CSD PROJECT

ON
“EMPLOYEES STOCK EXCHANGE SCHEMES”

SUBMITTED TO: SUBMITTED BY:

Prof. Mrs. Ipshita Das ANAMIKA
1682014
Bba.llb (A)
 EMPLOYEES STOCK EXCHANGE SCHEME

India is the third largest startup ecosystem in the world and has attracted global
investor attention as is evident from the expanding list of Indian unicorns. Small
businesses with strong founding teams are able to raise funds at a very early stage,
despite having no revenue. The hope to transform from a small business to a unicorn
drives these entrepreneurs and schemes such as Employee Stock Option Scheme
(ESOS) ensure that everyone in the company is striving for the same goal, that is,
stock value, appreciation.

All SMEs/startups, that is, unlisted companies must follow the rules laid out in the
Companies Act 2013 for issuances of employee stock options. In this article we have
listed key features of ESOS for unlisted companies.
An Employee Stock Option Plan (ESOP) is essentially an incentive, granted to an
employee, director or officer to buy or subscribe to the shares of the company at a
pre-determined price in the future. In this way, grantees are offered equity
compensation instead of/in addition to the remuneration. The benefit of ESOPs is that
it allows grantees to have a stake in the company which directly results in greater
loyalty and motivation while aligning the incentives of various stakeholders.

 What is ESOP?
ESOP is a system under which the employees of a company are generally given the
right to acquire the shares of the company for which they are working. In some of the
cases, the foreign holding/subsidiary company also grants such options to the
employees of the Indian subsidiary/ holding company. Under such a scheme, the
employees are granted some rights, called as stock options, to get the shares of the
company for free or at a concessional rate, at a predetermined price or the price to be
determined on the prefixed method, as compared to the potential market rate.

 Why are ESOPs given?

There are various reasons for which the employees of a company are given such
stock options. The phenomena of stock options is more prevalent in start-up
companies which can not afford to pay huge salaries to its employees but are willing
to share the future prosperity of the company. In such cases the employees are given
the stock options as part of the compensation package. Moreover in some cases, the
employee is given such stock options which he can exercise in future date/s, in order
to ensure long-term commitment of the employee. So apart from rewarding the
employees with monetary gains, ESOP also help create a sense of belonging and
ownership amongst the employees.
  ESOS term

The term of the ESOS is called the vesting period. It is the time period that a grantee
must wait in order to exercise the option to buy the shares. ESOPs may vest in a
phased manner, that is, 5% in the second year, 5% in the third year and so on.

 Understanding the vesting date and grant price

Under the ESOP schemes, the stock option is free when it is given to an employee.
The terms and conditions on which employee can exercise his rights are spelt in the
ESOP scheme. The option given to the employee can be exercised after a certain lock
in period, which is generally more than one year.
The right to exercise the option may get vested in the employee in the next future
date/s. The dates on which the employee becomes entitled to exercise the right to
acquire the shares is called as “vesting date.” The rights may vest fully or partially
over the vesting period. For example, an employee is given 1000 options on 31st
March, 2016 which can be exercised in phases like 20% on completion of one year,
30% on completion of second year and the balance on completion of the third year
from the date of such grant. So in the instant case, the vesting dates for 200 options is
1st April, 2017, for 300 shares it is 31st March 2018 and for balance 500 shares it is
31st March 2019. The plan may stipulate same or different grant price or exercise
price for such vesting. The grant price or the price at which the employee can buy the
share from the company is generally fixed and is generally substantially lower than
the prevailing market price of the shares in case the shares are listed.
Since the employee is given just an option without any obligation attached to it, it is
not mandatory for the employee to exercise the option. The employee may decide to
exercise the option or may decide to let the option lapse in case the prevailing price of
the shares is lower than the exercise price. The employee is given a time period during
which the he has to exercise the option failing which the vested rights may lapse. The
date on which the employees exercise their option to buy the shares is known as
‘exercise date’.
There are no cash outflows or taxation implications when the options are granted as
well as when the options are vested in the employee.

 Eligibility

Permanent employees, directors and officers are eligible to receive an option under an
ESOP scheme. However, the following individuals are not eligible to participate in
the scheme:
 an Independent Director,
 an employee who is a promoter or belongs to the promoter group,
 a Director who directly or indirectly holds more than 10% of outstanding
equity shares
 ESOS price

The company granting an option under ESOS has the freedom to determine the
exercise price subject to accounting policies and regulations. The pre-determined
price at which an employee can exercise the option is called strike price or exercise
price.

If the price of the stock increases, the employee gains by exercising the option at the
strike price, which is below the current stock price. However, If the stock goes down,
the option will be worthless, and the employee will not incur a notional loss which is
the case with normal stock ownership. Simply put, the employee benefits from the
gains when the stock price rises but loses nothing in case the company is
unsuccessful.

 Tax implications when exercising the option

The taxation of ESOP has a typical structure. It is taxed in two stages. First stage is
when the employee exercises the option to buy the shares at the exercise price. The
second stage is when the shares are ultimately sold.
Let us first discuss the first stage. As and when the options under the ESOPs are
exercised, the difference between the exercise price and the value of the security is
treated as perquisite in the hand of the employee. The employer is required to deduct
tax at source on the employee exercising the option, treating the same as perquisite.
The value of the shares allotted to the employee shall be the average of market price
(average of highest and lowest price) on the date the option is exercised in case the
shares are listed on any stock exchange in India. In case the shares are not listed the
fair market value of the same shall be as per the valuation certificate obtained from
merchant banker. The certificate of valuation of shares should not be older than 180
days from the date of exercise of the option. Even if the shares are listed outside India,
the company will have to obtain the certificate from the Merchant Banker as such
shares are treated as unlisted shares for ESOP purposes.

 Tax implications when the shares acquired under ESOP are disposed off

Now let us understand the second leg of the taxation of the ESOP shares, i.e. when the
employee actually sells the shares. The incidence of sale will attract capital gains tax.
The gains can be either long term or short term, depending on the period for which the
employee has held the shares. The holding period requirement is different for listed
shares as well as for unlisted shares. Listed shares shall become long term if held for
more than one year. Unlisted shares become long term after three years. The period of
three years has been proposed to be reduced to two years in the current budget.
The rate at which the short term or long term gains shall be taxed will depend on
whether the shares have been traded on the platform of stock exchange on which the
Security Transaction Tax has been paid. In case shares are traded through a broker,
the long term capital gains are taxed under Section 112A at 10% over Rs 1 lakh of
capital gains. However, such short-term capital gains shall be taxed at a flat rate of
15% under Section 111A.
However, in case the shares are not sold through the platform of the stock exchange,
the long term capital gains shall be calculated after applying the indexation to the
original cost of purchase. Indexed gains so calculated shall be taxed at a flat rate of
20% plus applicable surcharge and education cess. You have the option to pay tax @
10% on capital gains without applying indexation benefits. Such short-term capital
gains are be treated like any other income and added to other income and taxed at the
slab rate applicable.
For the purpose of computing the capital gains the fair market value as on the date of
exercise, taken into account for the purpose of perquisites of the options, is treated as
the cost of acquisition and not the price actually paid by the employee.
The tax implications would be different in case the ESOPs are allotted to a person
who is not an employee either by the holding or subsidiary company or the any non-
executive director or any other eligible person. The question of it being taxed as
perquisite does not arise when the option is exercised by such persons. However, the
capital gains tax will have to be paid as and when such shares are sold.

 Compliance requirements for issuance of ESOP

1. Approval of shareholders of the company shall be obtained by passing a special

resolution

2. The company shall make the following disclosures in the annexure to the notice for
passing a special resolution

· Total number of stock options to be granted

· Identification of classes of employees entitled to participate in the ESOS
· Appraisal process for determining the eligibility of employees to the ESOS
· Requirements of vesting period and period of vesting
· Maximum period within which the options shall be vested
· Exercise price and the formula for arriving at the same
· Exercise period and process of exercise
· Lock-in period, if any
 

3. The company shall obtain approval of shareholders by passing a separate resolution

in case of
 Grant of option to employees of subsidiary or holding company
 Grant of option to identified employees, during any one year, equal to or
exceeding 1% of the issued capital of the company at the time of grant of option

4. The company may vary the terms of ESOS not yet exercised by the employees by
passing a special resolution, provided such variation is not prejudicial to the interest
of the shareholders.

5. The company shall maintain a Register of Employee Stock Options in Form SH-6.