Employee Stock Option (ESOP) and
Sweat Equity (SE) are new tools, which are in use by a lot of multinational
companies and consulting companies coming to India and engaging the real brain
of Indian professionals who are offered ESOP/SE by such companies as an
incentive to them. In absence of any set law or precedent about its legality,
taxation and accounting, a great deal of confusion is prevailing and an attempt
is made to resolve the same.
Why ESOP or SE ?
The employee stock option plan
is a good management tool for retention of human talent and guarding against
poaching of staff of a running organisa-tion by a rival company.
When a company is newly formed
or starts a new line of business, the company engages the best executives and
employees available, who bring in their IPR (Intellectual Property Rights) and
know-how, skill and expertise with them, which make a value addition for the
company. Certain key professionals would like to invest in the company’s
capital and would like to risk their own contribution to the capital of the
company along with their own IPR, know-how, skill and expertise. Such employees
would like to be a strategic part of the promoter group and would like to make
value addition to their capital invested in the company. Such an employee is
awarded with Sweat Equity as an incentive to join the
As the company grows, the
management would like to see that all its core management team remains with them
and further, such core management team is given additional incentive as a reward
for the efforts put in by them in managing the company. Such employees are
offered ESOP at a price which is less than the real value of the share.
Companies Act, 1956 :
Sweat equity :
1. Issue of sweat equity shares
is governed by the provisions of S. 79A of the Companies Act. Explanation II to
the said Section defines the expression ‘sweat equity shares’ to mean equity
shares issued by the company to employees or directors at a discount or for
consideration other than cash for providing the know-how or making available
rights in the nature of intellectual property rights or value additions, by
whatever name called. It is, therefore, necessary for the issue of sweat equity
shares that the concerned employee either provides the know-how, intellectual
property rights or other value additions to the company.
2. In terms of the said Section,
a company may issue sweat equity shares of a class of shares already issued, if
the following conditions are satisfied :
(a) such issue is authorised
by a special resolution of the company in the general meeting;
(b) such resolution specifies
the number of shares, current market price, consideration, if any, and the
class or classes of the directors or employees to whom such shares are to be
(c) such issue is after expiry
of one year from the date on which the company was entitled to commence
(d) in the case of an unlisted
company, such shares are issued in accordance with the prescribed guidelines.
3. The guidelines referred to in
S. 79A are the Rules issued by the Central Government, which need to be followed
by unlisted companies. The Rules inter alia provide the procedure to be
followed by a company issuing sweat equity shares for consideration other than
cash. Rule 9 of the Rules provides that where a company proposes to issue sweat
equity shares for consideration other than cash, it shall comply with the
(a) the valuation of the
intellectual property or of the know-how provided or other value addition to
consideration at which sweat equity capital is issued, shall be carried out by
(b) the valuer shall consult
such experts, as he may deem fit, having regard to the nature of the industry
and the nature of the property or the value addition;
(c) the valuer shall submit a
valuation report to the company giving justification for the valuation;
(d) a copy of the valuation
report of the valuer must be sent to the shareholders with the notice of the
(e) the company shall give
justification for issue of sweat equity shares for consideration other than
cash, which shall form part of the notice sent for the general meeting; and
(f) the amount of sweat equity
shares issued shall be treated as part of managerial remuneration for the
purposes of S. 198, S. 309, S. 310, S. 311 and S. 387 of the Act, if the
following conditions are fulfilled :
(i) the sweat equity shares
are issued to any director or manager;
(ii) they are issued for
non-cash consideration, which does not take the form of an asset which can
be carried to the balance sheet of the company, in accordance with the
relevant accounting standards.
4. Rule 8 of the Rules
prescribes that the issue of sweat equity shares to employees and directors
shall be at a fair price calculated by an independent valuer.
5. Rule 2(v) of the Rules
defines the expression ‘value addition’. The said Rule reads as under :
"(v) ‘value addition’
means anticipated economic benefits derived by the enterprise from an expert
and/or professional for providing the know-how or making avail-able
rights in the nature of intellectual property rights, by such person to whom
sweat equity is issued for which the consideration is not paid or included
(a) the normal
remuneration payable under the con-tract of employment, in
the case of an employee, and/or
(b) monetary consideration
payable under any other contract, in the case of non-employee."
The term ‘know-how’ is not
restricted to technical know-how but can extend to practical knowledge, skill
and expertise. Hence, imparting practical
knowledge to the company would be considered as value
6. Rule 6 of the Rules restricts
the issue of sweat equity shares in a year to 15% of the total paid-up equity
share capital or shares of a value up to Rs.5,00,00,000/- (Rupees five crores only), whichever
is higher. If this limit is to be exceeded, the same is required to be done with
the prior approval of the Central Government.
7. For issue of sweat equity
shares, the following broad procedure needs to be followed :
(i) Convene and hold a board
meeting to consider the proposal of issue of sweat equity shares and to fix up
the date, time, place and agenda for general meeting and to pass a special
resolution for the same;
(ii) Issue notices in writing
for general meeting with suitable explanatory statement containing the
particulars required as per Rule 4 of the Rules;
(iii) Pass a special
(iv) Allot sweat equity
Employee Stock Option
S. 81 read with various SEBI
Guidelines speaks about ESOP. As per the SEBI Guidelines, promoters and
directors cannot be offered ESOP. Further, ESOP should not exceed 5% of post
issue capital of the company.
Income-tax Act, 1961 :
The relevant Sections, relating
to ESOP or SE are 17(2), 47(iii), 48 & 49(2AA).
1. Salary & perquisite :
S. 17(1) of the Income-tax Act, 1961 contains an inclusive definition of ‘Salary’
which includes inter alia ‘any fees, commissions, perquisites or
profits in lieu of or in addition to any salary or wages’.
The ESOP availed or SE received
by an employee would not amount to salary, fee, commission or profit in lieu of
salary. At the maximum, it can be argued to be a ‘perquisite’.
S. 17(2) contains an inclusive
definition of the term ‘perquisite’, and sub-clause (iii) thereof states
that the term includes the value of any benefit or amenity granted or provided
free of cost or at a concessional rate by an employer (including a company) to
an employee to whom the provisions of paragraphs (a) and (b) of this sub-clause
do not apply and whose income under the head ‘Salaries’ (whether due from,
or paid or allowed by, one or more employers), exclusive of the value of all
benefits or amenities not provided for by way of monetary payment, exceeds fifty
The proviso below the above
clause reads as under :
"Provided that nothing in
this sub-clause shall apply to the value of any benefit provided by a company
free of cost or at a concessional rate to its employees by way of allotment of
shares, debentures or warrants directly or indirectly under any Employees
Stock Option Plan or Scheme of the company offered to such employees in
accordance with the guidelines issued in this behalf by the Central
The Central Government issued
the ‘guidelines’ referred to in the proviso above by Notification No.
323/2001 (R.No. 142/48/2001-TPL) dated October 11, 2001, effective from April 1,
2000, which enumerates the various aspects that ought to be included in any
Employees Stock Option Plan or Scheme. The guidelines, inter alia,
provide for the following :
Para 2 of the ‘Guidelines’
specifies the conditions which are to be incorporated in the Option Plan or
Scheme, and the proviso which follows the said para, reads as follows :
"Provided that the
conditions contained in the written document shall not be changed after the
date the scheme or plan comes into effect".
Para 2 of the Guidelines states
that the plan or scheme shall be as per the SEBI Guidelines.
Para 4 of the Guidelines states
that it applies to both listed and unlisted companies which are defined in S.
2(17) of the Act.
Para 5 of the Guidelines states
that a person holding more than 10% of the shares in a company would not be
eligible to participate in employee stock option plan or scheme of the company.
Further, para 6 of the
guidelines reads as follows :
"Every company issuing
shares directly or through its parent under an Employees Stock Option Plan or
Scheme to its employees shall furnish a copy of the document describing the
particulars as specified in clause (2) above to the Chief Commissioner of
Income Tax having jurisdiction over it within a period of 6 months from the
date of issue of these guidelines or within 6 months of the effective date of
the scheme or plan, whichever is later. If the Plan or Scheme is incorporated
in any language other than English, an English translation of the same should
also be enclosed".
The foregoing is summarised as
The perquisite value which
arises out of issuance of stocks under an Employees Stock Option Plan or Scheme
shall not be taxed, if
(a) the Plan or Scheme
conforms to the ‘Guidelines’.
(b) a copy of the Plan or
Scheme is furnished to the Commissioner of Income tax having jurisdiction over
(c) the conditions contained
in the Plan or Scheme are not ‘changed’.
Note that the ESOP Plan or
Scheme needs no ‘approval’ of the authority. Mere ‘furnishing’ of the
Plan or Scheme is sufficient compliance with the ‘Guidelines’.
2. S. 47 lists transactions not
regarded as transfer, but the proviso to clause (iii) of the section, specifies
that the transfer of a capital asset in the form of ESOP, when transferred under
a gift or will, shall attract capital gain. Such transfers are excluded from the
exemption granted by the substantive portion of the clause. Additionally, the
4th proviso to S. 48, read with the proviso to S. 47(iii), specifies that if
ESOP are gifted, the market value on the date of the gift, would be considered
as the sale price on which the transfer of the ESOP would be taxed.
3. S. 49(2AA) specifies that
where the capital gain arises from the transfer of the shares, the value of
which has been taken into account while computing the value of perquisite under
clause (2) of S. 17, the cost of acquisition of such shares shall be the value
under that clause.
1. Any payment to an employee is
accounted as per Accounting Standard 15 issued by ICAI. The present AS 15 ‘employee
benefits’ does not speak of accounting for ESOP or SE. The same is under
revision and an exposure draft is published. However, even the exposure draft
excludes employee share-based payments. The accounting for such benefit is being
dealt with in the guidance note on accounting for employee share-based payments,
under issue by the Institute of Chartered Accountants of India. In view of this,
the accounting for ESOP or SE when
(a) issued at par (at face
value) i.e. the face value of the share is fully received in cash from
the employee. In this case the accounting is simple.
Bank/Cash a/c debit and credit
share capital a/c.
(b) Issued at premium i.e.
the share is issued at a price above the face value, and the premium and face
value of share is paid in cash by the employee. Again in this case the
accounting is simple.
Bank/Cash a/c debit and credit
share premium a/c and credit share capital a/c.
(c) Issued at discount i.e. under
ESOP or SE, the share is issued to the employee below the face value. As per
the Companies Act, the shares cannot be issued at discount and thus the
controversy would start about the accounting of amount between face value and
the amount received from employee. To explain it in a simple language, when a
share of face value of Rs.100/- is issued to an employee at Rs.10/-, how the
difference of Rs.90/- would be accounted in the books of account of the
company, in absence of any accounting standard or guidance note published by
ICAI. As explained above, basically ESOP or SE given to an employee is an
incentive to the employee i.e. the employee would stand to benefit by
getting a share at a discounted price. In case of quoted company, when a share
is quoting above par, say, if share of Rs.100/- is quoting at Rs.500/- and
ESOP/SE is granted at Rs.200/- (subject to SEBI Regulations), the employee
gets a share worth Rs.500/- at Rs.200/- and such ESOP/SE works as an incentive
to him. By such ESOP even the company stands benefited i.e. the
employee remains with the company for longer period and thus becomes a
valuable asset in the organisation. However, the controversy starts when a
quoted share, say, of face value of Rs.100/- and quoting at say Rs.150/- is
issued as ESOP/SE to an employee at Rs.50/- by way of incentive, how the 50
Rupees i.e. difference between face value and issue price of ESOP is to
be accounted. An argument can be advanced, that since the company has received
an amount lesser than face value of equity share for giving benefit to its
employee, it should be treated as a revenue expenditure under any name called,
say ‘employee benefit account’ and accordingly, it is suggested that the
accounting be made as below.
Bank/Cash a/c debit
Employee benefit a/c debit
To Share capital a/c credit.
However, Mr. Hargovind,
retired member ITAT, in one of his article on the subject opined that as per the
SEBI Guidelines, the amount discounted is to be accounted as employee
compensation. It has to be amortised over a period of time. However, the learned
author further opined that the issue of amortisation can be finally resolved by
a specific provision in the Act; thus the issue is a debatable matter and not
free from doubt.
In view of the various rules and
notifications both under the Companies Act and under the Income-tax Act, a
proper blending of Companies Act, Income-tax Act and Accounting for maximum
benefit, both to the employer and to the employee is desired.
Under the Companies Act, ESOP
and SE are separately defined and considered separately in S. 81 and S. 79A,
The Income-tax Act defines only
the ESOP and is absolutely silent on SE. However, on reading of S. 17(2), one
would notice that ESOP includes shares issued to employees free of cost. Thus it
can be concluded that under the Income-tax Act, ESOP and SE are the same, though
distinguished under the Companies Act.
When ESOP or SE is issued at
lesser than the face value, as explained in para ‘c’ under ‘Accounting’,
the employer company can claim the difference as revenue expenditure
and reduce its total tax liability. If the ESOP or SE is issued before the
commencement of business, the expenditure would be considered as of enduring
nature incurred before starting the main line of activity and might be treated
as part of pre-operative expenses and could be amortised over a period of 5
In the hands of the employee at
the time of exercising the option for ESOP or receipt of SE, as mentioned above
under Income tax, the same would not, under the proviso to S. 17(2)(iii)(c),
amount to a taxable perquisite and would be taxed only at the time of encashment
of shares received under ESOP or SE. Even such receipt, at the time of
encashment of such share, would amount to a capital receipt taxable as a capital
gain as per the period of holding of such share. In case it is a long-term
capital gain, the benefit of the three Sections, S. 54EC to S. 54F would be
available to the employee.
I thank Shri Jal Dastur, Chartered Accountant
for giving me all the guidance for compiling this article and finally correcting