Share Based Payments

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Note on“Share Based Payments”

Contents

Definition & Scope – ESOP/ESPP

Guidance note by ICAI

Definition & Scope – SAR

Taxability for Employees & Company

Accounting for Corporates

Determining the Value

Glossary

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Definition & Scope: Employee Stock Options(ESOP's)

• While ESPP and SAR models are prevalent in the global market, the ESOP model isprevalent in India due to certain legal regulatory framework.

•Employee Stock Option is a plan under which the companygrants options to employeesESOP

•Employee Stock Purchase Plan is a plan under which thecompany offers shares to employees as part of a public issue orotherwiseESPP

•Stock appreciation rights (SARs) is a method for companies togive their management or employees a bonus if the companyperforms well financially.SAR

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• A stock option is defined under the Guidelines as “a right but not an obligation granted toan employee in pursuance of the employee stock option scheme to apply for shares ofthe company at a pre-determined price”.

• In simple terms the consequence of the above definition is that an option can beconverted to shares if the holder of the option fulfils certain conditions. These conditionsare the “vesting criteria” and can be either number of years of continued service afterreceiving the option, satisfaction of some performance goals by the option holder, orboth. After the vesting criteria are satisfied the options are said to be “vested”

• A vested option gives the option holder an unfettered right to “exercise” the option andbe allotted shares of the company. But if the employee is terminated for misconduct,then even his vested options may lapse. Exercise of an option is the process by which avested option is converted into shares by payment of the exercise price. The exerciseprice is normally determined at the time the option is granted to the employee.

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• The shares received on exercise of the option will rank pari passu with the other shares inthe same class. The option holder is not entitled to either dividend or voting rights untilhe exercises his option and is allotted shares. If the company so wishes, it can impose alock-in on the shares issued pursuant to the exercise of the options.

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Employee Stock Options(ESOP's): Flow of events

Grant of Options

Vesting of Options

Exercise of Options

Sale of Shares by Employees

Company

Options

Exercise Price

Shares

• The company grants options to the employees. Once the options gets vested, theemployee gets the right to apply for and be issued shares of the company. Once theoptions are exercised, the company issues the granted options and receive exerciseprice against it. This exercise results in taxation of perquisite in the hands ofemployees.

• Once shares are allotted to employees, they can sell them in the secondary marketwhich will attract capital gains tax to employees.

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Definition & Scope: Stock Appreciation Rights (SAR)

• Stock Appreciation Right (SAR) is one of the alternatives adopted for implementing anequity based compensation plan like Employee Stock Option Plan (ESOP), EmployeeStock Purchase Plan (ESPP) or Restricted Stock Units (RSU). SARs can be furtherstructured as either ‘Equity settled–SARs’ or ‘Cash settled–SARs’. The Cash settled-SARs are known as Phantom Options.

• The mode of settlement generally is defined beforehand at the time of grant of SARs.There might be any one of the following choices of settlement of appreciation:

I. Settlement only by way of equity shares;

II. Settlement either by way of equity shares or cash payment at the option of theCompany;

III. Settlement either by way of equity shares or cash payment at the option of theEmployee;

IV. Settlement only by way of cash payment (where Company may deal with sharesof the Company through Trust route); and

V. Settlement only by way of cash payment (without Company’s dealing in sharesdirectly or indirectly).

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Definition & Scope: Stock Appreciation Rights (SAR)

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Amount received on redemption of SAR’s is a revenue receipt, liable to tax as income under the head salaries.

SAR’s result in receipt of a reward, though measurable in terms of money by which the share price has gone up. While ESOPs result in acquisition of an asset at a concessional price by the beneficiary.

The exact quantum of benefit or reward is ascertained at the point of time when SAR’s are redeemed. Whereas in the case of a stock option, the benefit can be ascertained when shares are actually sold.

Upon exercise, SAR’s provide only for cash payment and not for the issue of shares.

In case of SAR’s. the employee does not have to pay for acquiring an underlying security under the SAR’s scheme. The employee only receives appreciation in the value of an underlying security.

SAR’s are different from stock options

Example: Stock Appreciation Rights

• Say, a Company grants 10,000 SARs today (Y0 ) to an employee with an equal annualvesting schedule over 4 years (Y1 to Y4 ) with an exercise period of 1 year given thefollowing market prices over the period. The appreciation can be determined as under:

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S. No. Particulars Y0 Y1 Y2 Y3 Y4 Total

1 Market Price 100 (Base Price)

150 200 275 350

2 Less: Base price(SAR Price)

100 100 100 100

3 Annual vesting percentage

25% 25% 25% 25% 100%

4 Appreciation per SAR(1-2)

50 100 175 250

5 Annual vesting of SARs(1000*25%)

2500 2500 2500 2500

6 Cash-for cash settlement(4*5)

125000 250000 437500 625000 1437500

7 Equity-for equity settlement

833 1250 1590 1785 5485

Example: ESOP/ESPP

Example 2:

• A company announces an ESOP plan under which company will allot 500 shares ofcompany to certain employees at a price of Rs 100. Those eligible employees willhave option of getting allotment of 100 shares on 1st day of October every year startingfrom 1/4/2012 for next five years. Let us say, Mr. X an employee fills outthe ESOP application form on 1.7.2012 for allotment of shares. He is allotted 100 shares on1/10/2012. The market value on 1/10/2012, (vesting date) is Rs. 600. These 100 shares, letus think, hypothetically, sold by the employee on 31/3/2013 at a price of RS 1000. Then

Tax 1. On allotment day i.e. 1st October 2012, your employer will deduct TDS or Perquisite Tax@ the slab rate you fall in, on the amount of FMV minus Exercise Price. The income and thetaxes paid will reflect in the Form 16 and you should report it as part of salary in your personaltax return.

In our case, let us assume Mr. X falls in highest tax bracket i.e. of 30%, now

(600-100) x 100 x 30.9% = Rs.15,450

Tax 2. On sale day i.e. 31st March, 2013, Short Term Capital Gain will be levied onthe difference between Sale Proceed and FMV at the time of exercise of option, @ 15%, now

(1000-600) x 100 x 15% = Rs.6,000.

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Stock Appreciation Rights(SAR’s): Taxability for Employees

In case of Equity settled-SARs:

a) Perquisite tax: As per Section 17(2)(vi) of the Income Tax Act, 1961 the taxable value ofperquisite refers to ‘value of equity shares issued or transferred to the employee as on dateof exercise’ as reduced by ‘amount recovered from employee’. As per Rule 3(8) of theIncome Tax Rules, 1962 value of listed equity shares refers to average of opening and closingmarket price of equity shares on the relevant Stock Exchange. In case of unlisted equityshares, the value refers to the fair market value of equity share as on date of exercise asdetermined by a Category-I Merchant Banker registered with SEBI. This tax is determined ason date of exercise of SARs at the rate of tax that applies to Salary of that individualemployee.

b) Capital gains tax: Further, at the time of sale of equity shares, the employee is liable topay income tax on the capital gain arising out of such sale. The capital gain refers to theexcess of ‘sales consideration of shares’ over the ‘cost of acquisition of shares’. As persection 49(2AA) of the Income Tax Act, the cost of acquisition refers to the value of suchshares as on date of exercise of SARs which was considered for perquisite tax determination.Long-term gains are taxed at preferential rates than the short-term capital gains. Even attimes, the long-term capital gains exempt in case of listed shares.

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Stock Appreciation Rights(SAR’s): Taxability for Employees

In case of Cash settled-SARs:

The amount of appreciation received by way of cash payment from the Company is subjectto tax in the hands of the employee as perquisite. It is treated as part of salary and isaccordingly taxed.

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Stock Appreciation Rights(SAR’s): Taxability for Company

• As a consequence of perquisites being taxable at the time of exercise of equity / cashsettled SARs as salary, the Company is liable for tax deduction at source under Section192 of the Income Tax Act.

• In case of Equity settled-SARs, the Company may claim deduction up to perquisiteearned by the employees on the basis of decision of Special Bench of Income TaxAppellate Tribunal, Bangalore which was rendered in ESOP context. The principleupheld was that perquisite earned by an employee is at the cost of the Companywhich is a claimable expense. However, in the absence of any supporting provisions inthe Income Tax Act or precedent of Supreme Court, acceptability of such claim by theTax Authorities in other Jurisdictions is not certain.

• In case of Cash settled-SARs, the cash compensation made by the Company isdeductible as allowable expenditure under Section 37 of Income Tax Act.

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Stock Appreciation Rights(SAR’s): Accounting for Company

• Equity settled-SARs:The principle of accounting cost recognition is that there must be some cost (whethernotional or otherwise) to the Company. With the presumption that Equity settled-SARs shallbe granted with reference to the fair market value/ market price of shares as on date ofgrant of such SARs (i.e. without any discount), there shall not be any accounting cost withreference to intrinsic value method prescribed under the Guidance Note issued by ICAI.However, the scenario would change in case a Company adopts IFRS 2 for accounting ofemployee share based payment in which case the fair value of SARs (as per Black Scholes orother prescribed Binomial Method) shall be accounted for.For equity settled stock options, an enterprise should recognise as an expense (except whereservice received qualifies to be included as a part of the cost of an asset) the servicesreceived in an equity-settled employee share-based payment plan when it receives theservices, with a corresponding credit to an appropriate equity account, say, ‘Stock OptionsOutstanding Account’.

• Cash settled-SARs:As per Appendix-IV of the Guidance Note issued by ICAI, the Company is required to makeprovisions for estimated cash requirement for settlement on the basis of estimated FairMarket Value as at end of each financial year till the estimated life of SARs or actual exercise/settlement of SARs, whichever is earlier. As and when any cash payment is made on accountof settlement of SARs, the provision is accordingly adjusted.

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Share Based Payments: Guidance Note by ICAI

• The guidance note issued by ICAI establishes financial accounting and reportingprinciples for employee share-based payment plans, such as ESOP, ESPP and SAR.

For the purpose of accounting, employee share based payment plans are classified into:

Equity Settled

Employee receives the equity shares.

Cash Settled

Employee receives cash based on the price of shares.

Employee share based payment plans with cash alternatives

There is a choice that settlement could be in the form of shares or

cash.

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Share Based Payments: Guidance Note by ICAI contd.

• For equity settled stock options, an enterprise should recognise as an expense (exceptwhere service received qualifies to be included as a part of the cost of an asset) theservices received in an equity-settled employee share-based payment plan when itreceives the services, with a corresponding credit to an appropriate equity account,say, ‘Stock Options Outstanding Account’.

• This account is transitional in nature as it gets ultimately transferred to another equityaccount such as share capital, securities premium account and/or general reserve.

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• An enterprise might grant rights such as stock appreciation rights(SAR) to employeesas part of their remuneration package, whereby the employees will become entitledto a future cash payment (rather than shares), based on the increase in the shareprice of the enterprise from a specified level over a specified period of time. Or anenterprise might grant to its employees a right to receive a future cash payment bygranting to them a right to shares (including shares to be issued upon the exercise ofstock options) that are redeemable, either mandatorily (e.g., upon cessation ofemployment) or at the option of the employee.

• For cash settled share based payment plans, an enterprise should recognise as anexpense (except where service received qualifies to be included as a part of the costof an asset) the services received in a cash-settled employee share-based paymentplan when it receives the services with a corresponding increase in liability by creatinga provision therefor.

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• If an enterprise has granted the employees the right to choose whether a share-basedpayment plan is settled in cash or by issuing shares, the plan has two components, viz.,(i) liability component, i.e., the employees’ right to demand settlement in cash, and (ii)equity component, i.e., the employees’ right to demand settlement in shares rather thanin cash. The enterprise should first measure, on the grant date, fair value of theemployee share-based payment plan presuming that all employees will exercise theiroption in favour of cash settlement. The fair value so arrived at should be considered asthe fair value of the liability component. The enterprise should also measure the fairvalue of the employee share-based payment plan presuming that all employees willexercise their option in favour of equity settlement. In case the fair value under equity-settlement is greater than the fair value under cash- settlement, the excess should beconsidered as the fair value of the equity component. Otherwise, the fair value of theequity component should be considered as zero. The fair value of the equity componentshould be accounted for in accordance with the recommendations in respect of ‘Equity-settled employee share-based payment plan’. The fair value of the liability componentshould be accounted for in accordance with the recommendations in respect of ‘Cash-settled employee share-based payment plan’.

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Share Based Payments: Determining the Value

• The manner of determining the value of perquisite differs for shares, which are listed ona recognised stock exchange in India vis-à-vis shares not listed on a recognised stockexchange in India (overseas equity shares). In case the shares of a company are listed ona recognised stock exchange in India, the fair market value (FMV) is to be determined asthe average of the opening price and the closing price of the share on that date.

• In case the shares are not listed, the FMV shall be such value as determined by amerchant banker (registered with the Securities and Exchange Board of India) on thespecified date. The term ‘specified date’ means

(i) the date of exercising of the option, or

(ii) any date earlier than the date of exercising of the option, not being a date that

is more than 180 days earlier than the date of exercise.

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Glossary - Key Definitions: Employee Stock Options

• Grant is a process by which an employee is given an option. Itis the delivering of the options to the employee. The grant shallspecify the number of options given, the time of vesting, etc.

• Exercise means making of an application by the employee tothe company for issue of shares against option vested in him inpursuance of the employee stock option scheme

Vesting

Exercise

Grant

Lapse

• Vesting means the process by which the employee is given theright to apply for shares of the company against the optionsgranted to him in pursuance of the employee stock optionscheme.

• Option may be said to be lapsed on the expiry of the exerciseperiod or on the happening of the events like separation,abandonment etc

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Economy & Finance

Share Based Payments