In this era of competition, retaining competent professionals is an uphill task for most employers and the most crucial question deliberated by organisations is - Are the employees happy?

While the conventional cash awards are an immediate recognition of one's effort, it also important for the organisation to inculcate a sense of satisfaction and ownership in the employees. Employee Stock Options (ESOPs) are an important tool to link the personal growth of the employee with the growth of the organisation and achieve this objective. Nevertheless, other objectives achieved by implementing ESOPs are wealth creation for employees, retention and attracting new talent.

Here are a few industry trends in ESOP grants and tax implications for an employee during the ESOP life cycle.

Industry trends

KPMG in India recently carried out an ESOP survey collating data regarding existing practices, market trends relating to ESOPs across various multi-national and Indian companies (both listed and unlisted).

The survey report indicates that companies believe that ESOPs enhance productivity, motivate employees and increase their interest in the company's overall performance. Many Indian companies with overseas operations are increasingly awarding equity incentives to attract and retain talent. Information Communication and Entertainment sector dominates the ESOP space followed by Financial Services and Private Equity and Manufacturing and Consumer Goods sector, respectively.

Indian companies though, continue to prefer simple stock options over other types of equity-linked plans. In comparison to foreign companies, these companies are yet to explore other variants such as employee stock purchase plans, restricted stock awards, restricted stock units, phantom equity plans, etc.

Companies generally grant options on an annual basis linked with the performance cycle of their employees. Further, companies provide greater emphasis on the level of employees and past performance as the main criterion for grants. The tenure/loyalty with the organisation also plays a vital role in determining the eligibility of an employee in respect of ESOP grants. Considering the accounting impact (especially the impact on convergence of International Financial Reporting Standards) on the financials, companies are generally averse to granting options at a discount.

With respect to vesting of ESOPs, a schedule of 3-4 years with annualized vesting is generally prevalent. Usually, ‘Performance' is not a common criterion amongst Indian companies for determining the vesting schedule. It is still very much time-based in India.

The majority of companies provide a window of 2-5 years to exercise vested options with no lock-in thereafter.

The survey indicates that even closely held companies are offering stock options to their employees to enable them to participate in the growth of the company and create value. Many unlisted Indian companies which are contemplating an Initial Public Offering (IPO) also grant options to their employees, as it provides a tax efficient exit mechanism to the employees.

Tax impact

Taxation of ESOPs in India has also witnessed a continuous change. Currently, ESOP benefits are taxable as perquisites (i.e. salary income) in the hands of the employees. The employer is required to comply with the routine salary related withholding tax obligations in respect of such perquisite. The perquisite value is ascertained as a difference between the Fair Market Value (FMV) of the share on the date of exercise and the exercise price.

There are specific valuation rules prescribed for listed and unlisted companies. The FMV of shares of a company not listed on Indian stock exchange needs to be determined by the Category I Merchant Banker registered with Securities and Exchange Board of India (SEBI).

The incremental gain, if any (i.e. difference between sale consideration and the FMV on the date of exercise), on sale of shares is considered to be capital gain in the hands of employees. For the purpose of computing capital gains, FMV on the date of exercise becomes the cost base. The capital gains tax treatment also depends on the holding period and whether the shares are sold on a recognized stock exchange in India. The capital gains on transfer of shares would be characterized as long term capital gains when shares are held for more than 12 months. Where the shares are held for twelve months or less, the gains on transfer are considered as short term.

The tax treatment on ESOPs under the proposed Direct Taxes Code Bill, 2010 (DTC) is expected to be similar, though the Valuation Rules are yet to be prescribed.

Equity plans have been a popular tool of the executive remuneration package for a number of years in many countries and their global spread is likely to continue. The feeling of ownership aligns employees' aspirations with the long-term objectives of the organisation.

(The authors are senior personnel of KPMG)

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