ESOPs – Is It Worth the Sweat?
Is it worth the Sweat anymore?
Historically, words like loyalty, longevity, perpetuity were a part regular board room jargon and C-suite conversations. Enter COVID-19 and boardrooms have been inundated with an unnerving undertone of newer entrants like layoffs, restructuring, cost cutting, all of which is unbecoming of a culture and prospects one is familiar with.
Given the shift in mindset, what does it do to the reward mechanism in the form of ESOP’s, the very genesis of which has been to recompense long stay while encouraging performance. Hence, the question, is it worth the Sweat?
ESOPs, earlier known to form a part of the offers doled out to the elite/ senior management, are now more commonly associated with start-ups. ESOPs often prove to be the compelling incentive responsible for attracting talent at an otherwise abysmal remuneration. However, there is always more to ESOPs than what meets the eye. ESOPs, given its ever-evolving regulations, need to be understood to gain insight into what really is in it for you. While the universe of ESOP related regulations can be complex, we have shared certain aspects of ESOPs to aide in understanding specific plans.
ESOPs – Is It Worth the Sweat?
ESOPs can be issued to
- a permanent employee in a company, its subsidiary and its holding company, who has been working in India or outside India; or
- a Director in the company, its subsidiary and its holding company
ESOPs – Is It Worth the Sweat?
However, ESOPs cannot be issued to
- independent directors
- 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 ten percent of the outstanding equity shares of the company.
The last two exclusions do not apply to registered start-up companies up to 10 years from the date of their incorporation or registration.
Amongst the various plans commonly known, the more topical ones are discussed below.
ESOPs – Is It Worth the Sweat?
1. Stock Appreciation Rights (SARs)
SARs are not technically employee stock options. However, companies often use them in a like manner where employees are given the option to exercise the right upon the same being vested. SARs can be equity-settled or cash-settled. In equity-settled SARs, the settlement amount i.e., the amount based on the increase in price of the shares on the grant date, compared with the price on exercise date, is provided in the form of shares of the company. In cash-settled SARs, companies settle employees in cash equivalent to the appreciation of the company’s stock over a specified duration, without issuing any equity to them. Thus, unlike other options, SARs provide employees with an equity upside without exposure to a fall in the stock price of the Company.
2. Phantom Stocks
These are similar to cash settled SARs where shares are not issued to employees and hence, there is no transfer of ownership. But unlike SARs, employees do not have the option to exercise such stocks. This is a form of long-term deferred compensation using Company shares as the measuring device for calculating the value of the deferred compensation. The Company simply provides the benefit of the stock in the form of bonus payable at a future date if certain objectives are met or if a specific event occurs.
Phantom shares are usually redeemed in cash, with its payment being treated as a bonus. However, if the plan agreement provides, the payment obligation may be satisfied by distributing actual stock to the employees.
3. Employee Stock Option Scheme (ESOS)
Traditional yet popular, the option granted under this plan confers a right but not an obligation on the employees to exercise their rights to subscribe to shares. Such stock options are subject to vesting, requiring continued service over a specified period or upon fulfilment of specified conditions. Upon vesting of the option, employees can exercise their right and subscribe to the shares, by paying the pre- determined exercise price and qualifying as shareholders in the company.
Other popular plans include Restricted Stock Award (RSA), Restricted Stock Unit (RSU) and Employee Stock Purchase Plan (ESPP).
While stock option plans are oriented specifically, a tweak to their existing forms could give rise to a host of tax implications, making an analyst out of every commoner. Highlighted below is a summary of select tax issues based on various interpretations.
1. Taxation of SARs
Taxation of SARs depends on whether they are equity-settled SARs or cash-settled SARs.
Taxation of equity-settled SARs is like the taxation of a traditional ESOP scheme where the incidence of tax arises while exercising the ESOP and during subsequent sale of such shares.
In the case of cash settled SARs and phantom stocks, is the same is taxable only at the time of receipt of such incentive.
The question that arises is in respect of characterisation of income, whether the said income should be taxable as perquisite or capital gains in the hands of the employees?
The Income-tax Act, 1961 (“the Act”) does not define ‘specified securities’ nor are there any Central Government guidelines which specifically decode SARs. Further, SARs do not fall within the definition of ‘securities’ under the Securities Contract Regulation Act, 1956.
Different Courts have interpreted taxability of cash settled SARs differently and hence, it is critical to consider all aspects of the scheme carefully before being lured into the perceived incentives.
ESOPs – Is It Worth the Sweat?
2. Taxation of ESOPs in cases involving change in residential status of the employees
It is commonly seen that share options are granted in the home country and are exercised by the employee in the host country. This gives rise to the issue of determining the jurisdiction where the tax out to be levied.
Most countries have their own specific tax laws which must be respected while designing ESOP plans for the employees around the world. The Model Tax Convention on Income and Capital, 2017 issued by the OECD also provides guidance in respect thereof. However, the Indian Judiciary seems to have divergent views on taxation in this aspect.
Considering the multiple issues and their varied interpretations, ESOPs must be addressed with minuteness and proximity. Adequate drafting of schemes and fluidity of interpretation are critical keeping the interest of both companies and stakeholders in mind.