Meaning, Accounting and Tax Treatment
ESOP’s are Employee Stock Option Plans under which employees receive the right to purchase a certain number of shares in the company at a predetermined price, as a reward for their performance and also as motivation for employees to keep increasing their performance. As a founder, we would always want to hire the best of resources for our startup, but the problem is that the best has cost attached to it, which a startup may not be able to afford initially. Thus, Employee Stock Option Plan (ESOPs) gives a solution to the
founders, by which they can look to instill founder’s motivation among their founding team by offering stake in the business by way of ESOPs.
Employees will have to wait for a certain duration known as vesting period before they can exercise the right to purchase the shares.
From long term perspective, Employee Stock Option Plan is considered as a good management tool for retention of human talent. Under this scheme, employees are provided stake in the company in the form of shares / options at reduced price than what prevails in the market. The personnel can exercise the options only after the vesting period elapses.
The main aim of giving such a plan to its employees is to give shares of the company to its employees at a discounted price to the market price at the time of exercise. Many companies (especially in the startup phase) have now started giving Employee Stock Options as this is beneficial to both the employer as well as the employee.
Benefits of ESOP’s
The major benefits of awarding Employee Stock Options are mentioned below:
Lock-in Period:
ESOP’s come with a lock-in period known as vesting period and employees can exercise the options only after this period. If the employee leaves the organisation before completing the specified period – these ESOP’s get lapsed and the employee will not get any benefit.
A ‘Sense of Ownerhip’ for the employees:
When the employees are given shares of the same company in which they are working, it gives them a sense of feeling that now they are not employees of this organisation but are the owners. As they are now they owners, they also have a share in the profits of the company. In fact, since employees directly benefit from the increase in the share price, they focus on overall value creation for the company.
Kind instead of Cash:
ESOP’s are a way of awarding the employees in kind instead of cash. In the initial days of ESOP’s in India, small organisations who were cash strapped used to give ESOP’s to their employees to increase the overall pay package. In this manner, they were able to compensate the employees in kind without affecting their cash reserves (if a organisation issues ESOP’s- its cash reserves are not affected).
Illustration
Many companies like Infosys in their early days used to award employees and even clerical staff with ESOP’s. This way, there were able to manage their direct costs. Moreover, giving ESOP’s to employees was also a way of motivating the employees to work harder by creating the sense of ownership and directly rewarding employees for increase in the company’s valuation.
Infosys grew very fast; many employees who got ESOP’s of Infosys in the early days and preferred to keep these shares have today turned millionaires. Infosys used to even award Drivers, Office Assistants and Secretaries with ESOP’s and many of them have also turned millionaires.
Many small companies which are growing fast but are in need of cash have started replicating the ESOP’s model which was implemented by Infosys. This model not only helps the organisations preserve cash but also keeps the employees motivated. In fact, Narayan Murthy went on record saying that “Every Indian employee at every level who joined the company on or before March 2010 is a stakeholder of Infosys”.
Word of Caution: Infosys earlier used to award ESOP’s to almost all its employees but has now started awarding ESOP’s judicially as awarding too many ESOP’s may dilute the promoters’ & investors’ stake.
Accounting Treatment of ESOPs
Employers use share-based payments as a part of remuneration package for their employees. Hence the employers engaged in such arrangements with employees recognize the cost of services received over the requisite service period. The accounting value is determined by finding either fair value of the option or intrinsic value of the option. Intrinsic value means the excess of the fair value of the share at the date of grant of the option over the exercise price of the option. Fair value of an option means the market price of the option, had it been traded in the market.
When we account for employee stock options, following new accounts come into existence:
• Employee compensation expense account – It forms part of the compensation expense account and is taken in the profit and loss account.
• Deferred employee compensation expense – This account is created at the time of grant of options for the total amount of compensation expense to be accounted. This account is a part of the Balance sheet and forms a negative balance in the Shareholders equity or Net worth.
• Employee Stock Options Outstanding account – It is a part of the Shareholders equity and is transferred to Share Capital, Share Premium or General Reserves. Amortized employee stock compensation expenses are taken in the Profit and loss account.
Calculation of Compensation Expense / Cost: The total compensation cost is the fair value of the instruments issued multiplied by the number of instruments that actually vest. This cost is recognized over the requisite service period with a corresponding credit to Employee Stock Options Outstanding account. The number of instruments expected to vest is estimated at the service inception date, and is revised during the requisite service period to reflect subsequent information. Total compensation cost is also revised accordingly. Employees earn the right to exercise the option after the completion of the vesting period, which is generally the service condition. The requirement that an individual remain an employee for that period is a service condition. An explicit service condition is explicitly stated in the terms of share-based arrangements (e.g., three years of continuous employee service from January 3, 2012). The objective of accounting for transactions under share-based arrangements with employees is to recognize compensation costs related to employee services received in exchange for equity instruments issued.
The Accounting treatment discussed above can be illustrated by the following numerical example.
Options granted – 500 on 01/04/2012 at Rs. 40
Vesting Period – 2 years.
Fair Value of options: Rs. 15
Fair Value per share: Rs.10
Hence, Total Employee Compensation Expense – Rs. 7500 (500×15)
The accounting entries would be as follows:
Employee Compensation Expense A/C 7500
Employee Stock Options Outstanding A/C 7500
(This entry to be made every year till the vesting period expires)
And in the year of exercising the option, the entry would be:
Bank A/C (Amount actually received)
Employee Stock Options Outstanding A/C
Equity Share Capital A/C
Security Premium A/C (if any)
Taxation of ESOP’s
There have been various changes in the taxation of ESOP’s in the past 20 years. The Government finally seems to have found a logical way of taxing ESOP’s. The manner of computation of Tax of ESOP’s in the hands of the employee has been explained hereunder:-
At the time of giving ESOP’s:The benefits arising on ESOP’s are taxed as Perquisites in the hands of the employee and form a part of the employee’s salary income. The employer is also required to deduct TDS in respect of such perquisite. The perquisite value is computed as the difference between the fair market value of the share and the Exercise price. It shall be taxable only when shares are allotted under ESOPs.
Where shares in the company are listed on a single recognised stock exchange then FMV shall be the average of opening and closing price of shares on the date of exercise of option. However, if on the date of exercise of option there is no trading in shares, the FMV shall be the closing price of the share on any recognised stock exchange on a date closest to the date of exercise of option and immediately preceding such date of exercise of option.
Where shares in the company are not listed on a recognised stock exchange then FMV shall be such value of the share in the company as determined by a category I merchant banker registered with SEBI on the specified date.
Specified date means the date of exercise of option or any date earlier than the date of exercise of option, not being a date which is more than 180 days earlier than the date of exercise of option.
The deductor can claim deduction for the compensation (as well as other expenses) is from firm’s gross income to arrive at its taxable income. Hence the deduction is allowable in the year in which the option is exercised by the employees i.e. when the liability became certain and not proportionately over the vesting period as claimed by the employee
At the time of sale of such ESOP’s by the employee: The gains arising on the sale of ESOP’s are considered to be Capital Gains; Capital Gains Tax is levied on the such gains and tax is liable to be paid in the year in which such ESOP’s are sold. The Capital Gain is computed as the difference between the sale price and the price at which it was awarded by the Employer.
The Capital Gains treatment further depends on the holding period of the ESOP’s i.e. if the shares are held for less than 12 months – Short Term Capital Gains Tax@ 15% is levied and if the shares are held for more than 12 months- Long Term Capital Gains Tax is levied (this is currently NIL). Thus, if such ESOP’s are held by the employee for more than 12 months, the gains arising on the sale of such ESOP’s is effectively exempt from Tax.
ESOP’s are Employee Stock Option Plans under which employees receive the right to purchase a certain number of shares in the company at a predetermined price, as a reward for their performance and also as motivation for employees to keep increasing their performance. As a founder, we would always want to hire the best of resources for our startup, but the problem is that the best has cost attached to it, which a startup may not be able to afford initially. Thus, Employee Stock Option Plan (ESOPs) gives a solution to the
founders, by which they can look to instill founder’s motivation among their founding team by offering stake in the business by way of ESOPs.
Employees will have to wait for a certain duration known as vesting period before they can exercise the right to purchase the shares.
From long term perspective, Employee Stock Option Plan is considered as a good management tool for retention of human talent. Under this scheme, employees are provided stake in the company in the form of shares / options at reduced price than what prevails in the market. The personnel can exercise the options only after the vesting period elapses.
The main aim of giving such a plan to its employees is to give shares of the company to its employees at a discounted price to the market price at the time of exercise. Many companies (especially in the startup phase) have now started giving Employee Stock Options as this is beneficial to both the employer as well as the employee.
Benefits of ESOP’s
The major benefits of awarding Employee Stock Options are mentioned below:
Lock-in Period:
ESOP’s come with a lock-in period known as vesting period and employees can exercise the options only after this period. If the employee leaves the organisation before completing the specified period – these ESOP’s get lapsed and the employee will not get any benefit.
A ‘Sense of Ownerhip’ for the employees:
When the employees are given shares of the same company in which they are working, it gives them a sense of feeling that now they are not employees of this organisation but are the owners. As they are now they owners, they also have a share in the profits of the company. In fact, since employees directly benefit from the increase in the share price, they focus on overall value creation for the company.
Kind instead of Cash:
ESOP’s are a way of awarding the employees in kind instead of cash. In the initial days of ESOP’s in India, small organisations who were cash strapped used to give ESOP’s to their employees to increase the overall pay package. In this manner, they were able to compensate the employees in kind without affecting their cash reserves (if a organisation issues ESOP’s- its cash reserves are not affected).
Illustration
Many companies like Infosys in their early days used to award employees and even clerical staff with ESOP’s. This way, there were able to manage their direct costs. Moreover, giving ESOP’s to employees was also a way of motivating the employees to work harder by creating the sense of ownership and directly rewarding employees for increase in the company’s valuation.
Infosys grew very fast; many employees who got ESOP’s of Infosys in the early days and preferred to keep these shares have today turned millionaires. Infosys used to even award Drivers, Office Assistants and Secretaries with ESOP’s and many of them have also turned millionaires.
Many small companies which are growing fast but are in need of cash have started replicating the ESOP’s model which was implemented by Infosys. This model not only helps the organisations preserve cash but also keeps the employees motivated. In fact, Narayan Murthy went on record saying that “Every Indian employee at every level who joined the company on or before March 2010 is a stakeholder of Infosys”.
Word of Caution: Infosys earlier used to award ESOP’s to almost all its employees but has now started awarding ESOP’s judicially as awarding too many ESOP’s may dilute the promoters’ & investors’ stake.
Accounting Treatment of ESOPs
Employers use share-based payments as a part of remuneration package for their employees. Hence the employers engaged in such arrangements with employees recognize the cost of services received over the requisite service period. The accounting value is determined by finding either fair value of the option or intrinsic value of the option. Intrinsic value means the excess of the fair value of the share at the date of grant of the option over the exercise price of the option. Fair value of an option means the market price of the option, had it been traded in the market.
When we account for employee stock options, following new accounts come into existence:
• Employee compensation expense account – It forms part of the compensation expense account and is taken in the profit and loss account.
• Deferred employee compensation expense – This account is created at the time of grant of options for the total amount of compensation expense to be accounted. This account is a part of the Balance sheet and forms a negative balance in the Shareholders equity or Net worth.
• Employee Stock Options Outstanding account – It is a part of the Shareholders equity and is transferred to Share Capital, Share Premium or General Reserves. Amortized employee stock compensation expenses are taken in the Profit and loss account.
Calculation of Compensation Expense / Cost: The total compensation cost is the fair value of the instruments issued multiplied by the number of instruments that actually vest. This cost is recognized over the requisite service period with a corresponding credit to Employee Stock Options Outstanding account. The number of instruments expected to vest is estimated at the service inception date, and is revised during the requisite service period to reflect subsequent information. Total compensation cost is also revised accordingly. Employees earn the right to exercise the option after the completion of the vesting period, which is generally the service condition. The requirement that an individual remain an employee for that period is a service condition. An explicit service condition is explicitly stated in the terms of share-based arrangements (e.g., three years of continuous employee service from January 3, 2012). The objective of accounting for transactions under share-based arrangements with employees is to recognize compensation costs related to employee services received in exchange for equity instruments issued.
The Accounting treatment discussed above can be illustrated by the following numerical example.
Options granted – 500 on 01/04/2012 at Rs. 40
Vesting Period – 2 years.
Fair Value of options: Rs. 15
Fair Value per share: Rs.10
Hence, Total Employee Compensation Expense – Rs. 7500 (500×15)
The accounting entries would be as follows:
Employee Compensation Expense A/C 7500
Employee Stock Options Outstanding A/C 7500
(This entry to be made every year till the vesting period expires)
And in the year of exercising the option, the entry would be:
Bank A/C (Amount actually received)
Employee Stock Options Outstanding A/C
Equity Share Capital A/C
Security Premium A/C (if any)
Taxation of ESOP’s
There have been various changes in the taxation of ESOP’s in the past 20 years. The Government finally seems to have found a logical way of taxing ESOP’s. The manner of computation of Tax of ESOP’s in the hands of the employee has been explained hereunder:-
At the time of giving ESOP’s:The benefits arising on ESOP’s are taxed as Perquisites in the hands of the employee and form a part of the employee’s salary income. The employer is also required to deduct TDS in respect of such perquisite. The perquisite value is computed as the difference between the fair market value of the share and the Exercise price. It shall be taxable only when shares are allotted under ESOPs.
Where shares in the company are listed on a single recognised stock exchange then FMV shall be the average of opening and closing price of shares on the date of exercise of option. However, if on the date of exercise of option there is no trading in shares, the FMV shall be the closing price of the share on any recognised stock exchange on a date closest to the date of exercise of option and immediately preceding such date of exercise of option.
Where shares in the company are not listed on a recognised stock exchange then FMV shall be such value of the share in the company as determined by a category I merchant banker registered with SEBI on the specified date.
Specified date means the date of exercise of option or any date earlier than the date of exercise of option, not being a date which is more than 180 days earlier than the date of exercise of option.
The deductor can claim deduction for the compensation (as well as other expenses) is from firm’s gross income to arrive at its taxable income. Hence the deduction is allowable in the year in which the option is exercised by the employees i.e. when the liability became certain and not proportionately over the vesting period as claimed by the employee
At the time of sale of such ESOP’s by the employee: The gains arising on the sale of ESOP’s are considered to be Capital Gains; Capital Gains Tax is levied on the such gains and tax is liable to be paid in the year in which such ESOP’s are sold. The Capital Gain is computed as the difference between the sale price and the price at which it was awarded by the Employer.
The Capital Gains treatment further depends on the holding period of the ESOP’s i.e. if the shares are held for less than 12 months – Short Term Capital Gains Tax@ 15% is levied and if the shares are held for more than 12 months- Long Term Capital Gains Tax is levied (this is currently NIL). Thus, if such ESOP’s are held by the employee for more than 12 months, the gains arising on the sale of such ESOP’s is effectively exempt from Tax.
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