What is Employee Stock Ownership Plan (ESOP): Scheme, Benefits, Taxation and Types
Most Indian companies, especially startups, offer a plethora of employee benefit plans in a bid to strengthen working relationships with employees and retain top talent. One of such employee benefit plans is the Employee Stock Ownership Plan (ESOP).
In this blog, we have dissected how employees and employers can benefit from ESOPs. But before delving deep, let’s first understand what an ESOP is.
What is ESOP?
An Employee Stock Ownership Plan (ESOP) is a type of employee benefit plan that gives employees an ownership stake in the company they have been working for. The company sets aside a certain number of shares of its stock to be held in trust for the benefit of its employees. The shares are then allocated to the individual employee accounts. Employees can usually purchase the shares over time, usually through payroll deductions.
How Do ESOPs Work?
Here’s how ESOPs work:
- The Company Establishes a Trust
The company creates an Employee Stock Ownership Trust (ESOT), which is responsible for holding the shares of stock allocated to the ESOP. - Stock is Allocated to the Trust
The company then contributes shares of its own stock to the ESOT, or it may purchase shares on the open market. These shares are allocated to individual employee accounts within the ESOP. - Contributions are made to Employee Accounts
Employees can make contributions to their ESOP accounts through payroll deductions, and these contributions are used to purchase shares of the company’s stock. - Vesting Happens
Employees typically vest in the shares allocated to their ESOP accounts over a period of time, usually several years. This suggests that the employee must complete a certain period of service with the company before they can take complete ownership of the shares allocated to their account. - Distribution of Shares
After an employee leaves the company, retires or is eligible for a distributable event, shares allocated to their account are distributed to the employee, usually in the form of cash or company stock.
Note that in some cases ESOP may also include a “Leaver provision” in which the departing employee has the option to sell their shares back to the company at fair market value.
Benefits of ESOPs for Employees
More than acting as a source of reward for their accomplishments, ESOP is beneficial for employees in the following ways:
1. Profit
Once employees acquire a stake in the company at a discounted rate, they can sell these shares. They not only acquire ownership within their organisation, but they can also make massive profits through the shares.
2. Earn a Stake in your Company
With ESOPS, an employee gets to acquire the shares of their company at a nominal rate. This gives a lot of traction in terms of earning returns if and when you plan to sell your stocks.
3. Passive Income
Most companies offer dividend payouts to their stakeholders. Thus, as employees own a stake in the company under ESOP, they can earn additional income through dividends.
Benefits of ESOP for Employers
There are various reasons why employers offer ESOPs to their employees.
Let’s look at the significance of ESOP for employers:
1. Employee Retention
ESOP’s strategy acts as an effective tool to attract employees and retain them for the company’s long-term growth. It incentivises staying within the organisation till the end of the vesting period, which is generally four years. Thus, by making them stakeholders, employers can ensure that they remain committed to the company’s interest in the long haul.
2. Improves Productivity
An employee who becomes a stakeholder stands to gain more when the company makes profits. By giving them a sense of ownership, employers can boost their workers’ productivity and generate higher gains.
3. Better Remuneration Mechanism
In the age of startups, ESOP is an effective scheme that helps budding companies to hire high-quality employees. Startups are not always in the position of offering attractive remuneration packages and thus, have a high attrition rate. However, with ESOP, startups can lure talented individuals by offering them shares in the company instead of massive salaries.
ESOP Eligibility
According to Rule 12 of the (Share Capital and Debentures) Rules, 2014, ESOPs can be issued to:
- Permanent employee of a company working in or outside India.
- A director of a company that includes full-time or part-time directors but is not an independent director.
- Permanent or director of India or a subsidiary outside India, or a holding company or affiliate.
The company may not issue ESOPs to the following employees:
- Promoter Group or who are promoters of the company.
- A director who holds 10% or more of a company’s issued shares, directly or indirectly, through himself or a corporation or its relatives.
However, the above two conditions are not applicable to startups for 10 years from the date of incorporation.
How to Calculate Tax on ESOP?
There are certain variables that one must keep in mind while calculating the tax implications of an ESOP. These include exercise date, Fair Market Value, Exercise price, taxable value, number of shares and total taxable perquisite.
Example:
Let the exercise date be 1st January 2022. It is the date on which the employee exercises his/her ESOP.
If the fair market value of the asset is Rs.160/share and the exercise price is Rs. 85/share, the taxable value of the perquisite is
160 – 85 = Rs.75/share
Let’s say that the number of shares exercised is 1000, so the total taxable perquisite is 1000 * 75 = Rs.75,000
So, the tax payable on the ESOP (30% according to tax slab rate) = 30/100*75,000 = Rs.22,500
However, startup companies enjoy certain tax relaxations in this regard. Employees of such companies are not required to pay the tax on the perquisite for the year when they exercise their ESOP. For them, TDS will be deferred to a date which can be 5 years from the ESOP grant date or when the employee sells the ESOP or if they leave the company.
As per the Income Tax Act of 1961, employees under Employee Stock Ownership Plan are subject to different tax implications under these circumstances:
When an employee decides to buy shares in the company, the difference between the exercise price and Fair Market Value on the exercise date is called a prerequisite. As per the taxation rules, tax applies to this prerequisite value.
An employer is liable to deduct tax at the source and deposit it with the government. For tax return purposes, this prerequisite amount falls under the category of “income from salary.”
However, to provide a boost to startups, the government does not charge any tax on prerequisite amounts for the exercise year.
If an employee decides to sell the shares they bought at a higher price than Fair Market Value, they are liable to incur capital gains tax. The percentage of tax varies according to the holding period.
If employees sell their shares within one year of exercising them, they incur a short-term capital gains tax of 15%. Meanwhile, if the sale takes place after 12 months, the applicable tax rate is 10% on gains above Rs. 1 lakh.
Furthermore, if employees have ESOP in foreign companies, their gains fall under their annual taxable income. Thus, taxation is according to their income tax slab.
What Happens to ESOP When Companies Get Listed?
It becomes a challenge for unlisted companies to sell their ESOPs. Moreover, shares sold by unlisted companies attract short-term capital gains when sold within 36 months of exercising them. Shares traded after three years attract long-term capital gains. These shares are taxed with a 20% indexation.
On getting listed, companies can enjoy more opportunities in terms of benefits while cashing out these shares in the fair market. ESOP schemes in listed companies are called Employee Stock Purchase Schemes (ESPS).
SEBI guidelines allow listed companies to offer shares to their employees as a public issue. Unlike ESOP, ESPS allows employees to purchase shares at rates lower than that of the fair market.
When to Cash-out ESOPs?
One can cash out his/her ESOP after retirement, death, or termination of services if the vesting schedule is over. The vesting period usually ranges from four to six years, after which one can exercise his/her right to the options.
However, if the vested period is not over before resignation or termination, an employee will lose the unvested portion of ESOP. For example, if an employee leaves after 2 years, and the vesting schedule is 15% every year, he or she will lose 70% of the ESOP.
The minimum age of an employee to cash-out ESOP is around 55-59 years, depending on a particular company’s policy. Employees might have to pay a 10% early withdrawal penalty for cashing out before the minimum age.
Final Word
Many Indian companies, especially startups, are very keen on offering Employee Stock Ownership Plans. Through ESOP, they can attract highly talented individuals with impressive wealth creation opportunities. This does not just lead to value addition for companies but also enhances the workplace experience of loyal and hardworking employees.
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FAQs
Ans: In India, numerous companies have set up massive Employee Stock Ownership Plan pools and trusts. Some of the leading names are Flipkart, Oyo, Nykaa, Zomato, and Paytm. Furthermore, 2021 was a significant year for ESOP; almost 40 companies spent Rs. 3,200 crores on buying back shares.
Ans: In India, any company can offer ESOP to their employees. There are no restrictions or eligibility criteria. Most organisations that offer ESOP, have long-term objectives. That said, for unlisted companies, selling shares through ESOP can be difficult.
Ans: Attrition rate, commonly referred to as churn rate, is the rate at which a company’s employees leave. You can determine this percentage by dividing the number of people who leave by the average number of employees.
Ans: No, if you exercise ESOP, it does not mean that you have voting rights within the organisation. Generally, only employees in senior positions or those with significant ESOPs (at least 5% stake) qualify to hold voting rights.
Ans: A company cannot issue ESOP to an individual who is part of the promoter group or is a promoter of the company. A director who holds 10% outstanding shares in a company through themselves or relatives, does not qualify for ESOP.
Ans: As per SEBI guidelines, there should be a minimum period of one year between the grant of options and vesting of options. Companies have the freedom to choose lock-in period duration as long as it is over 1 year.
Ans: The vesting period is the time period that an employee has to wait to be able to exercise their ESOPs. Once the vesting and lock-in period ends, the exercise period begins. This is the time during which the employee can buy the company’s shares.
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Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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