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

Objectives and benefits

The objectives may vary from the circumstances and requirements of each case and may include any of the following:-

• Incentive to employees to work for the prosperity and thereby enrich themselves also.

• Incentive to the employee to continue with the Company for a minimum period of time (thus, ESOPs are used as "golden handcuffs").

• Reward for past performance.

• Partial avoidance of immediate cash outflow for the Company on accounts of salary.

Explanation of some types of ESOPs

• Under Stock Option Schemes, the Company grants an option to the employee to apply for the shares of the Company during a specified period of time at a price that is either pre-determined or is to be determined at an agreed formula.

• Under Share Purchase Schemes (ESPS), the company offers shares to employee which are allotted against payment of offer price.

• Under a scheme of Stock Appreciation Rights, the employee is paid the appreciation in the price or value of the shares from the point of grant to the exercise date.

There can be numerous other types of scheme and their variants.

Aspects to be considered in the process of setting up and implementing an ESOPs scheme

• Ensuring adequate reward linked with performance.

• Compliance with SEBI guidelines, where applicable.

• Ensuring optimal tax treatment for employer and the employee.

• Proper accounting and disclosure.

Tax aspects

From A. Y. 2001-02 up to A.Y.2007-08 (see proviso to S. 17(2)(iii), S. 47 (iii) and fourth proviso to S. 48 of the Income-tax Act, 1961)

• ESOPs are 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 are subjected to FBT:

• ESOPs are 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].

Further, Rule 40C and Rule 40D have been prescribed for valuation of specified security being an equity share and specified security not being an equity share in a company respectively.

Valuation of shares of a listed company

• Where the share in the company is listed on a recognized stock exchange on the date of the vesting of the option, the fair market value will be the average of the opening price and closing price of the share on that date on the said stock exchange.

• Where the share is listed on more than one recognized stock exchanges on the date of vesting of the option, the fair market value will be the average of opening price and closing price of the share on the recognized stock exchange which records the highest volume of trading in the share.

• In case, on the date of vesting of the option, there is no trading in the share on any recognized stock exchange, the fair market value will be the closing price of the share on any recognized stock exchange on a date closest to the date of vesting of the option and immediately preceding such date.

Valuation of shares of an unlisted company or specified security not being an equity share

• Where the share in the company is not listed on a recognized stock exchange on the date of vesting of the option, the fair market value will be such value of the share in the company as determined by a merchant banker on the specified date. Similarly, the fair market value of a specified security not being an equity share in a company will be such value of the share in the company as determined by a merchant banker on the specified date.

Further, the CBDT has issued explanatory circular on FBT vide Circular No.9/2007 dated 20-12-2007 that gives following illustration besides providing answers to 25 Frequently Asked Questions (FAQs):

Illustration: A company X grants option to its employee R on 1st April, 2004 to apply for 100 shares of the company at a pre-determined price of Rs. 50/- per share with date of vesting of the option being 1st April, 2006 and exercise period being 1st April, 2006 to 31st March, 2010.

Employee R exercises his option on 31st March, 2007 and shares are allotted/transferred to him on 3rd April, 2007. On 25th October, 2007 these shares are sold for Rs. 200/- each. On the date of vesting of the option, fair market value of the share was Rs. 80/- per share. The tax implication of above situation will be as under:-

Since shares are allotted or transferred on or after 1st April, 2007, provision of fringe benefit tax are attracted. Fringe benefit with respect to employee R is (Rs. 80 – Rs. 50) x 100 = Rs. 3,000/-.

Company X will pay fringe benefit tax on Rs. 3,000/-.

Cost of acquisition in the hand of employee R = Rs. 80/- per share

Capital gain = (Rs.200 Rs. 80) X 100 = Rs. 12,000/-

Period of holding = 3rd April, 2007 to 25th October, 2007 i.e., less than 12 months. Hence, the amount of Rs. 12,000/- will be charged to short term capital gain.

From A. Y. 2010-11 onwards, the amended provisions are:

• Section 17(2)(vi) provides that the value of any specified security including ESOP or Sweat equity shares allotted or transferred, directly or indirectly, by the employer or former employer, free of cost or at concessional rate will be taxed as perquisites in the hands of the employee receiving such benefit.

• Explanation (c) to Section 17(2)(vi) provides that the perquisite value of specified security including ESOP or Sweat equity shares shall be the fair market value on the date on which the option is exercised by the employee as reduced by the amount actually paid by, or recovered from such employee.

• Explanation (d) to Section 17(2)(vi) provides that the fair market value to mean the value to be determined in accordance the method as may be prescribed.

Accounting treatment

a. For ESOPs

The SEBI guidelines require accounting treatment for ESOPs in accordance with the following illustration :

Suppose a company grants 500 options on 1-4-1999 at Rs. 40 when the market price is Rs. 160, the vesting period is two and a half years, the maximum exercise period is one year. Also suppose that 150 unvested options lapse on 1-5-2001, 300 options are exercised on 30-6-2002 and 50 vested options lapse at the end of the exercise period. The accounting value of the option being :

500 x (160-40) = 500 x 120 = 60,000

The accounting entries would be as follows :

The T-Accounts for Employee Stock Option Outstanding and Deferred Employee Compensation Expense would be as follows:

Employee Stock Options Outstanding Accounts

Deferred Employee Compensation Expense Account

Employee Stock Option Outstanding will appear in the Balance Sheet as part of Net worth or Shareholders, Equity.

Deferred Employee Compensation will appear in the Balance Sheet as a negative item as part of Net worth or Shareholders’ Equity.

b. For ESPS

Accounting treatment for Employee Stock Purchase Scheme (ESPS) is explained in the SEBI guidelines with the following illustration.

Suppose a company issues 500 shares on 1-4-1999 under an ESPS at Rs. 40 when the market price is Rs. 160. The accounting value of the shares being :

500 x (160-40) = 500 x 120 = 60,000

The accounting entry would be as follows :