Founders have this question and here is a comparative:
ESOP AND TAX IMPACT
An Employee Stock Option Plan (ESOP) is an option given to the employees to buy the shares of the Company. Until the option is exercised and converts into a share, an option holder does not get any shareholder rights of voting, dividends and the like. An Option is valuable because it gives the right to purchase the shares at typically a pre-determined price, and therefore gives the employee an upside to the current value of the share. Please read our 5 part blog series, which gives a complete overview here.
- Grant: Is the act of commitment by the employer through informing the employee of the eligibility for the Options under ESOP.
- Vesting: Vesting percentage is the portion of the total options Granted which can be exercised on completion of the Vesting Period.
- Exercise: Is the act of paying the Exercise Price to convert the Options into Shares
- Exercise Period: Any time after the Vesting Period within which the employee has to Exercise.
- Lapse of Options: After a certain period, typically termination, expiry of Exercise Period the Options lapse and cannot be converted to Shares.
An ESOP can be used for multiple purposes – as a talent retention tool, as an incentive, as a remuneration mechanism. Accordingly the parameters of the plan would be tailored, if retention, then probably the vesting period would be kept longer. If incentive, then probably the Exercise Price would be kept low, may be face value of shares, so that the employee enjoys a high upside, if remuneration tool, then the eligibility criteria would possibly be all employees. But typically, it is a combination of all of these factors and hence a good balance is required to be detailed in the Plan. An Option is different from Sweat Equity. Sweat Equity means Shares (not Options) granted “in lieu of” services, technology transfer etc. Also, tax treatment and accounting treatment is different compared to Options.
Tax Impact – ESOP:
Under ESOP, there is double incidence of tax on the employee. That is, first at the time of Exercise and second at the time of sale of shares by the employee.
The tax incidence is calculated on the difference between the Exercise Price and Fair Market Value (FMV) of the Shares on the date of Exercise which shall be construed as perquisite in the hands of employee as a component of salary and taxed according to his/her taxability as per Income Tax Act’s slab rate.
The FMV of the shares shall be as determined by a merchant banker or a chartered accountant as per the Discounted Free Cash Flow method.
When an employee ‘sells’ the Shares, then he further pays capital gains tax on the sale price (less) FMV calculated at time of Exercise. Depending on when the sale is undertaken by the employee, the capital gains will be either Short term or Long term capital gains. Sale within a period of 12 months is considered as Short term capital gain tax, and sale after 12month is considered as Long term capital gain tax.
SWEAT EQUITY SHARES
Sweat Equity Shares – Companies Act, 1956
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 person either provides the know-how, intellectual property or other value additions to the company.
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 authorized 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 issued;
(c) such issue is after expiry of one year from the date on which the company was entitled to commence business; and
(d) in the case of an unlisted company, such shares are issued in accordance with the guidelines as captured below.
Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003 (Rules):
The guidelines referred to in S. 79A are the Rules issued by the Central Government, which need to be followed by unlisted companies. Rule 8 prescribes that the issue of sweat equity shares to employees and directors shall be at a fair price calculated by an independent valuer. As per Income Tax Act, valuation shall be determined as per Discounted Free Cash Flow method.
Rule 6 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.
Rule 10 provides sweat equity shares issued to employees or directors shall be locked in for a period of three years from the date of allotment.
Taxation Impact: Sweat Equity shares as per the Income Tax Act, 1961 has 2 aspects. > Salaries. > Capital Gains.
Salaries: Whenever an employee receives a sweat equity shares, the value of such shares will be taxable as a perquisite under the head Salaries as per section 17 of IT Act.
Capital Gains: When an person ‘sells’ the Shares, then he further pays capital gains tax on the sale price (less) FMV calculated at time of allotment of shares. As per the period of holding, Short term or Long term capital gains shall be applicable. <12 months – Short term capital gain tax, >12month – Long term capital gain tax.
ALLOTMENT OF SHARES FOR CONSIDERATION OTHER THAN CASH
When Shares are allotted against services rendered or towards know-how, IP etc., then there would be an invoice for the services against which shares are issued.
Taxation Impact: TDS as applicable to the services (invoice).
Capital Gains: When an person ‘sells’ the Shares, then he further pays capital gains tax on the sale price (less) acquisition price calculated at time of allotment of shares.
Process: Shares allotted at the Board meeting and Forms 2 and 3 filed with ROC along with the relevant agreement for the services.
Disclaimer: This is not a legal opinion and should not be considered as one. Please check with your attorney before taking any actions.