B.A., LL.B. (Hons.

)/ Fifth Semester

“Employee Stock Option Plan”

Submitted to:
Mrs. Richa Kashyap
Assistant Professor

Submitted by:
Gopika Mundra
B.A., LLB. (Fifth Semester)
Roll No. A034

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ABSTRACT:
Employee Stock Option Plans (ESOPs) have gathered enormous attention in recent decades
and have become the most controversial component of the compensation package.
Organizations around the globe have been using ESOPs to compensate their employees at
managerial and non-managerial levels. While traditionally the stock options were reserved for
top management employees, lately there has been strong growth of broad-based plans
primarily to increase firm value. However, the shareholders have become increasingly
apprehensive about the size and proliferation of adoption of stock option plans. The present
paper outlines the basic information regarding ESOPs and tax implication when employees
are exercising the option. Though the evidence is mixed on the implications of ESOPs,
however, there exists robust support for a positive interrelationship between the adoption of
these plans and firm performance for large sized firms.

INTRODUCTION:
An ESOP (Employee stock ownership plan) refers to an employee benefit plan which offers
employees an ownership interest in the organization. Employee stock ownership plans are
issued as direct stock, profit-sharing plans or bonuses, and the employer has the sole
discretion in deciding who could avail of these options.
However, Employee stock ownership plans are just options that could be purchased at a
specified price before the exercise date. There are defined rules and regulations laid out in the
Companies Rules which employers need to follow for granting of Employee stock ownership
plans to their employees.
ESOP is a system under which the employees of a company are generally given the right to
acquire the shares of the company for which they are working. In some of the cases, the
foreign holding/subsidiary company also grants such options to the employees of the Indian
subsidiary/ holding company. Under such a scheme, the employees are granted some rights,
called as stock options, to get the shares of the company for free or at a concessional rate, at a
predetermined price or the price to be determined on the prefixed method, as compared to the
potential market rate.

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ESOP Works:

 The ESOP operates through a trust, setup by the company that accepts tax deductible
contributions from the company to purchase company stock.
 The contributions made by the company are distributed to individual employee
accounts within the trust.
 The amount of stock each individual receives may vary according to pre-established
formulas based on salary, service, or position.
 The employees may "cash out" after vesting in the program or when they leave the
company. The amount they may cash out may depend on the vesting requirements.
 When an ESOP employee who has at least ten years of participation in the ESOP
reaches age 55, he or she must be given the option of diversifying his/her ESOP
account up to 25% of the value. This option continues until age sixty, at which time
the employee has a one-time option to diversify up to 50% of his/her account. This
requirement is applicable to ESOP shares allocated to employee's accounts after
December 31, 1986.
 Employees receive the vested portion of their accounts at termination, disability,
death, or retirement. These distributions may be made in a lump sum or in instalments
over a period of years. If employees become disabled or die, they or their
beneficiaries receive the vested portion of their ESOP accounts right away.

Why are ESOPs given?

There are various reasons for which the employees of a company are given such stock
options. The phenomena of stock options is more prevalent in start-up companies which
cannot afford to pay huge salaries to its employees but are willing to share the future
prosperity of the company. In such cases the employees are given the stock options as
part of the compensation package. Moreover in some cases, the employee is given such
stock options which he can exercise in future date/s, in order to ensure long-term
commitment of the employee. So apart from rewarding the employees with monetary
gains, ESOP also help create a sense of belonging and ownership amongst the employees.

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 Understanding the vesting date and grant price
Under the ESOP schemes, the stock option is free when it is given to an employee. The
terms and conditions on which employee can exercise his rights are spelt in the ESOP
scheme. The option given to the employee can be exercised after a certain lock in period,
which is generally more than one year.
The right to exercise the option may get vested in the employee in the next future date/s.
The dates on which the employee becomes entitled to exercise the right to acquire the
shares is called as “vesting date.” The rights may vest fully or partially over the vesting
period. For example, an employee is given 1000 options on 31st March, 2016 which can
be exercised in phases like 20% on completion of one year, 30% on completion of second
year and the balance on completion of the third year from the date of such grant. So in the
instant case, the vesting dates for 200 options is 1st April, 2017, for 300 shares it is 31st
March 2018 and for balance 500 shares it is 31st March 2019. The plan may stipulate
same or different grant price or exercise price for such vesting. The grant price or the
price at which the employee can buy the share from the company is generally fixed and is
generally substantially lower than the prevailing market price of the shares in case the
shares are listed.
Since the employee is given just an option without any obligation attached to it, it is not
mandatory for the employee to exercise the option. The employee may decide to exercise
the option or may decide to let the option lapse in case the prevailing price of the shares is
lower than the exercise price. The employee is given a time period during which the he
has to exercise the option failing which the vested rights may lapse. The date on which
the employees exercise their option to buy the shares is known as ‘exercise date’.
There are no cash outflows or taxation implications when the options are granted as well
as when the options are vested in the employee.

When to exercise options

It is not necessary for an employee to exercise the option once it vests with him. The
employee can exercise the right within the stipulated time period. When the employee
should exercise the options is a very important question from financial and taxation angle
as well. Once the employee exercises the option, he has to pay for the shares at the price
predetermined and thus causing cash outflow. In case the shares are not listed on a stock
exchange, the same cannot be liquidated and thus the money gets locked till the shares get

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 listed or the promoters offer you an exit option. Moreover there is taxation implication if
you delay your exercise date because the holding period for capital gain purpose will start
from the exercise date. So the decision has to be taken after having considered cash flow
and taxation implications of such decision.

Tax implications when exercising the option

The taxation of ESOP has a typical structure. It is taxed in two stages. First stage is when
the employee exercises the option to buy the shares at the exercise price. The second
stage is when the shares are ultimately sold.
Let us first discuss the first stage. As and when the options under the ESOPs are
exercised, the difference between the exercise price and the value of the security is treated
as perquisite in the hand of the employee. The employer is required to deduct tax at
source on the employee exercising the option, treating the same as perquisite. The value
of the shares allotted to the employee shall be the average of market price (average of
highest and lowest price) on the date the option is exercised in case the shares are listed
on any stock exchange in India. In case the shares are not listed the fair market value of
the same shall be as per the valuation certificate obtained from merchant banker. The
certificate of valuation of shares should not be older than 180 days from the date of
exercise of the option. Even if the shares are listed outside India, the company will have
to obtain the certificate from the Merchant Banker as such shares are treated as unlisted
shares for ESOP purposes.

Tax implications when the shares acquired under ESOP are disposed off
Now let us understand the second leg of the taxation of the ESOP shares, i.e. when the
employee actually sells the shares. The incidence of sale will attract capital gains tax. The
gains can be either long term or short term, depending on the period for which the
employee has held the shares. The holding period requirement is different for listed shares
as well as for unlisted shares. Listed shares shall become long term if held for more than
one year. Unlisted shares become long term after three years. The period of three years
has been proposed to be reduced to two years in the current budget.
The rate at which the short term or long term gains shall be taxed will depend on whether
the shares have been traded on the platform of stock exchange on which the Security
Transaction Tax has been paid. In case shares are traded through a broker, the long term

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 capital gains are taxed under Section 112A at 10% over Rs 1 lakh of capital gains.
However, such short-term capital gains shall be taxed at a flat rate of 15% under Section
111A.
However, in case the shares are not sold through the platform of the stock exchange, the
long term capital gains shall be calculated after applying the indexation to the original
cost of purchase. Indexed gains so calculated shall be taxed at a flat rate of 20% plus
applicable surcharge and education cess. You have the option to pay tax @ 10% on
capital gains without applying indexation benefits. Such short-term capital gains are be
treated like any other income and added to other income and taxed at the slab rate
applicable.
For the purpose of computing the capital gains the fair market value as on the date of
exercise, taken into account for the purpose of perquisites of the options, is treated as the
cost of acquisition and not the price actually paid by the employee.
The tax implications would be different in case the ESOPs are allotted to a person who is
not an employee either by the holding or subsidiary company or the any non-executive
director or any other eligible person. The question of it being taxed as perquisite does not
arise when the option is exercised by such persons. However, the capital gains tax will
have to be paid as and when such shares are sold.

Taxation of Foreign ESOPs

In case the ESOPs are granted by foreign companies to the Indian resident, the same
would be taxable in India. Moreover, the taxation provisions of the country of the
company which grants the option as well as the double taxation avoidance agreement
shall have to be looked into for understanding the exact tax implication. Moreover
concessional tax on long term capital gains under Section 112A or concessional rate of
15% tax on short term capital gain in respect of such shares would not be available as
these shares would not be sold on Indian stock exchanges as these are not likely to be
listed in India

Benefits of ESOPs for the employers

Stock options are provided by an organization as a motivation to its employees. As

employees would benefit when the company’s share prices soar, it would be an incentive for
the employee put in his 100 percent. Although motivation, employee retention and awarding

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hard work are the key benefits which ESOP brings to the employers, there are several other
noteworthy advantages too.

With the help of ESOP options, organizations could avoid the cash compensations as a
reward, thus saving on immediate cash outflow. For organizations which are starting their
business operations on a bigger scale or expanding their business, awarding their employees
with ESOPs would work out to be the most feasible option than the cash rewards.

Problems related to ESOPs for the employers

It’s easy to pitch the benefits of ESOPs for the companies considering the liquidity and
succession alternatives. However, there are good reasons not to go for ESOPs.
Employee stock ownership plans have complex rules and need significant oversight.
Although outsourcing this function to external advisors and ESOP TPA (Third Party
Administration) firms could manage it, the ESOP Company requires some internal personnel
for championing this program. In case a company doesn’t have the staff to do the ESOP work
properly, they could risk issues and potential violations.

Once the ESOPs are established, the company needs a proper administration including the
third-party administration, trustee, valuation, legal costs. Company owners and the
management must be aware of the ongoing costs. In case the cash flow which is dedicated to
ESOPs limits the cash available for reinvesting in the business over a long-term, the ESOP
scheme isn’t a good fit for such a company.

For companies requiring significant additional capital for carrying on business operations,
they must avoid ESOPs. The ESOP schemes use the cash flow of the company for funding
purchase of shares from its shareholders. In case a company requires the funds for additional
working capital or capital expenditures, the ESOP transactions would compete with this
necessary requirement, creating a crisis situation for the management.

Conclusion:

Employee Stock Ownership Plan is one of the best plans to get best returns from employees
as well as without affecting the revenue of the company. Also it helps employer to engage
employees in giving their best for the company. It also provides motivation to employees and
at the end; they end by increasing the revenue of the company. But also sometime it needs
proper administration including the third-party administration, trustee, valuation, legal costs.

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Also sometime while providing ESOP to employees, employer sometime asks for certain
types of agreement which include lock-in period for employee and some other conditions
also, which creates negative impact on the mind of employee and sometime it also give
negative impact for the company. But this ESOP plan has more benefits and for a country
like India with increasing corporate sector, in future it is going to benefit Indian Corporate
Sector.

Bibliography:
1. COMPENSATION: INCENTIVE PLANS: ESOPJOB EVALUATION: RANKING METHOD ,
https://hr-guide.com/data/G446.htm (last visited Sep 11, 2018)
2. DEFINITION OF ESOP | WHAT IS ESOP ? ESOP MEANINGTHE ECONOMIC TIMES,
https://economictimes.indiatimes.com/definition/Esop (last visited Sep 11, 2018)
3. EMPLOYEE STOCK OPTION PLAN: ALL YOU NEED TO KNOW ABOUT ESOP AND ITS

TAX IMPLICATIONSTHE FINANCIAL EXPRESS,

https://www.financialexpress.com/money/employee-stock-option-plan-all-you-need-
to-know-about-esop-and-its-tax-implications/1162110/ (last visited Sep 11, 2018)
4. ESOP - EMPLOYEE STOCK OWNERSHIP PLAN - MEANING, WORKING &
BENEFITSFREE INCOME TAX EFILING IN INDIA: CLEARTAX, https://cleartax.in/s/esop
(last visited Sep 11, 2018)

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