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

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

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

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

3. Reward for past performance.

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

3.1 Under Stock Option Schemes, the Company grants an option to employees 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.

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

3.3 Under a scheme of Stock Appreciation Rights, employees are paid the appreciation in the price or value of the shares from the point of grant to the exercise date.

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

1. Ensuring adequate reward linked with performance.

2. Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003 where applicable

3. Compliance with SEBI guidelines, where applicable. *

4. Ensuring optimal tax treatment for employer and the employee.

5. Proper accounting and disclosure.

* Vide Circular No. CIR/CFD/DIL/3/2013 dated January 17, 2013, SEBI has amended (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999 to provide that no ESOS/ESPS shall involve acquisition of securities from the secondary market.

5.1 Section 79A of the Companies Act, 1956 enables Companies to reward their employees by way of issuing Sweat Equity Shares.

5.2 Those Companies which are not listed in any Recognized Stock Exchange shall issue Sweat equity shares in accordance with Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003.

5.3 Sweat Equity Shares are defined to mean equity shares issued by the Company to its employees or Directors at a discount or for consideration other than cash, for providing Know-how, or making available rights in the nature of intellectual property rights or value addition, by whatever name called.

5.4 Employees are defined to means:

1. a permanent employee of the company

2. a Director of the company employed as a Whole time Director or an Executive Director of the Company

5.5 The following conditions required to be fulfilled before issuing Sweat Equity Shares:

1. Issue of sweat equity shares should be authorised by a special resolution passed by the company in the general meeting

2. Special resolution should specify the number of shares, current market price, consideration, if any, and the class or classes of directors or employees to whom such equity shares are to be issued

3. Not less than one year has, at the date of the issue, should have elapsed since the date on which the company was entitled to commence business

4. Listed companies are required to comply with the regulations made by the SEBI in this behalf

5. Unlisted companies are required to comply with Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003

5.6 Key provisions of the Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003 are:

1. Explanatory Statement to be annexed with the notice for the General Meeting pursuant to Section 173 shall contain the following particulars:
   1. Date of meeting at which proposal of Sweat Equity Shares was approved by the Board

   2. Reasons/justification for the issue

   3. Number of shares, consideration for such shares and class or classes of persons to whom such Equity shares are to be issued

   4. Value of Sweat Equity Shares along with the valuation report and the price at which Sweat Equity Shares will be issued

   5. Names of persons to whom Equity shares to be issued and their relationship with the Company

   6. Ceiling of managerial remuneration, if any, will be affected by issuance of such Equity

   7. Statement to the effect that Company shall conform to the accounting policies

   8. Diluted Earnings per share pursuant to the issue of Securities to be calculated in accordance with the accounting standards

2. Approval of Shareholders by way of separate resolution in the general meeting is to be obtained by the company in case of grant of Sweat Equity Shares to identified employees and promoters during any one year equals to or exceeds 1% of the issued capital of the Company at the time of grant of Sweat Equity Shares.

3. A register of Sweat Equity Shares issued under Section 79 A to be maintained in specified format.

4. Not more than 15% of the total paid up capital of the Company in a year or Shares of the value of Rs. 5 Crores, whichever is higher, can be issued as Sweat Equity except with the prior approval of Ministry of Corporate Affairs.

5. Directors’ Report to disclose the following by way of annexure:
   1. Number of shares to be issued to the employees or the directors

   2. Conditions for issue of sweat equity shares

   3. Pricing formula

   4. Total number of shares arising as a result of issue of sweat equity shares

   5. Money realised or benefit accrued to the company from the issue of sweat equity shares

   6. Diluted Earnings per Share (EPS) pursuant to issuance of sweat equity shares

6. Pricing of Sweat equity shares to be issued to employees and Directors to be at the fair price calculated by Independent Valuer.

7. The following conditions are applicable where a company proposes to issue sweat equity shares for consideration other than cash:
   1. Valuation of the intellectual property or of the know-how provided or other value addition to consideration at which sweat equity capital is issued, to be carried out by a valuer

   2. Valuer to 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

   3. Valuer to submit a valuation report to the company giving justification for the valuation

   4. Copy of the valuation report of the valuer to be sent to the shareholders with the notice of the general meeting

   5. Company to 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

   6. Amount of sweat equity shares issued to be treated as part of managerial remuneration for the purposes of sections 198, 309, 310, 311 and 387 of the Companies Act, 1956 if the sweat equity shares are issued to any director or manager for non-cash consideration.

8. Sweat Equity shares issued to employees and Directors to be locked in for a period of three years from the date of allotment.

9. A certificate from auditors of the Company stating that Sweat Equity shares have been allotted in accordance with the resolution with the company in the General Meeting and unlisted companies (issue of Sweat Equity Shares), Rules, 2003 shall be placed at each AGM.

10. Accounting policies

In respect of sweat equity shares issued during accounting period, the accounting value of sweat equity shares shall be treated as another form of compensation to the employee or the director in the financial statement of the company.

Where the non-cash consideration takes the form of a depreciable or amortizable asset, it shall be carried to the balance sheet of the company in accordance with the relevant accounting standards otherwise it shall be expensed as provided in the relevant accounting standards.

6.1. Eligibility

1. An employee, other than a person who is a promoter or belongs to the promoter group, is eligible to participate in ESOS of the company.

2. A director who either by himself or through his relative or through any body corporate, directly or indirectly, holds more than 10% of the outstanding equity shares of the company is not be eligible to participate in the ESOS.

6.2. Compensation Committee (CC)

1. Constitution of a Compensation Committee is mandatory for administration and superintendence of the ESOS and to formulate the detailed terms and conditions of the ESOS.

2. CC to be a Committee of the Board of directors consisting of a majority of independent directors.

3. CC to frame suitable policies and systems to ensure that there is no violation of Insider Trading regulation and Prohibition of Fraudulent and Unfair Trade Practices relating to the Securities Market regulation by employee.

   6.3. Shareholders’ Approval

4. Shareholders’ approval required by way of a Special Resolution to be passed in the general meeting.

5. Explanatory statement to contain specified information including number of total option to be granted and eligibility, pricing method, appraisal method of employees and vesting information.

6. Separate approval of shareholders is required if the option is to be granted to the employees of subsidiary or holding company.

   6.4. Pricing of the option and variation in terms and conditions of the scheme

7. A company is free to determine the exercise price of the option subject to conforming with the accounting policies given in schedule I to the Guidelines.

8. Permitted by passing special resolution before the exercise of the option by employee as long as the variation is not detrimental to the interest of the employee

9. Re-pricing of the options, whether or not they have been vested, which are not yet exercised permitted if ESOSs were rendered unattractive due to fall in the price of the shares in the market as long as such repricing is not be detrimental to the interest of employees and approval of shareholders in General Meeting is obtained for such repricing.

6.5. Lock-in-Period

1. A company has the freedom to specify the lock-in period for the shares issued pursuant to exercise of option subject to minimum statutory lock-in-period of one year.

6.6. Rights of the option holders in respect of Dividend and voting

1. An employee does not have right to receive any dividend or to vote or in any manner enjoy the benefits of a shareholder in respect of option granted to him, till shares are issued on exercise of option.

6.7. Consequence of failure to exercise option

1. Amount paid, if any, may be forfeited by the company or refunded by the company to the employee failed to exercise the grant of option vested in him in accordance with the scheme.

2. Amount may be refunded to the employee if the options are not vested due to non-fulfillment of condition relating to vesting of option as per the ESOS.

6.8. Non-transferability of options

1. Option granted to an employee is not transferable, nor it an be pledged nor mortgaged nor hypothecated.

2. In the event of death of the employee while in employment, legal heirs of the deceased will be eligible.

3. In the event of termination or resignation of the employee all option not vested shall expire subject to terms formulated by CC in this regard.

6.9. Disclosure in the Directors Report

1. Directors’ report to disclose the information regarding ESOS as prescribed in the clause 12/19 of the guidelines.

6.10. Accounting Policies

1. Accounting value is to be determined and treated as employee compensation expenses in the financial statements by amortizing on a straight line method in accordance with the accounting policies given in schedule I to the Guidelines.

6.11. Certificate from Auditors

1. A certificate from the auditors of the company is required to be placed at every AGM stating that the scheme has been implemented in accordance with guidelines and the resolution of the General Meeting.

6.12. Listing

1. Shares arising pursuant to an ESOS shall be listed immediately upon exercise in any recognized stock exchange where the securities of the company are listed.

2. Statement as per Schedule V to the Guidelines is required filed with the concerned Stock Exchange and obtain the in-principal approval from exchange.

3. After each exercise of the option, the company to notify the stock exchange in statement as per the Schedule VI.

4. Shares arising after the IPO, out of options granted under any ESOS framed prior to its IPO to be listed immediately upon exercise subject to compliance with SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 and, where applicable, clause 22.2A

5. No change is permitted in the terms of options issued under such pre-IPO schemes, whether by repricing, change in vesting period or maturity or otherwise, unless prior approval of the shareholders is taken for such change and except in respect of any adjustments for corporate actions made in accordance with these guidelines.

6. Listed companies to file the ESOS or ESPS Schemes through EDIFAR filing.

7. When holding company issues ESOS/ESPS to the employee of its subsidiary, the cost incurred by the holding company for issuing such options/shares shall be disclosed in the 'notes to accounts' of the financial statements of the subsidiary company.

8. In case of ESOS/ESPS administered through a Trust, the accounts of the company shall be prepared as if the company itself is administering the ESOS/ESPS.

9. No ESOS/ESPS is permitted to involve acquisition of securities from the secondary market.

7.1. From A. Y. 2010-11 onwards, the ESOPs are again subject to tax in the hands of the employee as perquisite:

7.1.1. 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.

7.1.2. 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.

7.1.3. 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.

7.1.4. Further, as per Income-Tax (Thirteenth Amendment) Rules, 2009 notified vide Notification No. 94/2009 dated December 18, 2009, rule 3(8) prescribes the following to determine fair market value of specified security or sweat equity share:

1. In a case where, on the date of the exercising of the option, the share in the company is listed on a recognized stock exchange, the fair market value shall be the average of the opening price and closing price of the share on that date on the said stock exchange

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

3. Where, on the date of exercising of the option, there is no trading in the share on any recognized stock exchange, the fair market value shall be—
   1. the closing price of the share on any recognised stock exchange on a date closest to the date of exercising of the option and immediately preceding such date; or

   2. the closing price of the share on a recognised stock exchange, which records the highest volume of trading in such share, if the closing price, as on the date closest to the date of exercising of the option and immediately preceding such date, is recorded on more than one recognized stock exchange.

4. Where, on the date of exercising of the option, the share in the company is not listed on a recognised stock exchange, the fair market value shall be such value of the share in the company as determined by a merchant banker on the specified date.

7.2. Provisions applicable in earlier years are summarized below:

7.2.1. 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)

1. 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.

   ii. 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.

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

1. 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)];

2. The value on which the Employer pays FBT is treated as cost of acquisition in the hands of the Employee [S. 49(2AB)]; and

3. 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].

4. 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

1. 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.

2. 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.

3. 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 ` 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  ` 200 each. On the date of vesting of the option, fair market value of the share was `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 (

`80 –  `50) x 100 =  `3,000. Company X will pay fringe benefit tax on `3,000.

Cost of acquisition in the hand of employee R = `80 per share

Capital gain = (`200 - `80) x 100 = `12,000 Period of holding = 3rd April, 2007 to 25th October, 2007 i.e., less than 12 months. Hence, the amount of `12,000 will be charged to short term capital gain.

[2003] 86 ITD 342 (BANG.) - Infosys Technologies Ltd. v. DCIT

[2004] 2 SOT 611 (BANG.) - Wipro Ltd. v. DCIT

[2007] 13 SOT 706 (DELHI) - Alok Kumar v. JCIT

[2007] 15 SOT 555 (DELHI) - Ravi Kumar Sinha v. DCIT

[2008] 21 SOT 454 (HYD.) - Makarand Gadre v. ACIT

[2008] 166 TAXMAN 204 (SC) – CIT v. Infosys Technologies Ltd.

[2008] 112 ITD 1 (MUM.) (SB) - Sumit Bhattacharya v. ACIT

[2009] 118 ITD 177 (BANG.)- Giridhar Krishna M. v. ACIT

[2009] 120 ITD 444 (BANG.) - Muthuswamy Ravikumar v. ACIT

[2008] 23 SOT 565 (MUM.) - Kanu Kumar Mukerji v. ACIT

[2010] 1 ITR(TRIB.) 471 (MUMBAI) – ACIT v. Smt. Tripti Sharma

[2010] 39 SOT 17 (DELHI) (URO) - Ranbaxy Laboratories Ltd. v. ACIT

[2010] 35 SOT 18 (MUM.)(URO) - Bomi S. Billimoria v. ACIT

[2010] 127 TTJ 356 (HYD.) – ACIT v. Dr. Dhurjati Gupta

[2010] 191 TAXMAN 439 (MAD.) – CIT v. A.K. Khosla

[2011] 47 SOT 363 (Mum.)- ACIT v. Pramod H. Lele

9.1. 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 `40 when the market price is `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.

9.2. 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

`40 when the market price is `160. The accounting value of the shares being:

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

The accounting entry would be as follows:

2