In this article, Vibhuti Kochhar, pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata discusses on Phantom Stock Options

Introduction

The recent startup revolution and boom in the e-commerce industry has given rise to immense competition and an array of job opportunities. Therefore, it has become essential for companies to not only offer high remuneration packages but also incentives to its employees, primarily key managerial personnel and senior management to retain them and not lose them to their competitors in the long run. Such incentives include employee stock option schemes and employee purchase plans, stock appreciation rights, general employee benefit schemes and retirement benefit schemes.

Employee Stock Options

ESOPs or Employee Stock Option Scheme involves granting the employees some ownership stake in the company for the creation of ownership attitudes amongst the employees and aligning their interest with those of the company and its shareholders. These act as great motivators and can get employees highly involved in their jobs and focused on corporate performance. It is an imperative device to attract and retain quality employees and encouraging long-term attitudes in the employees.

Under a stock option plan, a company grants to an employee the right to buy a certain number of shares in the company at a fixed price for a certain number of years. The participating employees may purchase the stock at a discounted price.

Stock Appreciation Rights

Another way to curb attrition amongst employees is to offer Stock Appreciation Rights (SARs). These create a right to the increment in value of the company’s stock over a specified period of time. The employee makes no payment of a price for the share unlike in ESOPs. The right to appreciation is based on a specified number of shares of the company and the settlement of the appreciation right is either done through equity shares of the company or cash payment. The issue of SARs provides the employees with an impetus to work towards the growth of the company as their settlement is directly linked to the appreciation in the share price of the company.

Phantom Stock Options

Phantom Stock Options are those units of SARs that are settled by way of cash settlement. These options are based on the performance of the employees and are basically incentive plans through which the employee would receive a cash settlement after a specified period of time or on reaching a specified target. The value of the settlement is linked to the value of the share price. Therefore, if the share prices are high the employee is likely to get a high cash payment. Issuing of phantom stocks is a preferred means of incentivizing employees on the basis of the share price if the company does not wish to actually share equity with the employee and give up control of the company for under such a scheme the stock is never actually owned by the employee.

Basically, phantom stocks are a promise to pay a bonus to the employee proportionate to either the value of the shares or the increase in the value over a specified period of time.

Types of Phantom Stock Options

Phantom Stock Options can be of two kinds:

• Appreciation only
• Fully paid

Appreciation Only

When a phantom stock offered to an employee in appreciation only, the participants would not receive the cash settlement based on the current value of the shares but only the appreciated value. This means that they receive the difference between the value the phantom stock was worth when it was granted and the current value of the stock.

Full Value

Full value phantom stock pays exactly out what the stock is worth at the time of the cash settlement of the stock.

How does a Phantom Stock Plan Work?

In order to issue phantom stock to its employees, the company would enter into an agreement with the participant employees. The terms of the plan are given in the agreement. Conforming to the terms of the plan, the company would grant a number of units of shares or phantom stocks to the participating employees for a specified period of time. The agreement states the starting value of the shares as well as the other conditions of the plan like the vesting schedule, the payment events, dividend if applicable etc.

Once the terms of the plan are fulfilled, the employees become eligible to exchange their units of phantom stock for cash payment. The amount of the cash settlement is dependent on:

1. the number of vested units they hold,
2. the value of the units at the time of payment, and
3. whether the plan was for the full value of their units or strictly the appreciation in the value from the date of grant.

For example, an employee received 20 phantom shares with an initial value of Rs. 100, and the shares value on the payment date at Rs. 150. At the date of the payment, the employee would receive Rs. 3000 under a full value plan and Rs. 1000 under an appreciation only plan.

The payment of a phantom share is treated like a bonus and is usually redeemed in cash. It requires a formal agreement that determines the terms of plan and conditions of payment.

Legal Framework

The Companies Act, 2013 has prescribed rules for the issuance of ESOPS but it does not mention anything with regard to phantom stock. The applicability of SEBI (Share-Based Employee Benefits) Regulations, 2014 to Phantom Stock has been clarified in an informal guidance raised by Mindtree Limited.

The informal guidance by SEBI clearly states that for an employee benefit scheme to be covered under the SBEB Regulations, the scheme should actually involve “dealing in or subscribing to or purchasing securities of the company directly or indirectly”. However, Phantom Stock Scheme does not involve any actual purchase or sale of equity shares. Thus the SBEB Regulations are not applicable on Phantom Stock Schemes.

Tax and Accounting

On the exercise of Phantom Stock Options once the conditions of the plan are fulfilled the cash settlement received by the employee is treated as salary income in the form of perquisites of the employee. The company is liable to deduct tax at source before making the payment of the cash entitlement to the employee. The company is to make provisions for the cash required for the entitlement based on fair market value at the end of each financial year until the exercise of the Phantom Stock Options.

Phantom Stock Options in Partnerships and LLP

Since partnerships and LLPs do have equity shares and common stock they cannot issue phantom stock per se to the partners. However, partnership firms can exercise plans that are much alike to phantom stock but in this case, the value of the phantom stock unit would not be linked to the value of the common equity stock, rather it is linked to the partnership equity value. Other than this all aspects of the plan would remain the same and the entitlement received on the exercise of the stock would be treated as salary income. For the reason, that phantom stock is not actual equity stock in the partnership but the only way to incentivize by issuing hypothetical stock and is settled in cash and not equity the question of whether the partners are considered employees should be irrelevant here.

Advantages of Phantom Stock Options

Phantom Stock is usually preferred over Employee Stock Options by companies since it is a means of sharing the profits of the company without actually parting with the voting rights and giving equity to the employee. The employee is never actually the owner of the stock. As asserted before it basically like a cash bonus only it gives the employee the impetus to work harder towards the common goal of raising the value of the phantom stock unit as it is directly linked to the amount of the settlement he shall receive on the exercise of the stock. The higher the value of the shares, the higher the settlement he shall receive.

Thus, the following are the advantages of phantom stock:

• No voting rights – Phantom stock is never owned by the employees, therefore, they do not have voting rights in the company. Thus, the key decisions of the company remain with the management.
• Invested employees – Even though the employees do not have voting rights, they remain invested in the growth of the company as the cash settlement they receive on the exercise of the option depends on the appreciated value of the shares. The higher the appreciation, higher is their entitlement.
• Flexible– Since the phantom stock scheme does not actually deal in purchasing or subscribing shares, this option can be used by companies owned privately, publically, even partnerships and LLPs.
• Less complications- Phantom stock is only paid to the employees if the terms of the plan are met, which may be meeting of specific targets or appreciating the value of the stock over a specified period of time. If the terms of the plan are not fulfilled the employer is under no obligation to pay out the entitlement. In case the employee leaves the company before the meeting of the terms, the phantom stock would disappear. As compared to ESOPs where the right to the options vests in the employee even after he leaves the company, phantom stocks are less complicated.
• No taxes owed till the stock matures– Unlike equity shares held by the employees for a specific period of time that are taxable income on the company for the entire term, phantom stock is only taxed once the stock matures and the cash settlement is paid to the employee. Even then it is taxed as perquisites under the salary income head.
• Less Expensive– As compared to ESOPs, Phantom Stock is much less expensive as it is paid out as a cash bonus.

Even though the phantom stock is highly advantageous and globally a popular practice, it has not evolved as a practice in India. Employees usually prefer ESOPs as it gives them a stake in the company thus, a higher impetus to be involved in the company’s growth. With the growing start-up revolution, most companies go through the conventional method issuing ESOPs as a motivator for its key employees to ensure their long-term loyalties to the company and curb attrition. However, Phantom stocks would serve to be highly advantageous if the company chooses to employ this method rather than ESOPs as it would preserve the ownership and the decision making power of the company.

References

Bushman, A., 2017. RSM. [Online] Available at: https://rsmus.com/what-we-do/services/tax/lead-tax/9-frequently-asked-questions-about-phantom-stock-plans.html
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Sanjanwala, P., Mehta, N. & Kashmira, B., 2016. Economic Times. [Online] Available at: https://economictimes.indiatimes.com/small-biz/legal/can-phantom-stock-option-be-the-best-way-to-incentivize-employees/articleshow/52119814.cms
[Accessed 28 May 2018].

Shenoy, S., 2017. Novo Juris. [Online] Available at: https://novojuris.com/2017/05/09/phantom-stock-options/
[Accessed 28 May 2018].

Somayajula, D., 2018. IndiaCorpLaw. [Online] Available at: https://indiacorplaw.in/2018/04/sebi-regulation-phantom-stock-options.html
[Accessed 28 May 2018].