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Navigating Compliances: A Guide to the Regulations Governing ESOPs in India

The ESOP landscape in India is still evolving. When designing the stock option plan, various laws and regulations must be followed. Understanding these laws can be a daunting task especially to first-time founders. However, the knowledge is crucial for creating a fair and effective plan/strategy to align the employee incentives with the company’s vision. 

In this blog, we have given you a rundown on the legal requirements to keep in mind when issuing Employee Stock Ownership Plans (ESOPs) in your company.

1. Understanding the Companies Act

Any company that wants to give out stock options must follow the rules in the Companies Act 2013 and the Companies (Share Capital and Debentures) Rules, 2014. These rules cover the following:

Who can get stock options?

Usually, only employees of the company or its related companies can get stock options as part of their pay. The company’s owners or directors who form part of the promoter group and own more than 10% of the company’s shares are not eligible for stock options. However, there is an exception to qualifying startups up to the first 5 years for this.

How are stock options set up?

The company has to decide things like who gets the options, when they can start using them, how much they cost, and how long they have to wait before they can sell the shares they get.

What are the rights of the option holder?

An option holder does not have a right to vote or receive dividend until the shares are actually issued upon exercise.

What are the procedures and compliances relating to issuing stock options by companies?

The company has to plan out the options, get approval from its board and shareholders. Additionally,  companies must maintain a register of stock options, make filings with the MCA, issue share certificates to the shareholder upon exercise etc. 

2. Accounting for Employee Stock Ownership Plans

When a company issues ESOPs to its employees, it is required to treat the cost of these options as an expense. This means that the company must book the cost of the ESOPs in its financial statements. Startups in India typically use Indian GAAP (Generally Accepted Accounting Principles) to record these expenses. It provides guidance on the accounting treatment of the expense and the period over which the expense should be recognized. One of the key areas of accounting for ESOPs is the fair value of shares on the grant date

The cost of the ESOPs is recognized over the vesting period, which is the period of time over which the employees earn the right to exercise the options. There are various methods of valuing the shares such as Black-Scholes model, which is widely used. It is important to note that the fair value of shares on the grant date is the key factor to arrive at the expense of ESOPs. It is also important for the companies to have accurate valuations of their shares.

3. Income tax implications

For companies

When a company gives out stock options, it has to spread the cost over the vesting period. This is a deductible expense for the company.  

The taxable value of stock options is considered as ‘perquisite’ for employees and is taxed as ‘Salaries’. The company must deduct tax (TDS) on this perquisite value. 

In case of cash-settled SARs, tax is deducted before making the payment. When it comes to stock options, TDS on the notional perquisite value is deducted from the employee’s salary.

For employees

In equity settled stock options, there are 2 taxable events – one, at the time of exercise and another at the time of the ultimate sale of shares. The perquisite value of stock options is taxed as employment income at the applicable slab rates. Capital gains on the ultimate sale of shares are taxed depending on whether they are long-term or short-term shares. In cash-settled options like Stock Appreciation Rights (SARs) or Phantom Equity, the income from exercise of options is taxed as employment income at the applicable slab rates. 

Employees of eligible startups are entitled to deferment of tax payable for a period up to 4 years on satisfaction of certain conditions. Besides, if shares are issued at a price lower than the fair market value of shares, the difference is taxed as income of the employee. An employee exercising stock options does not receive any cash income at the time of exercise; yet tax is payable on a notional value

This is a very important factor which determines the success of the stock option plan. 

4. Navigating Foreign Direct Investment Regulations under FEMA

Indian companies can give stock options to non-residents employees. These employees may work for the parent company or for one of its sister companies, subsidiary companies, or partners.

Issue of stock options to non-residents is regulated by Foreign Direct Investment Regulations under FEMA ( Foreign Exchange Management Act). These rules have caps on how many shares can be given,  the route through which money will come in- automatic or government, and the price at which shares can be issued. The rules also say that the shares can’t be given at a price lower than their actual value. For instance, the shares on exercise cannot be issued at a price lower than the fair market value of shares of the company. 

Practical issues may arise if the fair market value of the company on the date of exercise is substantially different from the value on the date of grant. Sometimes, it can be difficult to decide the actual value of the shares when they’re given and when they’re used. This can cause problems.

Other Regulations:

In addition to the above, there are other regulations like Stamp Duty and Contract Act that govern stock options. The stock option agreement between the company, employees and the ESOP Trust (if any) must be in compliance with the Contract Act in order to be a valid contract. The agreements and shares issued on exercise must be duly stamped by paying stamp duty at the applicable rates. 

In conclusion, Employee Stock Ownership Plans (ESOPs) can be an effective way for companies to reward and retain top talent, but it’s important to understand the various laws and regulations that govern them in India. From the Companies Act to SEBI guidelines, there are many compliance requirements that companies must adhere to. By understanding these regulations and structuring ESOPs accordingly, companies can ensure the success of their plan to minimize legal hassles at a later stage. 

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