Decoding Employee Stock Option Plans

Employee Stock Option Plan (“ESOP”) is a tool often used as an incentive by companies or as benefits provided to its employees, allowing the employees the right to purchase or subscribe to the company’s shares at a pre-determined price, and ultimately becoming a beneficiary of the increased share value of the company.

Primary laws in India governing the grant of ESOPs are:

(i) Companies Act, 2013;

(ii) SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999, and the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (if the company is a publicly listed company);

(iii) Companies (Share Capital and Debentures) Rules, 2014 (if the company is a private company); and

(iv) Foreign Exchange Management Act, 1999,  Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, Foreign Exchange Management (Overseas Investment) Rules, 2022, Foreign Exchange Management (Overseas Investment) Regulations, 2022, Foreign Exchange Management (Overseas Investment) Directions, 2022, and the Master Direction – Liberalised Remittance Scheme (LRS) (in case of cross-border grant of ESOPs).

Business practices around the world have led to the development of two variants of ESOPs which are Phantom Stock Option Plan (“PSOP”) & Management Stock Option Plan (“MSOP”). These variants of ESOPs are subject to the same legal regime governing ESOPs and are therefore not distinguished under the eyes of law.

They are share-based incentives designed to combat attrition and encourage employee performance. PSOPs similar to Stock Appreciation Rights (“SARs”), are forms of equity-linked compensation that do not involve the issuance of actual stock but instead provide cash payments tied to the company's stock performance, often upon vesting or the achievement of performance goals. These cash payments can either represent the entire value of the stock on the settlement date (full value plan) or the appreciation in stock value during the measurement period (appreciation-only plan). A defining feature of PSOPs is that employees receive cash benefits without gaining actual ownership of the underlying stock, distinguishing them from ESOPs.

They are ESOPs granted specifically to management level employees in the company, such as the Chief Executive Officer (“CEO”), Chief Financial Officer (“CFO”), etc unlike ESOPs, which may be offered to all employees, subject to certain exceptions.

1. Grant of ESOPs via Trust

The grant of ESOPs through a trust route involves the establishment of an employee welfare trust that holds shares in a fiduciary capacity for employees. This trust can either acquire shares through fresh issues of stock or by purchasing existing shares from the secondary market. The trust structure requires that the company first grants a loan to the trust to acquire shares, which are then held on behalf of the employees. When an employee exercises their options after the vesting period, they pay the exercise price and applicable taxes to the trust, which subsequently transfers the shares to the employee. It is beneficial for companies with a larger employee base due to its more structured approach to share management.

2. Grants of ESOPs via Pool

The issuance of ESOPs via ESOP pool, also known as the direct route, involves the company issuing stock options directly to eligible employees. After the vesting period, employees can exercise their options by paying the exercise price and applicable taxes, after which the company issues the shares to the employees. It allows for a more straightforward process without the need for a trust structure. The direct route is generally more administrative in nature for companies with fewer employees.

ESOPs are taxed at two key instances.

First, at the time of allotment, when an employee exercises an ESOP, the difference between the Fair Market Value (“FMV”) of the shares on the exercise date and the exercise price paid by the employee is considered a perquisite. This perquisite is taxable under the head "Salaries," and the employer must deduct tax at source (TDS) as per Section 192 of the Income Tax Act, 1961.

Second, when the allotted shares are sold, the gains are taxable under the head "capital gains". The cost of acquisition is considered to be the FMV at the time of exercise, and the holding period begins from the date the shares are allotted.

In conclusion, ESOPs, along with their variants, provide a significant incentive structure for employees, linking their rewards to the company's performance. The regulatory framework ensures that these plans are granted with appropriate safeguards, whether through a pool or trust mechanism. Taxation on ESOPs, while complex, offers options for employees to manage their liabilities. As ESOPs continue to grow in popularity, they remain an essential tool for companies seeking to align employee interests with long-term corporate goals.

About the authors: Aakash Parihar is a Partner and Sanyukta Agrawal is an Associate at Triumvir Law.

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