Key considerations for issuing ESOPs to Promoters

Key considerations for issuing ESOPs to Promoters

Employee Stock Options (ESOPs) have been one of the tools for rewarding employees. It has been used by many companies including start-ups for employee retention as well as enabling employees to share in the value growth of the organization like an equity shareholder. Issue of ESOPs is governed by the provisions of section 62 of the Companies Act, 2013 and the Companies (Share Capital and Debentures) Rules, 2014 (“Companies Rules 2014”). Further, if a Company is listed, the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 also apply.

Issue of ESOPs to Promoters or Promoter Group has always been discouraged by corporate law. Corporate law does 2 Income tax deductibility not permit issue of ESOPs to promoters/promoter group or directors who directly or through their relatives hold more than 10% of the outstanding shares of the company. Probably the intention has been that ESOPs are intended to compensate genuine employees of the company and are not intended to be issued to promoters in the garb of employees.

However, the Companies Act contains an exception through a proviso to Rule 12 of Companies Rules 2014, which is very significant and which has its implications. The Proviso states that the said limitation does not apply to a start-up company defined as per notification no GSR 180(E), dated February 17, 2016 issued by the Department of Industrial Policy and Promotion. As per the notification subsequently amended on February 19, 2019, a company is considered as start-up which (a) has requisite registration with the regulatory authorities; (b) it is not more than 10 years old from the date of its incorporation or registration; (c) turnover of the entity does not exceed Rs 100 crores; and (d) it is engaged in innovation, employment generation etc.

This exception of the Companies Act creates a few dichotomies as well as requires to factor-in various considerations, a few of which are discussed below:

1. ESOPs given to promoters at significant discount to fair value and subsequently turnover increases beyond INR100 crores

The rules define a start-up as an entity satisfying multiple conditions important of which are that it is a start-up for 10 years from its incorporation and turnover is <100 crores. For example, if a promoter is granted an ESOP at face value of INR10 and fair value is INR100 vesting over 10 years (1000 ESOPS vesting per year). Let us say in year 4, the turnover touches INR120 crore and hence it does not remain a start- up by definition. By the end of year 3, 3000 ESOPs have got vested. It is unclear whether the balance 7000 ESOPs can continue to vest on the grounds that they were granted when the entity fulfilled the definition of start-up (view 1) or they get cancelled and cannot vest since for FY 4 and onwards the entity does not fulfil the definition of start-up (view 2). If view 1 is taken which is beneficial to promoters, there could be a significant abuse because promoters will grant significant ESOPs for the entire period in year 1 and it would vest over 10 years and if it gets listed prior to 10 years, the promoters will get ESOPs in a listed company in breach of the intention of SEBI guidelines. A clarification in this respect from MCA and SEBI would help this being implemented in the right spirit.

2. Income tax deductibility

Currently there is no limit up to which ESOPs can be issued to promoters in case of start-ups. So theoretically promoters can issue significant ESOPs to themselves at discount to fair value and book the differential between exercise price and fair value as cost in the P&L as permitted by Accounting Standards. Deduction of ESOP cost, including the timing and amount, has been one of the contentious issues by the Income tax authorities. There has been a recent decision of the Karnataka HC which allowed deduction of ESOP expenses. Presumably, the issue out there did not evaluate eligibility to claim deduction where ESOPs are issued to a promoter shareholder. It remains to be seen whether the company can claim a deduction of ESOP costs which are issued at a significant discount to the promoters (effectively shareholders). This could become a litigative issue in future with authorities claiming that this is not even an expenditure because it relates to a transaction with shareholders and is like a gift to the promoter and hence like a distribution rather than an expenditure.

3. Perquisite tax- A big miss sometimes

One other critical aspect which needs to be factored in is the taxability in future at the time of exercise. Typically, ESOPs get taxed as perquisite (salary) at the time of exercise based on fair market value (FMV) on the date of exercise less exercise price.

If an ESOP which was issued to a promoter at face value of 10 in Year 1 when FMV was INR100. INR90 would have been booked as ESOP cost in the books of accounts – the amount of deduction and timing to be claimed in the hands of the company to be planned. Now, let us say in year 4 the promoter exercises the vested ESOPs and the FMV on the date of exercise is INR300. In that case INR300-INR10 is treated as perquisite in the hands of the employee/promoter. Generally, in many cases the amounts at stake are large. If the amount of perquisite along with other sources of income exceeds INR2 crore the effective tax rate would be 39% and if the income exceeds INR5 crore then the effective tax rate would be 42.74% (assuming that such person has not opted for new tax regime). This can be a big surprise for many promoters since this is a personal tax liability and may force them to sell their shares to generate cash to pay the tax – subject to deferral as provided under the provisions of the Act. Hence, this needs to be planned well to balance between the deduction in Profit and Loss (litigative at 35%/25%) and the extra tax that needs to be paid as perquisite at 39% or 42.74% including other alternatives that could be explored.

However, in order to ease the burden of payment of taxes by the employees of the eligible start-ups, Finance Act, 2020 provides that taxes are required to be paid within fourteen days from (a) after the expiry of forty eight months from the end of the relevant assessment year; or (b) from the date of the sale of such specified security; or (c) from the date of which such person ceases to be the employee, whichever is the earliest on the basis of rates in force of the financial year in which the said specified security is allotted or transferred.

Generally, companies at start-up stage may not take much precautions when doing such transactions and sometimes may not be able to anticipate the potential value of their own companies in future. But when the stakes become large they can add a significant amount of tax burden and hassle to promoters. Hence it is important to plan this well in advance knowing the consequences in the future.