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ESOP - What is Employee Stock Ownership Plan - LawSimpl

ESOP – What is Employee Stock Ownership Plan

Employee Stock Ownership Plan (ESOP)

What is ESOP?

An Employee Stock Ownership Plan (ESOP) is a compensation plan for the employees to offer a share of ownership to the company in the form of direct stock, profit-sharing plans or bonuses. The employer is the person who has the sole discretion to decide which employee is capable to avail the options of ESOP.

However, the ESOPs are just possibilities that could be purchased at a particular price before the date of exercise. There are fixed rules and regulations outlined in the Companies Rules which employers want to follow for granting Employee stock ownership plans to their employees.

How ESOPs work?

An organization invests ESOPs to its employees for obtaining a specified number of shares of the company at a fixed price after the option period (a certain number of years). Before an employee could utilise his option, he needs to go through the pre-defined vesting period which implies that the employee has to work for the organization until a part of the entire stock options could be exercised.

Why Company offers ESOP to their employees?

Organizations often use Employee stock ownership plans as a mechanism for attracting and maintaining high-quality employees. Organizations usually issue the stocks in a phased method. For instance, a company might invest its employees the stocks at the ending of the financial year, thereby offering its employees an excuse for prevailing with the organization for holding that grant. Companies contributing ESOPs have long-term objectives. Not only do companies wish to hold employees for the long term, but also dedicated to making them the stakeholders of their company. Most IT companies have frightening attrition rates, and ESOPs could help them reduce such heavy attrition Start-ups offer funds for attracting talent. Often such organizations are cash-strapped and are incapable to offer impressive salaries. But by offering a stake in their organization, they make their compensation package competitive.

ESOPs from an employee’s perspective

With ESOPs, an employee gets the advantage of receiving the shares of the company at the nominal rate, and sell them (after a set tenure by his employer) and making a profit. There are several success stories of an employee raking in the riches together with the founders of the companies. A very notable example is Google when it went public. Its founders Sergey Brin and Larry Page became the richest persons in the world, even the stock-holder employees earned millions too.

Tax Implication of ESOP

Employee stock ownership schemes are considered as profits concerning taxation. On the other hand, for an employee, ESOPs are taxed at two below-mentioned instances –

  • While exercising – in form of a prerequisite:
    When an employee exercises his right, the difference between Fair Market Value (FMV) as on date of exercise and the exercise price is taxed as a prerequisite.
  • While selling – in the form of capital gain:
    An employee might sell his shares after buying them. In case he sells these shares at a price higher than FMV on the exercise date, he would be liable for capital gains tax.

The capital gains would be taxed depending on the period of holding. This period is calculated from the date of exercise up to the date of sale. Equity shares that are listed on the approved stock exchange are considered as long-term capital if they’re held for more than 12 months i.e. 1 year. In case the shares are sold within 12 months, these are then considered as short term. Presently, long-term capital gains (LTCG) on the listed equity shares are exempt from tax. However, as per the amendments made in Budget 2018, the Sale of equity shares that are held for more than a year on or after 1st April 1, 2018, would attract tax at the rate of 10% and cess of 4%. Short-term capital gains (STCG) are taxed at a rate of 15%.

Benefits of ESOPs for the employers

Stock options are granted by an organization as a motivation to its employees. As the employees would serve when the company’s share prices rise, it would be an encouragement for the employee to put in his 100 per cent. Although motivation, employee recognition and awarding hard work are the principal benefits that ESOP brings to employers, there are several other unique advantages too. With the help of ESOP options, organizations could avoid the cash payments as a bonus, thus saving on immediate cash outflow. For organizations that are starting their business operations on a bigger scale or advancing their business, awarding their employees with ESOPs would work out to be the most workable alternative of the cash rewards.

The tax benefits of the ESOPs are:

  • Benefits granted by the company are not taxable.
  • Fixed options are not taxable.
  • When an employee utilises the option of purchasing shares, the difference between the fair value of the shares and the performance value of the share will be payable according to the tax bracket the employee comes under.
  • When an employee trades the shares it is estimated capital gains. If the employee trades the shares within one year 15% tax is levied upon the capital receipts. If the employee trades the shares after one year they are considered long term assets and are not taxable.
  • If an employee has ESOPs in a company based overseas when the shares are sold it will be granted short-term capital receipts and will be added to the income of the employee. The employee will be charged according to the tax bracket he/she comes into after that.
  • If capital receipts are long term, 10% tax will be levied without the advantage of indexation or 20% tax will be levied with the advantage of indexation.

It’s easy to plunge the privileges of ESOPs for the companies regarding the liquidity and succession alternatives. However, there are good reasons not to go for ESOPs. Employee stock ownership plans have complicated rules and need meaningful errors. Although outsourcing this function to external advisors and ESOP TPA (Third Party Administration) firms could regulate it, the ESOP company needs some in-house employees for championing this agenda. In case a company doesn’t have the employee to do the ESOP work accurately, they could risk investments and potential violations. Once the ESOPs are established, the company requires proper management including the third-party administration, controller, valuation, legal costs. Company owners and the management must be informed of the ongoing costs. In case the cash flow which is assigned to ESOPs limits the cash ready for reinvesting in the business over the long term, the ESOP scheme isn’t a great fit for such a company. For companies wanting meaningful additional capital for leading business enterprises, they must avoid ESOPs. The ESOP plans use the cash flow of the company for funding the acquisition of shares from its shareholders. In case a company expects the funds for further working capital or capital investments, the ESOP transactions would struggle with this requirement, creating a mess for the management.

Companies Offering ESOPs

Some instances where Indian Companies offer ESOPs are as follows:

  • Tata Digital: Tata Digital is set to extend all of its employees stock ownership schemes (Esops) to hire talent from the startup community. The Tata Group company had advanced administration stock options to the founders of online grocery retailer BigBasket in which the company acquired a bulk stake in February.
    The company is expected to offer similar Esop schemes as the representatives it examined from the startup community are considered to have opted for stock options in their salary packages, according to a report in Economic Times.
    Tata Digital had roped in some senior executives from TCS which managed to interrogate whether the company would be capable to build a startup culture and draw fresh talent in order to compete with the unicorns and other startups in various digital shares.
    New-age companies are more focused on establishing unicorns and encashing stock options as opposed to older ones which concentrate on building institutions.
  • CarTrade Tech Limited: The company has notified that the Board of Directors of the Company on October 19, 2021, has confirmed the distribution of 6,91,000 equity shares of the face value of Rs. 10/ – each of the Company to 19 eligible Employees (including ex-Employee) upon Exercise of Options Vested under Employee Stock Option Plan 2011 and Employee Stock Option Plan 2015.

Ensuing to this share, the paid-up share capital of the Company holds raised from Rs. 458,340,670/- (consisting of 45,834,067 equity shares of face value of Rs. 10 each) to Rs. 465,250,670/- (consisting of 46,525,067 equity shares of the face value of Rs. 10 each), said company in a regulatory filing.

  • Mobikwik: In September 2021, MobiKwik said it had held 4.5 million equity shares for generating funds for Esops. The shares, when sufficiently diluted, add up to 7% shareholding in the firm, it said.

New Regulations For ESOPs

The Securities and Exchange Board of India (Sebi) has published the Sebi (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 that consolidated the erstwhile Sebi (Issue of Sweat Equity) Regulations, 2002, and Sebi (Share Based Employee Benefits) Regulations, 2014.

A significant change in the new administration is the change in the interpretation of “employee” who is incorporated under the ESOP (employee stock option plan) structure. The employee now includes non-permanent employees of a company, so long as he/she works “exclusively” for such a company. Now companies can issue Esops to employees on fixed-term agreements, or those on probation, earlier to acceptance of their employment. There is also greater transparency on the coverage of “non-executive directors” in the definition of employee, which means such administrators can also be awarded Esops. It is essential to note that autonomous directors remain to be excluded, given the uniqueness of their role.

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