ESOPS IN INDIA
Why should you opt for ESOPs?
“For Capitalism to survive there need to be more Capitalists.” – Louis Kelso, Father of ESOPs.
ESOPs are the modern day baits to hook or retain an employee without diminishing the liquidity of the company coffers. This plan is economically viable for both start-ups and existing companies as it serves the purpose of remunerating the employee in kind instead of cash. The attractiveness of ESOPs lies in the fact that once granted by the company, the employee can purchase stock options at a largely discounted price in comparison to the prevailing market value after the vesting period. When the employee decides to exercise his options on the completion of the vesting period and sells them, he makes unimaginable profits. The pitfalls that deter employees from choosing this option nowadays are the vesting period, unaffordability of even the discounted shares and taxation structure. However, it is evident that ESOPs in start-ups is paving the way for an employee owned market.
The benefits of ESOPs are multifold to both the employer and employee. The substantial advantages lie in the sense of ownership it instils in an employee, the remarkable gains that can be harnessed and the dynamic productivity it induces in the workforce. A promoter would certainly not mind diluting his stakes in order to propel the growth of his venture and the happiness of his staff. Take for example the success stories of clerks and drivers of Infosys or Flipkart who enthralled the public with their rags to riches tale. This is testamentary to the wealth sharing and wealth creating potential of ESOPs. All permanent employees, except the promoter or an employee of the promoter group or a director who owns directly or indirectly more than 10% of the equity shares of the company are eligible for ESOPs.
How are ESOPs issued?
The issuance of ESOP for a listed company is governed by the SEBI (ESOS and ESPS) Guidelines, 1999, whereas the unlisted companies fall under the ambit of Companies Act, 2013 and Companies (Share Capital & Debenture) Rules, 2014.
A start-up or Private Limited Company may issue ESOPs by a resolution passed by the Board of Directors or by setting up a Trust as per the Indian Trusts Act.
For an infant enterprise, the Board route would be far easier than going through the complexities of setting up a trust. Board route has been further simplified from June, 2015 as there is no need for a “special resolution” by the shareholders or ROC formalities. Presently, once an ESOP scheme is approved by shareholders, a Letter of Grant is issued to the employee informing him about the number of options, vesting period and exercise price and the employee may subsequently make an Exercise Application to convert his options into equity.
In case the company elects to take the Trust route which is highly recommended for large companies like Infosys and not start-ups, then the Trust needs to be set up and Trust deed registered. The Trust acts as a custodian of ESOPs for employees and purchases the required shares by borrowing loans from the company itself, financial institutions or sellers of the shares. The trust then utilises such loans to acquire shares through fresh allotment, purchase from existing shareholders in an open market or when the owner sells his shareholding to the ESOP Trust. When the employee exercises his options, the Trust allots him shares for a price which it uses to repay its outstanding loans.
Understanding Taxation of ESOPs:
ESOP incurs tax liability at different stages since its inception. There are four important stages of an ESOP, namely the granting date, vesting date, exercise date and selling date. ESOPs are preferable to employees willing to take risk and are not aiming for immediate liquidity as an ESOP holder must make smart investment strategies regarding when to exercise or sell these options. There have been scenarios where employees that did not make any profit by exercising these options due to poor investment strategies. The tax implications on ESOP is applicable only on the last two stages, firstly, during exercise of option where perquisites are taxed and secondly during selling of option where there is tax on the capital gains. Granting and Vesting of ESOPs are not taxable.
In order to grasp this concept in its entirety, it’s important to understand what ‘perquisites’ and ‘capital gains’ are.
Perquisite: When the employee exercises his option of buying the shares, the difference between the market value and exercise value is treated as perquisite and is taxable as per the tax bracket that the employee falls in. The employer is also required to deduct TDS in respect of such perquisite. This amount is shown in the employee’s Form 16 and included as part of total income from salary in the tax return.
Capital Gains: When the employee sells the shares, the profit is treated as capital gains. If the shares sold within one year, 15% short-term capital gains (STCG) tax has to be paid just like in the usual purchase and sale of shares. If the stock is sold after 1 year, there is no tax as it is considered as long-term and any tax liability is effectively waived off.
The following is a table representing the total tax burden applicable to an employee who has been granted 100 shares as ESOPs.
|Stage of ESOP||Date||Share Value||Taxation Scheme||Tax Amount to be paid.|
|Exercise||1/08/2002||200||Tax on difference between FMV on date of exercise and the exercise price.||100 Shares x (Rs.200 – Rs. 100) x 30% =
|Selling||1/12/2002||500||Tax on difference between Sale Price and FMV on the exercise date. STCG is applicable, as option sold within 1 year.||100 Shares x (Rs. 500 – Rs. 200) x 15% = Rs. 4500.|
If the employee has ESOPs of a company that is listed abroad, and sells the shares, short-term capital gains is added to income and one has to pay tax as per the tax slab that he/she falls into. If the capital gains are long-term, 10% tax has to be paid without indexation benefit or 20% tax has to be paid with indexation benefit.
The employee may also remember that there is no mandatory obligation to exercise the options and may refrain from doing so and thereby incur no tax or legal liability.
Listed and Unlisted Equity Shares and Applicable Tax Rate: FY-2017-18
A smart investment strategy would be to primarily understand whether the ESOPs are listed or unlisted equity shares and then exercise the bulk of ESOPs in parts within the time period allotted to exercise the option. This strategy for listed shares helps an employee spread the cost, not so much when shares are unlisted.
Listed Equity Share:
- Sold within 1 year = STCG = 15% Tax liability.
- Sold beyond 1 year = LTCG = Exempt from Tax liability.
Unlisted Equity Share:
- Sold within 24 months = STCG = Will get included in income and Tax liability will be in accordance with tax slab rates.
- Sold beyond 24 months = LTCG = 20% Tax liability.
It is evident that ESOPs may be a double edged sword paving the way to an employee owned economy where there is a constant dilution of ownership in few hands. It enables a company to provide for incentive even when it does not possess liquidity. While the employers use this as bait to hire or retain talent, the employees must pay heed to the various taxation and legal liabilities and restraints that surround such options and must invest in consultation with lawyers or accountants to embark upon smart investment strategies when it is time to exercise and subsequently sell such options. Ignoring the market conditions and being blind to the other possible options available could prove costly to an employee, eager to make a quick buck in a short time.