ESOPs, a wealth generating tool?

With the successful listing of Swiggy Ltd (‘Swiggy’) on the recognised stock exchanges in India, around 23.2 Crores equity shares belonged to employees. These 23.2 Crores equity shares were allotted as a result of conversion of 8.5 Crores ESOPs into equity shares, as a part of employee stock ownership plans (ESOPs) scheme of Swiggy. On the day of listing, such employees, together, generated wealth of ~ INR 9,048 Crores, creating financial stability for their families. Their wealth creation journey does not stop here. As ESOPs is an ongoing plan, where periodically, options / equity shares are granted to employees till the time they serve their company.

This is one of many such examples where generational wealth has been created by imbibing entrepreneurial spirit in a job. So let us understand the concept of ESOPs in India.

What is ESOP

With the rise of startup trend, incentives in the form of ESOP plays an important role. Startups directed towards innovating and disrupting the existing processes/ products / services / market altogether. Such innovation / disruption often comes with the challenges in the form of higher costs for hiring talented and hardworking workforce. ESOPs works as a tooI to incentivise such employees who can contribute to the growth and success of the company. ESOPs are established by employers with the goal of sharing ownership and financial rewards with their workforce.

One of the primary advantages of ESOPs is their role in creating a sense of shared ownership and responsibility, due to which employees feel invested in the success and growth of the company. ESOPs are typically used as an employee benefit plan and a corporate finance strategy.

How ESOPs Work

An ESOP is a qualified retirement plan that designs the manner in which employees can be rewarded effectively. ESOPs can be used as a mechanism for employee compensation, motivation, and retirement planning. Following the types of ESOPs which are prevalent in India:

1. Employee Stock Option Scheme: Allows employees to purchase company shares at a predetermined price.
2. Employee Stock Purchase Plan: Enables employees to buy company stock at a discount.
3. Restricted Stock Units: Employees receive company stock after a vesting period.
4. Restricted Stock Award: Employees receive actual company shares.
5. Stock Appreciation Rights: Employees receive cash or stock based on the increase in company stock value.

The above mode of ESOPs are executed either by forming an ESOP trust or by floating ESOP Scheme. ESOP trusts are separate legal entities formed for specific purpose of holding shares of the company and rewarding employees based on criteria decided by companies. ESOP Schemes are floated in the form of policy statements whereby various terms and conditions are enumerated as a part of company policies.

ESOPs works as a two way beneficial tool, benefitting not only employees but also employers. 

For employees,

• ESOPs provide employees with a direct ownership stake in the company they work for. This ownership interest gives them a sense of pride and a feeling of being personally invested in the company’s success.
• ESOPs often involve employees in the decision-making process, allowing them to have a say in the company’s direction and strategy. This can lead to a more engaged and committed workforce.
• Employees who participate in ESOPs tend to have a longer-term commitment to their jobs and the company. This can result in lower turnover rates and a more stable workforce.
• Over time, as the company grows and the value of its stock appreciates, ESOP participants have the potential to accumulate significant wealth. This can positively impact their financial well-being and future opportunities

This not only enhances entrepreneurial spirit in the employee, but also boost their focus towards growth of the company. It provides wealth creation opportunities, thereby also providing financial security.

For employers,

• ESOPs provide a structured and tax-advantaged way for business owners to transition ownership to employees. This can be an appealing exit strategy for owners looking to retire or sell the company while preserving its legacy and employee jobs.
• When employees have a direct stake in the company’s ownership, they are often more motivated and engaged in their work. This can lead to increased productivity, better customer service, and higher overall performance.
• ESOPs offer a succession planning solution, allowing the current owner to gradually transfer control and responsibility to a new generation of leaders within the company. This ensures a smooth transition and continuity of operations.
• ESOPs can be used as a tool to retain key employees. By offering them the opportunity to become partial owners of the company, employers can incentivize talented individuals to stay with the organization.
• ESOPs often foster a culture of collaboration, shared responsibility, and open communication within the organization. Employees may feel a stronger sense of ownership and pride in their workplace.

ESOP Taxation: 

The taxation of ESOPs (Employee Stock Ownership Plans) in India involves two key instances:

1.At the Time of Exercise – Perquisite:

• When an employee exercises their ESOPs by agreeing to purchase the shares, the difference between the Fair Market Value (FMV) on the exercise date and the exercise price is considered a perquisite.
• The employer deducts Tax Deducted at Source (TDS) on this perquisite amount.
• This perquisite amount is taxable in the hands of employee and is reflected in the employee’s Form 16 and is included as part of their total income from salary in their tax return.

Above provisions do not apply to employees who work for companies registered as eligible startup u/s 80IAC of the IT Act. employees receiving ESOPs from eligible start-ups are not required to pay tax in the year when they exercise the options. The TDS on the perquisite is deferred to the earlier of the following events:

• Expiry of five years from the year of allotment of ESOPs.
• Date of sale of the ESOPs by the employee.
• Date of termination of employment.

2. At the Time of Sale by the Employee – Capital Gain:

• If the employee chooses to sell the ESOP shares after acquiring them, another tax event occurs.
• The difference between the sale price and the FMV on the exercise date is taxed as capital gains.
• The taxation for listed and unlisted shares differs:
• For listed shares, short-term capital gains are taxed at 20%, while long-term capital gains are taxed at 12.5% without any indexation benefits on the costs.
• For unlisted shares, short-term capital gains are taxed at the individual’s income tax slab rate, and long-term capital gains are taxed at 12.5% without any indexation benefits on the costs.

For employers, in the absence of any specific section for allowance of ESOP expense, claim of contribution made to the ESOPs has been a topic of litigation for its ability to claim tax deduction. Over the years, various judicial pronouncements have been passed to iterate the quantum of tax deduction available to employer for claiming contribution made to ESOPs. One such landmark case in the case of Biocon Limited, whereby The Karnataka High Court affirmed the ruling of the special bench of the Bangalore Income Tax Appellate Tribunal in the case of Biocon Ltd. The case was about the allowability of ESOPs, which is the difference between the market value of shares and the value at which employees are granted the option to acquire shares of the employer. The court held that discount on issuance of ESOPs is an allowable business expenditure under Section 37 (1) of the Income-tax Act, 1961 for the employer. Depending upon the mode of ESOPs, deductibility in the hands of employers can be evaluated.

Thus, from tax front view, ESOPs are not only beneficial to employee to build wealth, but an effective tool for employers to use it for driving growth of the company.

For the detailed discussion on the concept of ESOPs in India, please feel free to contact devadhaantu@devadhaantu.in