Wednesday, December 30

Employee Stock Option Plans (ESOP)

Employee Stock Option Plans (ESOPs) also known as Equity Incentive Plans is one the commonly used compensation tools by companies. Organisations offer ESOPs to their employees as part retention strategies. Some of the other key drivers for implementing ESOPs are wealth creation for employees, enabling high performance, and instilling a feeling of ownership for the organization amongst employees.

What is ESOP?
An ESOP is a right to buy shares of the employer company at a pre-determined price. Organisations often grant their key employees an option under the plan that confers a right, but not an obligation, on the employee to buy the shares of their company. Stock options are subject to vesting, requiring continued service (and sometimes performance) over a specified period of time. Upon vesting of options, employees can exercise them to get shares, by paying the pre-determined exercise price.

ESOPs can be an important tool for both attracting and retaining good talent in an organisation. It is important to ensure that the ESOP is financially attractive for employees, tax friendly, simple to understand and administer and compliant with various regulatory requirements.
Companies engage consultants to draft an appropriate Employee Stock Option Plan, ensuring that it is compliant with the relevant provisions of income tax, corporate laws, listing requirements (under SEBI), foreign exchange regulations (wherever applicable) etc.

A retention tool
ESOPs come with a lock in period also known as Vesting period which ensures that employees stick around in the company for long. There are numerous examples where employees who stayed longer with companies in their growing phase were rewarded with handsome gains based on their ESOPs.

Ownership of Employees
Since the ESOPs entail giving shares of the company to the employees, employees become better performers (at least theoretically!) as they aim at increasing the performance of their ‘own company’ since they are the potential shareholders (owners!).

Save Cash, Reward higher
Companies plan their cash outflow by giving away ESOPs instead of cash incentives to the better performers. This saves them a lot of cash and also motivates the employees.


At the time of Granting ESOPs: No tax implication

At the time of Exercising ESOPs: The benefits arising on ESOP’s are taxed as Perquisites in the hands of the employee and form a part of the employee’s salary income. The employer is also required to deduct TDS in respect of such perquisite. The perquisite value is computed as the difference between the Fair Market Value (FMV) of the share on the date of exercise and the Exercise price.
Specific valuation rules apply in case of listed and unlisted companies. Unlisted companies are required to determine the FMV by a Category I Merchant Banker registered with SEBI.

At the time of Sale of Shares: The gains arising on the sale of ESOP’s by the employees are considered to be Capital Gains and accordingly attract Capital Gains tax. Tax is liable to be paid in the year in which such ESOP’s are sold. The Capital Gain is computed as the difference between the sale price and the FMV on the date of exercise.

While ESOPs have been in vogue for quite some time as an employee retention tool, it is just a piece of paper if the company doesn’t list on a recognized stock exchange or unless there is a strategic sale of company’s shares where the employees may be allowed to sell their stakes as well. 

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