13 August 2020
Employee Stock Option Plans (ESOPs) are a well-recognised method of compensating employees and attracting and retaining the best talent. Compensation in the form of equity shares helps in creating a sense of ownership in the mind of employees. Benefit schemes for employees, including ESOPs, have gained popularity, especially in technology start-ups that have limited financial resources in the initial years, but want to attract the best talent. ESOPs are the option or a right, but not an obligation, which is offered by a company to its employees to purchase its shares at a pre-determined price in the future. ESOPs align the interest of the employees with long term interest of the companies and play a vital role in retaining employees at the growing stage of the company.
Section 2(37) of the Companies Act, 2013 (“Act”), defines ‘employees’ stock option’ as the option given to 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 pre-determined price. The Act expressly prohibits ESOPs for Independent Directors[1] as the law makers believe that it compromises the ‘independence’ of such Independent Directors. Section 62(1)(b) of the Act provides for the approval of shareholders by a special resolution. Rule 12 of the Companies (Share Capital & Debentures) Rules, 2014, lays down the legal framework for issuance of ESOPs for unlisted companies. Listed companies having ESOP plans are required to comply with the SEBI (Share Based Employee Benefits) Regulations, 2014 (“ESOP Regulations”).
Ind AS 102 is the applicable accounting standard for the accounting treatment of ESOPs. Ind AS 102 provides for a fair valuation of share-based remuneration but does not mandate any specific method of valuation. Ind AS 102 has laid down six parameters[2] which must be considered under any method selected by the company to arrive at a fair value of shares. It is to be noted that a notional debit to the profit and loss (“P&L”) account for ESOP grant is arrived at by deducting the exercise price of ESOP from the fair value so determined and is divided pro rata over the vesting period and charged to the P&L account. However, such notional debits to the P&L account to comply with Ind AS 102 should not be confused with managerial remuneration.
A company may implement ESOP programme, either directly or by setting up an irrevocable trust[3]. In a nutshell, there are three stages in the life cycle of an ESOP i.e. grant, vesting and exercise. In the first stage, the company grants the options to its employees. In the second stage, there is an unconditional vesting period during which an employee cannot exercise the option. This vesting period cannot be less than one year from the date of grant of the option[4]. In the last stage, the employee gets the right to exercise the option by making an application for the issue of shares against the vested options. Once the option is exercised within the time limit, the vested option is converted into shares by payment of the exercise price. The exercise price is normally determined in advance at the stage of grant.
ESOPs as Managerial Remuneration:
An interesting question of the law is, at what stage, ESOPs granted by the company to its directors will be regarded as managerial remuneration for the purposes of Section 197 of the Act and Regulation 17 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“Listing Regulations”). The answer to this important question lies in the correct interpretation of the definition of the term “remuneration” under Section 2(78) of the Act, read with the definition of “perquisite” under Section 17(2)(vi) of the Income Tax Act, 1961 (“Income Tax Act”).
Section 2(78) of the Act defines the term “remuneration” as any money or its equivalent given or passed to any person for services rendered by him and includes perquisites as defined under the Income Tax Act. It is evident from this definition that only when any money or its equivalent is ‘given’ or ‘passed’ to any person for services rendered by him and includes perquisites as defined under Income Tax Act, such money or its equivalent shall be considered as ‘remuneration’ for the purpose of the Act. The term ‘give’ means to transfer or yield to or bestow upon another[5] or to make another the recipient of something or bestow gratuitously[6], whereas the term “pass” means to move from one person to another[7] or to go by transfer[8]. The definition of the term “perquisite” under Section 17(2)(vi) of the Income Tax Act includes the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at a concessional rate to the assessee. Market price of the shares on the exercise date, less the exercise price paid by the employee is treated as perquisite and withholding tax is levied at applicable rates.
It is evident that the word ‘remuneration’ under Section 2(78) of the Act means any money or its equivalent given or passed to any person. When the definition of ‘remuneration’ is read with the definition of ‘perquisite’, it is clear that the money or its equivalent is given or passed only on the date when the securities are allotted by the company to the concerned employee, pursuant to exercise of ESOPs by him. The perquisite will arise only when the ESOPs are exercised by the concerned employee, whereby the company allots the securities to the employee and the perquisite is effectively given and passed on to such person as required by Section 17(2)(vi) of the Income Tax Act. The perquisite value will be the fair market value of the specified security on the date of the exercise of the option, as reduced by the amount actually paid by such person in respect of such security.
At the stage of vesting, the employee gets only the right to exercise the option granted to him to get the allotment of securities of the company. He need not exercise this option. If he does not, then no securities are allotted to him and there is nothing given or passed to him as required by Section 2(78) of the Act. It is evident from the analysis of this provision that neither the date of grant nor the vesting date are relevant in the context of the definition of remuneration under Section 2(78) of the Act as nothing is given or passed to the person receiving the ESOP till the date of exercise. It is, therefore, the exercise date which is the relevant date for calculation of limit of managerial remuneration under Section 197 of the Act and Regulation 17 of the Listing Regulations.
Once the perquisite value of ESOPs is treated as ‘remuneration’ under the Act, then the provisions of Section 197 of the Act and Regulation 17(6)(ca) of Listing Regulations would become applicable, which requires shareholder approval by a special resolution. If the monetary limits on remuneration specified in those respective provisions are breached, then the same will be subject to the various conditions laid down under Section 197 of the Act, including conditions relating to no default of the company in payment of any dues to any bank or public financial institution, etc.
In the event where the options are granted, but not yet vested in the director who has retired or resigned or terminated as on that day shall expire. However, if the options are vested but not yet exercised, they can be exercised subject to the terms and conditions of the ESOP scheme of the company[9].
When a Non-Executive Director is exercising ESOPs, the company is required to pay GST @18% on the perquisite value of ESOPs as it would work on a reverse charge basis. The circular issued by the GST Authority[10] puts this matter beyond doubt. This will be in addition to 10% withholding tax under Section 194J of the Income Tax Act.
However, if the Non-Executive Director chooses to exercise his vested ESOP after he ceases to be a director of the company (if permitted under the ESOP scheme), it falls within the regulatory cracks as then the company cannot treat the perquisite value of ESOP as managerial remuneration and it escapes the shareholders scrutiny.
Concluding Thoughts:
In recent times, ESOPs have become a bit controversial particularly as a method of compensating the directors. In the west, claw back of ESOPs have become quite common in cases where accounting and financial frauds are discovered later. In India, Section 199 of the Act permits claw back of excess remuneration paid (including ESOPs) from any past or present Managing Director, Whole-Time Director, Manager or CEO, if a company is required to re-state its financial statements due to fraud or non-compliance with any requirements under the Act. It is interesting to note that Section 199 of the Act is silent on the remuneration paid or ESOPs given to Non-Executive Directors. It is an opportune time for the MCA and SEBI to re-visit regulatory architecture for ESOPs to plug such gaps and tighten the regime to protect interests of all stakeholders.
For further information, please contact:
Bharat Vasani, Partner, Cyril Amarchand Mangaldas
bharat.vasani@cyrilshroff.com
[1] Section 149 of the Companies Act, 2013.
[2] Appendix B of Ind AS 102: All option pricing models take into account, as a minimum, the following factors:
(a) the exercise price of the option;
(b) the life of the option;
(c) the current price of the underlying shares;
(d) the expected volatility of the share price;
(e) the dividends expected on the shares (if appropriate); and
(f) the risk-free interest rate for the life of the option.
[3] Regulation 3 of the SEBI (Share Based Employee Benefits) Regulations, 2014.
[4] Regulation 18 of the SEBI (Share Based Employee Benefits) Regulations, 2014.
[5] Black’s Law Dictionary (Revised 4th Edition).
[6] P Ramanatha Iyer (2nd Edition, 2001).
[7] Black’s Law Dictionary (Revised 4th Edition).
[8] P Ramanatha Iyer (2nd Edition, 2001).
[9] Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 and Regulation 9 of the SEBI (Share Based Employee Benefits) Regulations, 2014.
[10] Circular No: 140/10/2020 dated June 10, 2020 issued by the Central Board of Indirect Taxes and Customs.
