these kind of plans to motivate the employees. Compensatory plans are particularly useful for the fast growing knowledge-based companies that usually do not pay large salaries to the employees.

Various Stock Options Schemes Available

• Employee Stock Option Scheme (ESOS)

An Employee Stock Option Scheme or ESOS is a right to buy shares at a pre-determined price. The option provided under this scheme confers a right but not an obligation on the employee. Stock options are subject to vesting that requires continued service over a specified period of time.

Upon vesting of options, employees can exercise the options to get shares by paying the pre-determined exercise price.

• Employee Stock Purchase Plan (ESPP)

An ESPP provides the employees an option to purchase company shares often at a discount on FMV (fair market value) at grant or on exercise.

The plan term determines the date and price at which the employee is entitled to purchase company stock.

• Stock Appreciation Right (SAR)/Phantom Equity Plan (PEP)

Under SAR/PEP, the employees are allotted notional shares/units at a pre-determined price.

When the employee fulfills the vesting conditions, he is paid cash equivalent to the net gain i.e. appreciation in the price of underlying shares without any cash investment.

These plans generally result in cash outflow for the company.

• Restricted Stock Award (RSA)

Under RSA, an employee receives an award of stock, subject to certain underlying conditions.

If the underlying conditions are not met, the shares are forfeited.

The employee is considered to be the owner of the shares from the date of award, along with an entitlement to receive dividends and the voting rights.

The forfeiture conditions may be based on continued service over a specified period of time. The employee may be required to pay for RSA at grant which may be at a discount or more. It is usually awarded the stock at no cost.

• Restricted Stock Unit (RSU)

Under RSU, an employee is awarded an entitlement to receive stock at some specified date in the future, subject to certain conditions.

These conditions may relate to performance or tenure of employment. Until shares are actually delivered, the employee is not a shareholder and does not have voting rights or rights to receive dividends.

It is important to note that –

RSU is not an immediate transfer of shares,subject to forfeiture, but a promise to give shares in the future. RSUs are generally entitled to quasi-dividends.

REGULATORY FRAMEWORK IN INDIA

The Companies Act, 1956,  defines the Sweat Equity Shares under Sec. 79, which states-

Notwithstanding anything contained in the Section 79, a company may issue sweat equity shares of a class of shares already issued, if the following conditions are fulfilled:

• The issue of sweat equity shares is authorized by a special resolution passed by the company in the general meeting.
• The resolution specifies- the current market price, the number of shares, consideration, if any, and the class or classes of the employees, or directors to whom such equity shares are to be issued.
• Not less than one year has passed since the day on which the company was entitled to commence the business.
• The sweat equity share of a company, whose shares are listed on a recognized stock exchange, are to be issued according the guidelines issued by SEBI.

Under the Companies Act, 2013 Sweat Equity Shares‘ (given by Company to employees or director), the conditions to be followed for issuing sweat equity shares are provided under Sec. 54, which states-

• A special resolution (3/4th majority) is required to be passed in a general meeting.
• Limit on quantum of issue– Company cannot issue sweat equity shares for more than 15% of existing paid up equity share capital in a year or shares of the issue value of Rs. 5 crores, whichever is higher. Further, issuance of these shares in the Company shall not exceed 25% of paid up equity capital of company at anytime.
• These shares are to be valued at a price determined by a registered valuer as the fair price, giving justification to such valuation.
• Copy of valuation is to be sent to shareholders along with the notice of the general meeting.
• Accounting treatment- The consideration for these shares can be both in cash and non-cash form.

Cash / Non-Cash Consideration of Shares

Where the consideration is non-cash, on the basis of a valuation report from registered valuer, such non-cash consideration shall be treated in the following manner in the books of accounts of the company:

• Where non-cash consideration takes the form of a depreciable or amortizable asset, it shall be carried to the balance sheet of the company.

In case the above clause is not applicable, it shall be expensed off as provided in the accounting standards.

In respect of sweat equity shares issued during an accounting period, the accounting value of the shares shall be treated as a form of compensation to the employee or the director in the financial statements of the company.

• Register of sweat equity shares- the company has to maintain a register of Sweat Equity Shares in Form No. 4.3 and has to record the particulars of the shares issued under Sec. 54.
• At least 1 year should have elapsed since the commencement date of the business as on the date of issue of the sweat equity shares.
• Lock In– the shares issued shall be subject to a lock in period of 3 years and this fact needs to be stated boldly in the share certificates.

Guidelines issued in 1999 regarding ESOPs

There are no specific directions issued by the Institute of Chartered Accountants of India (ICAI) with regard to ESOPs in India. The guidelines issued by the Securities and Exchange Board of India (SEBI) in the year 1999 are the guiding principles.

These guidelines govern the legal requirements and accounting practices to be followed under ESOPs. Though a Guidance Note was issued by ICAI in the year 2003, as per the professional ethics requirement of the ICAI, the requirements of the guidance note are not mandatory for compliance, and such a note only indicate guidance on any accounting matter to the preparers and auditors of the financial statement.

As such, in practice, the Indian Companies rarely follow the requirements given under the Guidance Note.

Under such circumstances, the guidelines issued by SEBI in 1999 act as the source of regulation, which are –

• It requires a mandatory disclosure of the disclosure of impacts on profits for not following the fair value approach.
• It provides  a detailed disclosure rules for Director’s Report and the financial statement i.e. Amortization of compensation costs over the vesting period on straight line basis and a detailed disclosure of option statistics regarding grant, vesting and exercise.
•  The requirements laid down by the SEBI are applicable on all stock option schemes established on or after June, 1999. Thus, the prior schemes are out of the purview of these guidelines.

SEBI Guidelines went under Amendment in the year 2002 and 2003 and now the amended guidelines provide for a detailed disclosure of stock option compensation expenses computed by applying fair value method and also the impact of non-recognition of fair value compensation cost on basic and diluted EPS.

New Regulations

Recently, in the year 2013 SEBI restricted the scope of the application of ESOPs by limiting listed Companies from acquiring their own shares from secondary market.

The concern was that the framing & administration of such schemes through fraudulent practices led to inflation, depression or fluctuations in the price of the securities.

Subsequently, same year in the month of November, SEBI issued a discussion paper to review the ESOP Guidelines. There was a proposal to replace the ESOP Guidelines with a set of regulations in order to ensure better enforce ability, to provide for a regulatory framework for all kinds of employee benefit schemes, involving securities of the company- to address the concerns raised with reference to composition of employee welfare trusts, disclosures, etc. and to enable secondary market transactions with adequate safeguards.

The proposal was accepted in the Board meeting of SEBI held in June, 2014 and accordingly SEBI issued new ESOPs Regulation on 28th October, 2014.

Applicability of New Regulations

The new regulations are applicable to all the schemes listed as follows:

1. Employee Stock Option Schemes (ESOS)
2. Employee Stock Purchase Schemes (ESPS)
3. Stock Appreciation Rights Schemes (SAR)
4. General Employee Benefits Schemes (GEBS)
5. Retirement Benefit Schemes (RBS)

The provisions of the new regulations are applicable to every listed Company in India which has schemes for the following purposes:

• For direct or indirect benefit of employees.
• For dealing with or subscribe to or the purchase of securities of the company, directly or indirectly.
• For satisfying, directly or indirectly, any one of the following conditions:
  • scheme is set up by the company or any other company in its group
  • scheme is funded or guaranteed by the company or any other company in its group
  • scheme is controlled or managed by the company or any other company in its group

The term ‘group’ has been used in the provisions as a part of the company.

It has been defined as two or more companies which, either directly or indirectly, are capable or are in a position to exercise 26% or more voting rights in any other company, or to appoint 50% or more members in the Board of Directors in the other company or control the management or affairs of the other company.

Further, several new definitions and amendments have been added –

‘Employee’ is now defined in line with the definition of ‘employee’ provided under the Companies (Share Capital and Debenture) Rules, 2014. i.e. it excludes directors and employees of an associate Company are included in the purview of this term.

Definition of ‘market price’ is amended & it means:

Latest available closing price on a recognised stock exchange on which the shares of the company are listed on the date immediately prior to the ‘relevant date’.

‘Relevant date’ is the date of the meeting of the compensation committee on which the grant is made (for grant) or the date on which the notice of exercise is given to the company or to the trust by the employee (for exercise).

‘Secondary acquisition’ is defined to mean acquisition of existing shares of the company by the trust on a recognised stock exchange for cash consideration.

A company is free to implement scheme either directly or by the way of setting up an irrevocable trust. Additionally, there are limits prescribed, such as in a financial year the Secondary acquisition by the trust shall not be more than 2% of the paid up equity capital of the company as at the end of the previous financial year. Also, the total number of shares under secondary acquisition held by the trust shall be within the following prescribed limits:

Serial No	Particulars	Limits
1	For ESOS, ESPS or SAR	5%
2	GEBS or RBS	2%
3	All schemes in aggregate	5%

 

TAXATION

Taxation of ESOPs in India has witnessed continuous changes. Until the financial year-ending March 1999, there were no specific guidelines for taxing the benefits arising from ESOPs. The ESOPs were usually taxed as a perquisite in the hands of the employees on the difference between the FMV of the stock on the date of vesting of the options and the exercise price. Subsequently, there was a concessional tax treatment for ESOPs, which were designed in accordance with the prescribed ESOPs Guidelines. The taxation is initiated only at the time of sale of the shares for such qualified ESOPs.

ESOPs falling in unqualified category were taxable as a perquisite on the difference between the Fair Market Value (FMV) on the date of vesting/exercise and the exercise price.

During the period of April 2007 to March 2009, employer was required to pay a Fringe Benefit Tax (FBT) on benefit derived by employee from ESOPs. The employer was free to recover such FBT from the employees. Currently, ESOPs benefits are taxable as perquisite and are included in the salary of the employees as a part of it. The employer is required to withhold tax at source in respect of such perquisite. The value of the perquisite is computed as the difference between the FMV of the share on the date of exercise and the exercise price. The employer is also required to deduct the TDS in respect of such perquisite.

Specific valuation rules have been prescribed for listed and unlisted companies.

Unlisted companies need to determine the FMV by a Category I Merchant Banker registered with SEBI. The incremental gain i.e. the difference between sale consideration and the FMV on the date of exercise, on sale of shares is regarded as a capital gain for the employee. For computing capital gains, the FMV on the date of exercise becomes the cost base.

At the Time of Sale of ESOPs by Employee

The gains that arise out of the sale of ESOPs are considered as Capital Gains and thus, the Capital Gains Tax is levied on ESOPs and it is to be paid in the year in which such sale has been made. Capital Gain is computed as the difference between the price at which the ESOPs are sold by the employee and the price at which it was awarded by the Employer.

Further, the Capital Gains treatment depends upon the holding period of the ESOPs. For instance, if such shares are held for a period of less than 12 months or on year, the Short Term Capital Gains Tax@15% is levied and if such shares are held for more than 12 months, the Long Term Capital Gains Tax is levied. This Long Term Capital Gains tax is currently NIL. In other words, if the employee sells his shares given to him through ESOPs, the sale is effectively exempt from Tax.

That’s all about ESOPs ( Employee stock option plans) for now. Did you find this post useful? Let us know in the comments section. Don’t forget to Share!

 

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