This Blog is written by Subhendu Sanyal, a Law Graduate of Calcutta University

What is ESOP?

The Employee Stock Option Plan (ESOP) is an employee benefit plan. It is issued by the company for its employees to encourage employee ownership in the company. The shares of the companies are given to the employees at discounted rates. Any company (Listed/Unlisted) can issue ESOP. All companies other than listed companies should issue it by the provisions of the Companies Act, 2013 and Companies (Share Capital and Debentures) Rules, 2014. In the case of listed companies, they should be issued by the Securities and Exchange Board of India Employee Stock Option Scheme Guidelines.

Key Features:

● Stock Options: Employees are given options to buy company shares at a pre-determined price, usually lower than the market price at the time of granting.

● Vesting Period: Employees must wait for a specific period (usually 1-4 years) before they can exercise their options and buy the shares.

● Exercise of Options: After the vesting period, employees can choose to exercise the option by paying the exercise price. If they exercise the option, they own the shares and can sell them (subject to any lock-in restrictions).

● No Initial Ownership: Employees do not initially own shares, only the option to buy them in the future.

● Profit: Employees benefit when the company’s stock price increases beyond the exercise price. The difference between the market price and the exercise price determines the profit.

● Taxation: Employees are taxed on the "perquisite" (difference between the exercise price and the fair market value) at the time of exercise, and capital gains tax applies when the shares are sold.

Objective:

Section 2(37) of the Companies Act, 2013 defines employee stock option as the option given to the directors, employees, or officers of the company or of its holding or subsidiary company, the right to purchase or benefit or subscribe for the shares of the company at a predetermined price on a future date. Thus, ESOP is a scheme where a company proposes to increase its subscribed share capital by issuing further shares to its employees at a predetermined rate.

Importance of ESOP in the Indian scenario

Employee Retention: ESOPs are widely used by companies, particularly startups, to retain key talent. By offering stock options, employees feel a sense of ownership in the company and are incentivized to stay longer.

Aligning Interests: ESOPs align the interests of the employees with the company’s growth. As employees become shareholders, they are motivated to contribute more effectively to the company’s performance.

Wealth Creation: ESOPs can lead to wealth creation for employees if the company's share value appreciates over time. This provides an additional financial incentive, apart from salary, for employees.

Tax Benefits: ESOPs can provide tax advantages for both the company and the employees if structured correctly. Employees can defer tax liability until they exercise their options and sell the shares.

Encourages Entrepreneurship: In the Indian startup ecosystem, ESOPs are an important tool to attract talent without offering high salaries, especially for early-stage startups with limited cash flow.

Statutory Provisions

In India, ESOPs are primarily governed by the Companies Act, 2013, and the Securities and Exchange Board of India (SEBI) regulations for listed companies. The key statutory provisions guiding ESOPs are

1. Companies Act, 2013 (For Public and Private Companies)

1.1 Section 62(1)(b): Deals with the issuance of shares to employees under a scheme like ESOP. It allows companies to offer shares to employees, directors, or officers under an ESOP.

1.2 Shareholders’ Approval: The issuance of shares under ESOP requires approval from the shareholders by passing a special resolution in a general meeting.

1.3 Eligibility: ESOPs can be issued to permanent employees, directors (excluding independent directors), and officers of the company. However, the following employees are excluded:

1.4 Promoters of the company.

Directors holding more than 10% of the equity shares of the company.

1.5 Minimum Vesting Period: The minimum vesting period for ESOPs must be one year, as per the Companies (Share Capital and Debentures) Rules, 2014.

2. SEBI (Share-based employee benefits and Sweat Equity) Regulations, 2021

2.1 These regulations apply to listed companies in India. They govern the issuance and administration of ESOPs by companies whose shares are listed on recognized stock exchanges.

2.2 Compensation Committee: A listed company must have a Compensation Committee consisting of independent directors to administer the ESOP scheme.

2.3 Disclosure Requirements: Companies must make detailed disclosures about the ESOP plan, including the terms and conditions, the vesting period, exercise price, etc., in their annual reports.

2.4 Lock-in Period: SEBI mandates a minimum one-year lock-in period between the grant of options and vesting.

2.5 Limits on Issuance: ESOPs must not exceed 5% of the company's paid-up capital in a single year unless a shareholders' resolution approves a higher limit.

3. Income Tax Act, 1961

3.1 Taxability at Exercise: When an employee exercises their stock options, the difference between the fair market value (FMV) of the shares on the exercise date and the exercise price paid is considered as perquisite income. This is taxed under the head "Salaries" and is subject to tax deduction at source (TDS) by the employer.

3.2 Capital Gains Tax: When the employee eventually sells the shares, any gain or loss is treated as capital gain or loss. If the shares are sold within 12 months, it is considered a short-term capital gain (taxed at normal rates), and if sold after 12 months, it is considered a long-term capital gain (subject to a concessional tax rate of 10% on gains exceeding ₹1 lakh for listed companies).

3.3 Deferral of Tax for Startups: Recognized startups in India can defer the payment of tax on ESOPs. Employees of startups are allowed to defer tax liability for up to five years or until they leave the company or sell the shares, whichever is earlier.

4. FEMA

4.1 For companies with employees based overseas, offering ESOPs may involve compliance with FEMA regulations, particularly for foreign subsidiaries of Indian companies or foreign employees being granted ESOPs in India.

Procedure for implementation

Drafting the ESOP Scheme: The company must prepare an ESOP scheme that lays out the terms and conditions such as eligibility, the number of options, vesting period, exercise price, etc.

Board Approval: The company’s board must approve the ESOP scheme.

Shareholders’ Approval: A special resolution must be passed in the general meeting for issuing shares under the ESOP scheme.

Granting Options: The company grants options to eligible employees as per the scheme.

Vesting: Employees need to complete the vesting period before they can exercise their options.

Exercise of Options: Once vested, employees can exercise their options by paying the exercise price to acquire shares.

Issuance of Shares: Upon exercise, the company issues the shares to the employees, and the ESOP is converted into equity ownership.

Who is eligible for ESOP?

The following employees are eligible to receive an ESOP:

1) A company’s long-term worker who is based in or outside of India

2) A director of the company, whether they are employed full-time or part-time; independent directors are not included.

3) A permanent employee or director of a holding company, associate company subsidiary company based in India or abroad.

The following employees are ineligible for ESOP from their employer:

1) An employee who is a company promoter or a member of the promoter group.

2) A director who controls more than 10% of the outstanding equity shares of the company, directly or indirectly, either personally, through a corporate body, or a relative.

However, for 10 years following the date of establishment, Start-up Companies are exempt from the aforementioned two restrictions.

Contraventions that may arise

In India, companies implementing Employee Stock Option Plans (ESOPs) must comply with various statutory regulations under the Companies Act, 2013, SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, FEMA and Income Tax Act, 1961, among others. Any deviation from these regulations can result in significant contraventions and penalties.

Case laws favoring employees

Here are five significant case laws in India that are relevant to employee stock ownership plans (ESOPs), many of which have upheld the rights of employees or provided clarifications regarding ESOP-related disputes.

1. P. Sainath Sanyal Vs Mastek Limited (2020)

Summary: The employee claimed that the company violated its ESOP scheme by wrongfully denying his vested options. The NCLT ordered Mastek to issue the vested stock options, upholding the employee's rights under the ESOP scheme.

Impact: This ruling reinforced that companies cannot arbitrarily deny vested ESOPs to employees who meet the terms of the plan.

Legal Principle: ESOP vesting rights must be honored by the employer according to the terms of the plan.

2. Kotak Mahindra Bank Limited Vs SEBI (2021)

Summary: disclosure norms and issuing shares that violated SEBI’s guidelines. Kotak Mahindra Bank challenged the order.

Impact: The case highlighted the role of SEBI in overseeing ESOP implementation and reinforced regulatory compliance for listed companies.

Legal Principle: Strict adherence to SEBI regulations on ESOPs is essential to protect employees’ financial interests.

3. Chola Financial Services Limited Vs SEBI (2020)

Summary: The company was found in violation of SEBI’s Share Based Employee Benefits Regulations for issuing ESOPs without following the appropriate disclosure requirements.

Impact: Reaffirmed SEBI’s authority to regulate ESOPs, with an emphasis on protecting employees by ensuring transparency and fairness.

Legal Principle: ESOP issuance must follow strict procedural norms, and deviations can lead to penalties.

4. Satyam Computer Services Ltd. Vs Union of India (2011)

Summary: Post the Satyam scandal, this case dealt with the violation of employee rights under the ESOP scheme, where employees were deprived of their benefits due to corporate fraud.

Impact: The court’s decision highlighted that employees' vested stock options should not be unfairly diluted or taken away, even in cases of corporate malfeasance.

Legal Principle: ESOP benefits cannot be unjustly denied or diluted due to internal fraud or mismanagement.

5. Tata Consultancy Services Vs SEBI (2022)

Summary: SEBI initiated action against TCS for violating SEBI regulations in the administration of its ESOP scheme. The company was penalized for inadequate disclosures related to stock option grants.

Impact: This case strengthened the enforcement of SEBI’s regulations on listed companies offering ESOPs, ensuring greater transparency.

Legal Principle: ESOP disclosures must be comprehensive and transparent, failing which, penalties can be imposed.

These cases underscore the evolving judicial approach in India towards protecting employee rights under ESOP schemes. Courts and regulatory bodies like SEBI play a crucial role in ensuring that companies follow the regulatory framework, uphold disclosure norms, and honor their commitments to employees regarding ESOPs. This ensures that employees who are beneficiaries of ESOPs are treated fairly, with their rights being safeguarded in the event of corporate changes or contractual breaches.

CONCLUSION

Companies in India must exercise caution and comply strictly with the relevant provisions of the Companies Act, SEBI Regulations, Income Tax Act, and FEMA when offering ESOPs. Failure to comply with these regulations can result in significant legal and financial consequences, including invalidation of the ESOP, penalties, interest on unpaid taxes, and reputational damage. A well-structured ESOP, supported by proper legal and regulatory compliance, is crucial to avoid contraventions and achieve the desired objectives of employee retention, motivation, and alignment of interests.

In India, the forum for instituting legal action against a company found in ESOP contravention depends on the specific nature of the violation, such as corporate governance issues, securities law breaches, or employment contract disputes, etc. The NCLT, SEBI, Labour Courts, High Courts, Arbitration Tribunals, and Supreme Court are key forums, each with its specific jurisdiction based on the applicable laws like the Companies Act, 2013, SEBI Act, 1992, and Industrial Disputes Act, 1947.

References:

1. Companies Act, 2013

2. SEBI Act, 1992

3. Industrial Dispute Act, 1947

4. FEMA,1999

5. Companies (Share Capital and Debentures) Rules, 2014

6. Income Tax Act, 1961

SEBI (Share Based Employees Benefits and Sweat Equity) Regulations, 2021