Sweat Equity - ESOP

SWEAT EQUITY (SE) AND EMPLOYEE STOCK OPTION SCHEMES (ESOP) IN
UNLISTED PRIVATE COMPANIES

WHY SE OR ESOP?

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 know-how, skill
and expertise with them which adds great value to the growing enterprise. 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. The shares issued to such employees (either at a discounted price or
against the know-how contributed) are given the nomenclature “Sweat Equity”.

On the other hand, as the company grows, the management would like to see that their
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 market
value of the share. ESOP is to recognize loyalty and / or performance and a good
employee retention tool.

1. SWEAT EQUITY SHARES
Issue of sweat equity shares is governed by the provisions of Section 79A of the
Companies Act, 1956. This section is applicable to both private limited as well as public
limited companies. 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.

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 passed by the
shareholders 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
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(d) Such shares are issued in accordance with the prescribed guidelines referred to in
section 79A i.e. The Unlisted Companies (Issue of Sweat Equity Shares) Rules,
2003.
The Rules inter alia provide the procedure to be followed by a company issuing sweat
equity shares for consideration other than cash. Some of the key Rules are enlisted
below :

•
Rule 2(v) 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 available 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 in :

(a) the normal remuneration payable under the contract 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 addition.

•
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.
The approval of the shareholders of the Company must be obtained by a separate
special resolution if the issue of shares to the identified employees and Directors is
equal to or exceeds 1% of the issued capital of the Company (excluding warrants and
conversion) in a year at the time of grant of such sweat equity shares.

If the Company intends to formulate the scheme for the issue of equity shares with no
voting rights it has to be verified whether the charter documents of the Company i.e. the
Memorandum or Articles of Association has provision for the issue of equity shares with
differential voting rights. For the purposes of issue of Sweat Equity with differential voting
rights, the Company has to ensure that equity shares of the particular class with
differential voting rights have been issued prior to the issue of Sweat Equity shares of
such class.

•
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.
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•
Rule 9 provides that where a company proposes to issue sweat equity shares for
consideration other than cash, it shall comply with the following:
(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 a
valuer;
(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 general meeting;
(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 Section 198, Section 309, Section 310, Section 311
and Section 387 of the Act, if the sweat equity shares are issued to any whole time
director or manager and 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.
However, these sections are not applicable to a private limited unless it is a
subsidiary of public limited.

In case of issue of shares to an NRI, apart from compliance with Sec. 79A including
valuation of IPR/know-how etc., the Company needs to obtain FIPB approval, since
shares are issued to non-residents without receiving FDI.

2.
EMPLOYEE STOCK OPTION SCHEMES
ESOPs refer to various schemes of offering an equity stake by a Company to its
employees. The stake may be in various forms such as allotment of shares, grant of
stock options that entitle the employee to acquire shares in the future, or simply by way
of rewarding an employee based on the appreciation in the value of the shares.

In other words, Employee Stock Option Scheme means an option but not obligation
reserved in favor of employees by the Company to subscribe to the equity shares of the
Company at a pre-determined price and at a future date.

Unlike public companies, private companies are not bound by specific regulations as
relating to the formulation and operation of an Employee Stock Option Scheme for the
employees of the company. A private company can set up an Employee Stock Option
Scheme in two ways:

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a.
Creation of Trust: A Trust can be created by the company by appointing a
Trustee with a power to hold the shares/options in Trust for the employees who
can subscribe to the shares reserved at a later date and at a pre-determined
price. The Trust can assist the employee to obtain financial assistance to buy the
shares from the company from financial institutions, banks or others.
b.
Directly to employees: The company can formulate a scheme of ESOP wherein
an option can be reserved in favor of the employees to subscribe to the shares of
the company at a future date and at a pre-determined price.
A private company can formulate a scheme by providing the rules governing the ESOP
including but not limited to the eligibility criterion required of the employees to subscribe
to shares at a future date, the pre-determined price, the nature of equity shares forming
the subject matter of the option, the exit mechanism etc.

Treatment of SE and ESOP under Income-tax Act, 1961:

From A. Y. (Assessment Year) 2001-02 up to A.Y.2007-08 ESOPs were not taxed at the
time of grant or exercise. As per proviso to S. 17(2)(iii), value of benefit arising out of
allotment of shares, warrants or debentures free of cost or at concessional rate under a
scheme of stock options in accordance with guidelines issued by the Central Govt. is not
treated as perquisite. Transfer under a gift or irrevocable trust of shares, warrants or
debentures allotted under a scheme of stock options would attract capital gains. The
market value of such shares, etc. would be treated as full value of consideration of such
transfer.

From A. Y. 2008-09 up to A.Y. 2009-10, the ESOPs were subjected to FBT:

•
ESOPs were subject to Fringe Benefit Tax (FBT) at the time of allotment or transfer
of shares on the excess of fair value as on the date of vesting and the Exercise Price
[S. 115WB(1)(d),S.115WC(1)(ba)];
•
The value on which the Employer pays FBT is treated as cost of acquisition in the
hands of the Employee [S. 49(2AB)]; and
•
The Employer can recover FBT from the Employee if scheme is suitably modified
and the recovery of fringe benefit tax is deemed to be the tax paid by such employee
in relation to value of fringe benefits provided to him. However, the employee is not
be entitled for any refund out of such deemed payment of tax and is also not be
entitled to claim any credit of such deemed payment of tax against tax liability on
other income or against any other tax liability [S. 115WKA, S.115WKB].
Perquisite taxation of ESOPs :

The taxability of ESOPs under the FBT regime received a lot of criticism from the
corporate sector as well as tax experts. This was on account of the fact that it required
the employer to pay tax on a benefit clearly identifiable and accruing to the employee.
Also the value of the benefit had to be computed in relation to a future valuation of the
share, determined by market, rather than a value controlled by the employer.

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Further, the FBT paid by the employer was not a tax deductible expense leading to a
much higher post-tax expenditure. Taking these issues into consideration, the Finance
Minister has abolished FBT and again brought ESOPs within the ambit of the perquisite
tax regime. Now ESOPs are being taxed as perquisite in the hands of employees on the
date of exercise. The benefit would be computed as the difference between the Fair
Market Value (FMV) of the shares on the date of exercising the options and the exercise
price. It would be interesting to note that the Finance Minister has not reverted back to
the pre-FBT regime of ESOPs being exempt from perquisite tax if they qualified as per
the erstwhile Central Government (ESOP Guidelines). Instead, the treatment is identical
to the ESOP tax regime during the period 1 April 1999 to 31 March 2000. The amended
provisions are effective from 1st April 2009. Any exercise of options on or after 1 April
2009 are now being taxed as perquisite in the hands of the employees. Further, for the
purpose of computing capital gains, FMV on date of exercise would form the cost basis.

The relevant provisions, as on date, are briefly reiterated hereunder:

•
Any benefit from ESOPs would be taxed as perquisite in the hands of the employees
on the date of exercise, at the difference between the FMV of the shares on the date
of exercising the options and the exercise price.
•
Any subsequent sale of shares by employees would trigger capital gains tax liability
in the hands of the employee. For the purpose of computing capital gains FMV on
date of exercise would form the cost basis.
•
The holding period of shares shall be reckoned from the date of allotment/ transfer of
the security. If such shares are listed on the Indian stock exchange, long term capital
gains tax liability will be ‘Nil’.
Conclusion:

In view of the various rules and notifications both under the Companies Act and under
the Income-tax Act, a proper reading and analysis of Companies Act, Income-tax Act
and Accounting Standards / Guidance Note of ICAI needs to be undertaken in order to
structure the schemes in a way that maximum benefit, both to the employer and to the
employee is achieved.

Under the Companies Act, ESOP and SE are separately defined and considered
separately in Section 81 and Section 79A, respectively.

The Income-tax Act defines only the ESOP and is absolutely silent on SE. However, on
reading of Section 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.

Credit:
Vivek Hegde, Company Secretary in Practice
Divya Paras, Advocate