Comprehensive Guide to ESOP Policy | Planning | Taxation | Legal Compliances

ESOP Policy and Taxation: An Employee Stock Option Plan (ESOP) is a program that grants employees the right to purchase company shares at a pre-determined price after meeting specific conditions, such as tenure or performance. ESOPs are designed to retain talent, align employee interests with company goals, and boost ownership culture. Taxation on ESOPs occurs at the time of exercise, where the difference between the exercise price and the Fair Market Value (FMV) is taxed as a perquisite under salary income. Upon sale, the capital gains tax applies based on the holding period. Companies can structure ESOP policies with tenure-based or performance-based vesting, and may use a trust route for simplified management and liquidity.

Table of Contents

1. ESOP v/s Sweat Equity
2. Community Stock Options Pool
3. How are ESOPs Planned?
4. Drafting an Effective ESOP Policy
5. Backfire & Safeguard
6. Trust Route of Issuing ESOP
7. Why Private Limited Company Choose the ESOP Trust Route?
8. Legal Compliances

By CA. Darshak Shah – Partner | S N & Co.

1. ESOP v/s Sweat Equity

2. Community Stock Options Pool

2.1 Advantages

• Efficient Standard Agreement
• Access to Growth Stage Startups
• Financial Protection
• Direct Investment
• Information Rights

2.2 Disadvantages

• No Entry on the Cap Table
• Mandatory Call Option
• No Voting Rights
• No GST Credit

3. How are ESOPs Planned?

A company is planning to introduce ESOP in their co. where, vesting is through performance based conditions for the upper management (KRA & KPI). For Marketing Manager, the vesting conditions are:

Wherein the additional conditional is to earn minimum Revenue of Rs. 1 Cr per city annually

Performance-based conditions for the upper management (KRA & KPI)

For Operations Manager (role of bookings), the vesting conditions are:

Tenure based conditions for the middle management:

For Managers, wherein FMV = 100 based on minimum 3 years with exercise price = 20

4. Drafting an Effective ESOP Policy

• Eligibility

1. 1. Tenure-Based: Employees who have completed more than 12 months in the company.
   2. Performance-Based: (KRA) or (KPI).

• Grant and Acceptance

1. 1. Formal offering of ESOPs to eligible employees.
   2. Employees must accept the grant to participate.

• Vesting Schedule/Conditions

1. 1. Tenure-Based: Vesting is linked to the employee’s duration of service.
   2. Performance-Based: Vesting depends on meeting specific performance targets.

• Exercise

1. 1. Exercise Price: Determined using the Black-Scholes Valuation Model.
   2. Exercise Period: Employees have a 5-year window to exercise their options.

• Lock-in Period

1. 1. A lock-in period of 5 years applies to the shares acquired through the ESOP

5. Backfire & Safeguard

Ways to retain the employees who desire to leave the company:

• Reverse Vesting Clauses to Safeguard the Company:

1. 1. Unvested Shares Forfeiture
   2. Partially Vested Shares Buyback
   3. Performance Clawbacks

• Hybrid Vesting
• Second ESOP Grant Plan
• Profit Sharing (Cash Bonus)
• Leadership Perks

Ways Safeguarding employees:

• Define Clear Tiers: Segment ESOP grants based on roles and contributions.(to rule out imbalance)
• Performance-Linked ESOPs: Tie the vesting of ESOPs at all levels (CEO, senior managers, and others) to company-wide goals
• Non-Equity Rewards for Balance: Complement ESOPs with cash bonuses, profit-sharing, or promotions for non-ESOP employees to create a sense of fairness

6. Trust Route of Issuing ESOP

7. Why Private Limited Company Choose the ESOP Trust Route?

Simplified Approval Process

• Using an ESOP trust, the company avoids the need for separate approvals for every individual stock allotment.
• Once the ESOP scheme is approved by shareholders and regulators, the trust can manage allotments in line with the pre-approved framework, reducing administrative overhead.

Liquidity Management
The ESOP trust can buy back shares from exiting employees. This ensures:

• Liquidity for employees when they leave the company.
• Retention of ownership within the company by preventing shares from being sold to external parties.

8. Legal Compliances

8.1 ROC

• Board Approval: The Board drafts the ESOP scheme and passes a resolution.
• Remuneration Committee: Approval of the scheme by the committee.
• Shareholder Meeting: Convene a meeting, approve the scheme, and pass a special resolution for trust creation.
• Submit Scheme to Income Tax Dept.
• Employee Details: Shareholder notice must include employee details and pricing.
• Trust Setup: Prepare and register a Trust Deed under the Indian Trusts Act with Registrar
• PAN and Bank Account: Obtain PAN and open a bank account for the trust.
• Valuation: Get a Registered Valuer’s report for share valuation (for unlisted companies).
• Loan to Trust: Provide a loan to the trust to purchase shares.
• Share Allotment: Allot shares to the trust.
• Transfer to Employees: The trust transfers shares to employees at the Exercise Price.
• Loan Repayment: Trust repays the loan to the company using proceeds from employees.

8.2 Trust

• ESOP Trust registration is done under Indian Trusts Act, hence company need to prepare a Trust Deed. This need to be executed on stamp paper.
• A Trust Deed is to be registered in a sub-registrar.

8.3 Taxation FAQs

• Tax Deductibility of ESOP Expenses
• Taxation at the Time of Exercise (TDS)
• Taxation under Trust Route

8.4 Valuation of ESOPs

• Grant of options: Registered Valuer
• Exercise of options:

1. 1. Listed Co.: FMV of RSE
   2. Unlisted Co.: Merchant Banker