Employees Stock Options And Ownership Plans (ESOPs)

1. Meaning

ESOPs refer to various schemes by a company, offering an equity stake or ownership linked incentives to its employees. The stake may be in various forms such as allotment of shares, grant of stock options, etc. that entitle an employee to acquire shares in the future, or simply by way of rewarding him based on the appreciation in the value of the shares.

2. Objectives and benefits

The objectives may vary from the circumstances and requirements of each case and may include any of the following:

• To attract talent for the business of the Company;
• To retain and motivate the employees;
• To provide wealth creation opportunities
• Reward for past performance;
• Partial avoidance of immediate cash outflow for the company on account of salary;
• To align the interest of the employees with the shareholders and the Company

3. Explanation of some commonly preferred ESOPs

Under Stock Option Schemes, the company grants an option to employees, subject tofilment of certain conditions linked to continued employment or fulfilment of performance conditions, to apply for the shares of the company during a specified period of time at a price that is either pre-determined or is to be determined at an agreed formula.

Under Share Purchase Schemes (ESPS), the company offers shares to employees which are allotted against payment of offer price and are subject to certain lock in conditions.

Under a scheme of Stock Appreciation Rights or Phantom Equity Plan, employees are paid the appreciation in the price or value of the shares / notional units from the point of grant to the exercise date.

4. Aspects to be considered in the process of setting up and implementing an ESOPs scheme

4.1. Ensuring adequate reward linked with performance

4.2. Compliance with provisions of Companies Act, 2013

4.3. Compliance with Rules made under the Companies Act, 2013, in case of unlisted companies

4.4. Compliance with SEBI guidelines, in case of listed companies

4.5. Ensuring optimal tax treatment for employer and the employee

4.6. Compliance of exchange control regulations in case of cross border ESOPs

4.7. Proper accounting and disclosure

5. Companies Act

Sections 54 and 62(1)(b) of the Companies Act, 2013 (Act) enable the companies to issue sweat equity shares and ESOPs. Rule 8 and Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 specify rules in respect of issue of sweat equity shares 
and ESOPs respectively for companies other than listed companies.

Section 149(9) and section 197(7) of the Companies Act, 2013 state that an independent director is not entitled to any stock option.

6. Sweat Equity Shares:

Definitions: Sweat equity shares are defined to mean equity shares issued by a company to its directors or employees at a discount or for consideration, other than cash, for providing know-how, or making available rights in the nature of intellectual property rights or value addition, by whatever name called.

Employee is defined to mean:

• A permanent employee of the company, working in India or outside India for at least 1 year; or
• A director of the company, whether whole-time director or not; or
• An employee or a director as defined in sub-clause (a) or (b) above of a subsidiary, in India or outside India, or of a holding company of the company

The clause 8(10) of the Companies (Share Capital and Debentures) Rules, 2014 specifies that the amount of sweat equity shares issued shall be treated as part of managerial remuneration for the purposes of the Act, if the following conditions are fulfilled:

• The sweat equity shares are issued to any director or manager; and
• They are issued for consideration other than cash, which does not take the form of an asset which can be carried to the balance sheet of the company in accordance with the applicable accounting standards.

Issue of Shares for consideration other than cash

The following conditions are applicable where a company proposes to issue sweat equity shares for consideration other than cash:

• Valuation of the intellectual property or of the know-how provided or other value addition in respect of which 
  sweat equity capital is issued, has to be carried out by a valuer.
• The valuer is required to 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.
• The valuer is required to submit a valuation report to the company giving justification for the valuation.
• The copy of gist along with critical elements of the valuation report of the valuer is required to be 
  sent to the share holders with the notice of the general meeting.
• The company is required to give justification for issue of sweat equity shares, which shall form part of the notice sent for the general meeting.

7. Employee Stock Options:

Definitions: ESOs means the option given to the directors, officers or employees of a 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 predetermined price / pricing formula.

Employees are defined to mean:

• Permanent employees of the company who have been working in India or outside India; or
• A director of the company, whether a whole-time director or not but excluding an independent director; or
• An employee as defined above, of a subsidiary, in India or outside India, or of a holding company of the company but does not include:
• An employee who is a promoter or a person belonging to the promoter group; or
• A director who either himself or through his relative or through any body corporate, directly or indirectly, holds more than 10% outstanding equity shares of the company.

Disclosure in Director’s Report

Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014

Vide Notification No. LAD-NRO/GN/2014-15/16/1729 dated 28th October, 2014, the SEBI has notified (Share Based Employee Benefits) Regulations, 2014 (“SBEB Regulations”) to provide for regulation of all schemes by companies for the benefit of their employees involving dealing in shares, directly or indirectly, with a view to facilitate smooth operation of such schemes while preventing any possible manipulation and matters connected therewith or incidental thereto. SBEB Regulations are effective from the date of their publication in the Official Gazette. It replaces SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999.

8. Provisions of SBEB Regulations will be applicable to:

• Employee Stock Option Schemes [“ESOS”]
• Employee Stock Purchase Schemes [“ESPS”]
• SBEB Regulations are now also applicable to Stock Appreciation Rights Schemes [“SARS”]
• General Employee Benefits Schemes [“GEBS”]
• Retirement Benefit Schemes [“RBS”]

Provisions of SBEB Regulations will be applicable to any company whose shares are listed on any recognised stock exchange in India and has a scheme:

• For direct or indirect benefit of employees; and
  Involving dealing in or subscribing to or purchasing securities of the company, directly or indirectly; and
• Satisfying, directly or indirectly, any one of the following conditions:
• The scheme is set up by the company or any other company in its group;
• The scheme is funded or guaranteed by the company or any other company in its group;
• The scheme is controlled or managed by the company or any other company in its group.

SBEB Regulations will not be applicable to shares issued to employees on preferential allotment basis in compliance with SEBI (ICDR) Regulations 2009.

8.1. Implementation through Trusts

A company may implement the scheme either directly or through irrevocable trust(s). Scheme(s) involving secondary acquisition or gift or both have to be mandatorily implemented through trust(s). Implementation schemes through setting up irrevocable trust(s) has to decide upfront while taking approval of share holders for setting up the schemes.

Trust deed and any modifications thereto are mandatorily required to be filed with the stock exchange in India where the shares of the company are listed.

1. Trustees:Ineligibility: A person cannot be appointed as a trustee, if he – Is a director, KMP or promoter of the company or its holding, subsidiary or associate company or any relative of such director, KMP or promoter Beneficially holds 10% or more of the paid-up share capital of the company
2. Minimum number of trustees:2, if individuals or OPCs are trustees. Sole trustee is required, if corporate entity is trustee
3. Voting rights: Trustees not entitled to vote on the shares held by such trusts, to avoid any misuse
4. Restrictions on secondary acquisitions:
   • Not to deal in derivatives – undertake only delivery based transactions for the purpose of secondary acquisitions.
   • Secondary acquisition in a financial year by the trust not to exceed 2% of the paid-up equity capital as at the end of the previous financial year.
   • Total number of shares under secondary acquisition held by the trust not to exceed the following limits any time:

5. Sale / appropriation of secondary market acquisition:

The unappropriated inventory of shares not backed by grants, acquired through secondary acquisition by the trust under ESOS, ESPS or SARS is required to be appropriated within a reasonable period – not beyond the end of the subsequent financial year.

• If such trust(s) existing as on 28th October, 2014 are not able to appropriate the unappropriated inventory within 1 year,
• It has to be disclosed to the stock exchange(s) at the end of such period and then the same is required to be sold on the recognised stock exchange(s) where shares of the company are listed, within 5 years from the date of notification of SBEB Regulations
• The trust is required to hold the shares acquired through secondary acquisition for a minimum period of 6 months except where they are required to be transferred for participating in open offer under the SEBI Takeovers Regulations, 2011, or participating in buy-back, delisting or any other exit offered by the company generally to its share holders
• The trust is permitted to undertake off-market transfer of shares in the following circumstances only:
  • Transfer to the employees pursuant to scheme(s);
  • When participating in open offer under the SEBI Takeovers Regulations, 2011, or participating in buy-back, delisting or any other exit offered by the company generally to its share holders
• The trust cannot become a mechanism for trading in shares and can sell the shares in secondary market under the following circumstances only:
  • Cashless exercise of options under ESOS;
  • On vesting or exercise, as the case may be, of SAR under SARS;
  • In case of emergency for implementing the GEBS, RBS, after recording the reasons for sale, subject to utilisation of money realised within definite period as per the scheme or trust deed;
  • Participation in buy-back or open offers or delisting offers or any other exit offered by the company generally to its share holders, if required;
  • For repaying the loan, if the unappropriated inventory of shares held by the trust is not appropriated within the specified timeline;
  • Winding up of the scheme(s); and
  • Based on approval (relaxation) granted by SEBI to ESOS, ESPS, SARS for the reasons recorded in writing.
• The trust is subjected to the compliance and disclosures requirements as applicable to insiders or promoters under the SEBI (Prohibition of Insider Trading) Regulations, 1992.
• Shareholding of the trust to be disclosed as ‘non-promoter and non-public’ to the stock exchanges - It shall not form part of public shareholding which needs to be maintained at minimum 26%

6. Eligibility of employees:

An employee shall be eligible to participate in the schemes of the company as determined by the Compensation Committee.

If such an employee is a director nominated by an institution as its representative on the board of directors of the company, then specified compliances are required to be followed.

7. Compensation Committee

• A company has to constitute a Compensation Committee for administration and superintendence of the schemes. Any other committee fulfilling the applicable requirements (e.g. Nomination and Remuneration Committee) can be designated as Compensation Committee. If the scheme is being implemented through a trust, the compensation committee has to delegate administration of such schemes to trust(s).
• Composition: Compensation Committee be comprised of such board members as provide in section 178 of the Companies Act, 2013, that is, 3 or more non-executive directors out of which not less than half to be independent directors. While the Chairperson of the company (whether executive or non-executive) may be appointed as a member of the Nomination and Remuneration Committee but he cannot chair such Committee.
• Role: The Compensation Committee has to, inter alia, formulate the detailed terms and conditions of the schemes frame suitable policies and procedures to ensure that there is no violation of securities laws by the trust, the company and its employees, as applicable.
• Shareholders’ approval - No scheme can be offered to employees of a company unless the share holders of the company approve it by passing a special resolution in the general meeting, and the explanatory statement to the notice and the resolution proposed to be passed by share holders for the schemes shall include the specified information.
• Variation of terms of the schemes

The company may by special resolution in a general meeting vary the terms of the schemes offered pursuant to an earlier resolution of the general body but not yet exercised by the employee provided such variation is not prejudicial to the interests of the employees, unless variation is to meet the regulatory requirements.

Repricing: A company may reprice the options, SAR or shares, as the case may be which are not exercised, whether or not they have been vested if the schemes were rendered unattractive due to fall in the price of the shares in the stock market, if such repricing is not detrimental to the interest of the employees and approval of the share holders in general meeting has been obtained for such repricing.

8. Winding up of the schemes: In case of winding up of the schemes being implemented by a company through trust, the excess monies or shares remaining with the trust after meeting all the obligations, if any, has to be utilised for repayment of loan or by way of distribution to employees as recommended by the Compensation Committee.
9. Non-transferability

• Option, SAR or any other benefit granted to an employee under the regulations shall not be transferable to any person.
• No person other than the employee to whom the option, SAR or other benefit is granted, shall be entitled to the benefit arising out of such option, SAR, benefit etc. except for the following:
  • In case of ESOS or SAR, under cashless exercise, the company may itself fund or permit the empanelled stock brokers to fund the payment of exercise price which shall be adjusted against the sale proceeds of some or all the shares, subject to the provisions of the applicable law or regulations
• The option, SAR, or any other benefit granted to the employee cannot be pledged, hypothecated, mortgaged or otherwise alienated in any other manner.
• While in employment,
  • In the event of death of employee all the options, SAR or any other benefit granted to him under a scheme till such date to vest in the legal heirs or nominees of the deceased employee.
  • If the employee suffers a permanent incapacity all the options, SAR or any other benefit granted to him under a scheme as on the date of permanent incapacitation, shall vest in him on that day.
  • In the event of resignation or termination of the employee,
    All the options, SAR, or any other benefit which are granted and yet not vested as on that day shall expire
    An employee shall be entitled to retain all the vested options, SAR, or any other benefit, subject to the terms and conditions formulated by the Compensation Committee.
  • If an employee who has been granted benefits under a scheme is transferred or deputed to an associate company prior to vesting or exercise, the vesting and exercise as per the terms of grant shall continue in case of such transferred or deputed employee even after the transfer or deputation

10. Listing

In case new issue of shares is made under any scheme, shares so issued have to be listed immediately in any recognised stock exchange where the existing shares are listed, subject to the specified conditions.

8.2. Schemes implemented by unlisted companies

The shares arising after the IPO of an unlisted company, out of options or SAR granted under any scheme prior to its IPO to the employees shall be listed immediately upon exercise in all the recognised stock exchanges where the shares of the company are listed subject to compliance with SEBI (ICDR) Regulations, 2009 and provisions mentioned below.

Compliances and conditions

A company cannot make any fresh grant involving allotment or transfer of shares to its employees under any schemes formulated prior to its IPO and prior to the listing of its equity shares ('pre-IPO scheme’) unless such pre-IPO scheme:

• Is in conformity with SBEB Regulations; and
• Is ratified by its shareholders subsequent to the IPO – any time prior to grant of new options or shares or SAR under such pre-IPO scheme.

When holding company issues option, share, SAR or benefits to the employee of its subsidiary, the cost incurred by the holding company for issuing such option, share, SAR or benefits is required to disclose in the 'notes to accounts' of the financial statements of the subsidiary company. If the subsidiary reimburses the cost incurred by the holding company in granting option, share, SAR or benefits to the employees of the subsidiary, both the subsidiary as well as the holding company are required to disclose the payment or receipt, as the case may be, in the ‘notes to accounts’ to their financial statements.

The company has to appoint a registered merchant banker for the implementation of schemes covered by SBEB Regulations till the stage of obtaining in-principle approval from the stock exchanges for listing of shares referred to at 8.1.10 above.

Certificate from auditors

The board of directors of every company that has passed a resolution for the schemes under SBEB Regulations is required to place before the share holders a certificate from the auditors of the company at each annual general meeting stating that the scheme(s) has been implemented in accordance with SBEB Regulations and in accordance with the resolution of the company in the general meeting.

Accounting policies

Any company implementing any of the share based schemes has to follow the requirements of the 'Guidance Note on Accounting for employee share-based Payments' (Guidance Note) or Accounting Standards as may be prescribed by the Institute of Chartered Accountants of India (ICAI) from time to time, including the disclosure requirements prescribed therein.

9. Tax aspects

From A.Y. 2010-11 onwards, the ESOPs are again subject to tax in the hands of the employee as perquisite:

• Section 17(2)(vi) provides that the value of any specified security including ESOP or sweat equity shares allotted or transferred, directly or indirectly, by the employer or former employer, free of cost or at concessional rate will be taxed as perquisites in the hands of the employee receiving such benefit.
• Explanation (c) to section 17(2)(vi) provides that the perquisite value of specified security including ESOP or sweat equity shares shall be the fair market value on the date on which the option is exercised by the employee as reduced by the amount actually paid by, or recovered from such employee.
• Explanation (d) to section 17(2)(vi) provides that fair market value means the value to be determined in accordance the method as may be prescribed.
• Rule 3(8) prescribes the following to determine fair market value of specified security or sweat equity share:

10. Important Case Laws

[2003] 86 ITD 342 (BANG.) - Infosys Technologies Ltd. v. DCIT

[2004] 2 SOT 611 (BANG.) - Wipro Ltd. v. DCIT

[2007] 13 SOT 706 (DELHI) - Alok Kumar v. JCIT

[2007] 15 SOT 555 (DELHI) - Ravi Kumar Sinha v. DCIT

[2007] 159 TAXMAN 440 (KAR.) Infosys Technologies Ltd.

[2008] 21 SOT 454 (HYD.) - Makarand Gadre v. ACIT

[2008] 166 TAXMAN 204 (SC) - CIT v. Infosys Technologies Ltd.

[2008] 112 ITD 1 (MUM.) (SB) - Sumit Bhattacharya v. ACIT

[2008] 23 SOT 565 (MUM.) - Kanu Kumar Mukerji v. ACIT

[2009] 118 ITD 177 (BANG.)- Giridhar Krishna M. v. ACIT

[2009] 120 ITD 444 (BANG.) - Muthuswamy Ravikumar v. ACIT

[2009]027 SOT 175(DELHI) Vijay Gopal Jindal

[2010] 1 ITR(TRIB.) 471 (MUMBAI) - ACIT v. Smt. Tripti Sharma

[2010] 39 SOT 17 (DELHI) (URO) - Ranbaxy Laboratories Ltd. v. ACIT

[2010] 35 SOT 18 (MUM.)(URO) - Bomi S. Billimoria v. ACIT

[2010] 127 TTJ 356 (HYD.) – ACIT v. Dr. Dhurjati Gupta

[2010] 191 TAXMAN 439 (MAD.) – CIT v. A. K. Khosla

[2010] 322 ITR 586 (MAD.) Mrs. Chitra Venkataraman

[2011] 47 SOT 363 (Mum.) - ACIT v. Pramod H. Lele

[2012] 150 TTJ 240 (Delhi - Trib.) – ACIT v. Ambrish Kumar Jhamb

[2012] 53 SOT 70 (Chandigarh)(URO) – ACIT v. Spray Engineering Devices Ltd.

[2012] 023 Taxmann.com 286 (MAD) PVP Ventures Ltd

[2013] 155 TTJ 649 (Bengaluru - Trib.) (SB) –Biocon Ltd. v. DCIT

[2013] 59 SOT 203 (Delhi - Trib.) - ACIT v. Robert Arthur Keltz

[2013] 33 taxmann.com 415 (Delhi - Trib.) Abhiram Seth

[2013] 40 taxmann.com 451 (Chennai - Trib.) Murugappa Management Services Ltd

[2013] 35 taxmann.com 454 (Delhi) Smt. Neenu Dutta

[2014] 50 taxmann.com 236 (Delhi - Trib.) Kamlesh Bahedia

[2014] 45 taxmann.com 338 (Bengaluru - Trib.) – ACIT v. Chittaranjan A. Dasannacharya

[2014] 63 SOT 242 (Bangalore - Trib.) - Novo Nordisk India Pvt. Ltd. vs. DCIT

[2014] 65 SOT 79 (Hyderabad - Trib.)(URO) - P. Sudhakar Prasad

[2014] 66 SOT 159 (Hyderabad - Trib.)(URO) - Dr. Reddy's Laboratories Ltd.

[2014] 362 ITR 38 (AAR – New Delhi) - Mrs. Smita Anand

[2014] 41 taxmann.com 16 (Madras) K Parthasarathy

[2014] 40 CCH 0824 (Del ITAT) Lemon Tree Hotel Ltd.

[2015] 229 Taxman 236 (Gujarat) - Bharat V. Patel

[2015] 61 taxmann.com 361 (Mumbai - Trib.) HDFC Bank Ltd

[2015] 62 taxmann.com 390 (Mumbai - Trib.) Mahindra & Mahindra Employees' Stock Option Trust

[2016] 68 taxmann.com 433 (Ahmedabad - Trib.) Cera Sanitaryware Ltd

[2016] 65 taxmann.com 304 (Mumbai - Trib.) Vernan Private Trust

11. Accounting treatment

The Ministry of Corporate Affairs has notified the Companies (Indian Accounting Standards) Rules, 2015 to be effective from 1st April, 2015 that has made the converged Indian Accounting Standards, i.e. Ind AS applicable in a phased manner. One of them, Ind AS 102 on “Share based Payment” specifies the financial reporting by an entity when it undertakes a share-based payment transaction including. Once applicable, the Ind AS 102 will replace the Guidance Note on Accounting for Employee 
share-based payments (“the GN”) issued by the ICAI in 
January 2005.

The GN establishes financial accounting and reporting principles for employee share-based payment plans, viz., employee stock option plans, employee stock purchase plans and stock appreciation rights. For the purposes of the GN, the term 'employee' includes a director of the enterprise, whether whole time or not.

For accounting purposes, employee share-based payment plans are classified into the following categories:

An employee share-based payment plan falling in the above categories can be accounted for by adopting the fair value method or the intrinsic value method. The accounting treatment specified herein below is based on the fair value method.

Employee Share based payment plans are valued as per Intrinisic Value method or fair value method

• For Listed Companies - Intrinisic Value method - amount by which quoted market price exceeds the exercise price of the option
• For Unlisted Companies - based on valuation report by independent valuer