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FAQs on ESOP for the Employees

Last Saturday, Ranveer called me to Starbucks. Having nothing scheduled for the weekend I readily agreed. When I reached Starbucks the scene was amazing. Ranveer was cheering one of his employees perform a live stand-up show.

As soon as I entered the scene, all eyeballs rolled towards me, questioningly. Is Econative really doling out ESOPs? I soon realised that Ranveer had already made an informal announcement to his team. Here, they had gathered to play rapid fire with each team member to shoot out questions I was supposed to answer.

In Part III of the ESOP Series, I have attempted to resolve 10 FAQs on ESOPs for the Employee. Here they go:

1. Does an ESOP announcement equate to gains on ESOPs? Or does it provide a certainty of making gains in future?

Certainly not.

An ESOP announcement is merely a positive announcement by the company to reward the employees through ESOPs. The actual gains materialize only after the following stages are crossed:

  • The employee meets the conditions of vesting;
  • He decides to exercise the ESOPs; and
  • The shares are ultimately sold.

Employees often hesitate in exercising stock options where the possibility of listing or finding an investor does not seem imminent. In that case, the ESOP plan does not yield any benefit.

2. Is it mandatory to exercise ESOPs?

Exercising ESOPs is a right of the employees and not an obligation. The employees may decide not to exercise the ESOPs even after they have signed the ESOP agreement.

3. Exercising ESOPs entails a very huge cashflow? Why is it so? How to address it?

The traditional ESOP plan requires the employees to arrange for funds – firstly, to purchase the shares and secondly, to pay tax on the notional gains on the exercise of ESOPs. This event involves a substantial cash outflow and acts as a deterrent to employees exercising the ESOPs, especially where the possibility of making gains in future is not clear.

To address this, communication is very important. The employees are generally informed about the ensuing cash outflow right at the time of initiation of the plan and executing the documents. Some employers accumulate an ESOP pool where a portion of the employee’s monthly remuneration is deposited. The accumulated funds are used to exercise the ESOPs. Alternatively, employers tie-up with lenders to provide funding at a concessional rate.

4. Enonative is an unlisted private company. It may or may not list in the next 4-5 years. Then, how can I sell the shares acquired under the ESOP plan?

Listing is not the only method of providing an exit to the employees. ESOP buyback is also very popular. In this case, the employees are rewarded in the form of cash equivalent of the market value of the vested ESOPs instead of allotment of shares. In case the ESOP plan is managed by a trust, an employee can sell the shares to the trust. 

5. What happens to vested / unvested ESOPs if a new investor acquires substantial stake in Econative? Or say, Econative decides to go for merger / demerger?

The ESOP Agreement generally provides that the rights of the ESOP holder shall be protected in the event of a new investment or a merger / demerger. It may not be possible to contemplate exactly how the interests of the ESOP holders would be protected at the time of execution of the agreement. 

For instance, in the case of a merger of 2 entities, stock option holders of the amalgamating company may be granted ESOPs in the amalgamated company or provided an exit by way of cash settlement. The company may also allow the employees to elect for either of the options.

6.What happens if there is a bonus or rights issue while the ESOPs have not yet vested?

In such an event, the quantum of ESOPs granted is suitably increased so that the ESOP holders do not lose out.

7. What happens to the ESOPs if I were to resign?

Generally, in the case of a resignation, all the unvested options vest immediately. The employee is provided a time window during which he/she can exercise the ESOPs. The options lapse if the employee does not exercise them in that time period.

Here, it would be important to note that any lateral movement of employees within group companies is not considered as resignation. The employee continues to enjoy the benefits of the stock option plan.

8. What are the rights in the unfortunate event of my death or incapacitation?

In the case of termination of employment by reason of death or incapacitation, the unvested ESOPs vest immediately. The legal heirs are entitled to exercise the vested options and the accelerated unvested options.

9. How is income from ESOPs taxed for the employee?

You may find yourself elated on being granted ESOPs. However, your feelings are not taxed. Tax is payable only when you exercise your right to acquire ESOPs and solely on the quantum of ESOPs exercised. The ESOPs which are not exercised are not taxed. 

Income from ESOPs is taxable in two stages as follows:

1. At the time of exercise:

When you exercise the ESOPs, the notional taxable value of ESOPs is taxed as ‘Salaries’ in the financial year in which the shares are exercised. The employer deducts tax on such income and remits the rest of the salary to your account.

So, how do you determine the taxable value of ESOPS? The law provides that the difference between the Fair Market Value (FMV) of shares on the Exercise Date and the amount paid by you to acquire the shares is considered as perquisite (benefit in kind). This is the value which is taxed under the head ‘Salaries’ at the normal progressive tax rates applicable to an individual. The employer deducts tax at source in the year of exercise on the value so arrived at.

Ironically, though you do not receive any cash income at the time of exercise, tax is payable on a notional value.             

2. At the time of sale of shares:

Whenever you decide to sell the shares acquired under the ESOP plan, the income from sale is taxed as ‘Capital Gains’ in the financial year in which the shares are sold. The difference between the actual sale price and the FMV of shares on the Exercise Date is considered the taxable value of ‘Capital Gains’. Capital gains are taxed at concessional tax rates as compared to Salaries.

For instance, capital gains may be considered long term if the shares of the listed company are held for 12 months or more. They are taxed at the rate of 10%. If the shares are held for a period less than 12 months, capital gains are considered as short term and are taxed at 15%.

The benefit of tax deferment is available to the employees of an eligible startup up to a maximum period of 4 years. However, the narrow coverage of the benefit to ‘eligible startups’ ensures that many companies are left out of the purview of this benefit.

10. Econative is expanding in Singapore for spreading its wings in the pan-Asia region. A couple of employees may be posted overseas for the next 2-3 years. What would be the income tax implications if I am deputed to Singapore and become a non-resident in India at the time of exercise of ESOPs?

Taxability of ESOPs in India is generally dependent on where the income is earned. For example, if the ESOPs were allotted for services rendered in India, the income on exercise may be taxed in India even after you become a non-resident in India. If exercise of ESOPs was conditional upon achievement of certain milestones while performing the duties abroad, it may not be taxed in India.

This must be clearly captured in the ESOP documents to ensure that overseas income from ESOPs is not taxed in India.

Towards the end of our discussion, the Econative team felt comforted about the upcoming ESOP plan as their questions were answered. They felt convinced that there is something to gain and nothing to lose.

 More in this Series 

  • Part III – The ESOP Process
  • Part IV – Regulatory aspects of ESOPs
  • Part V – ESOPs as a hiring strategy
  • Part VI – Wealth creation through ESOPs
Stay tuned

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