It was a hectic Tuesday when a founder called me, frustrated. “I thought I had the ESOP all figured out,” he said, “but now I’m hearing complaints from employees, and I’m worried we didn’t set it up right.” Like many founders, he assumed offering stock options would be straightforward, But when you get into the details, ESOPs can be tricky. A small mistake can lead to unhappy employees, legal issues, or even expensive fines.
The truth is, while ESOPs are a powerful tool for attracting and retaining talent, they come with a complex legal framework that needs careful attention. Without understanding the regulations and legal obligations around ESOPs, you risk not only the dissatisfaction of employees but potential legal and financial challenges as well.
To help you understand this, we’ve broken down the key legal considerations every startup in India should know. Whether you’re just setting up your first ESOP or refining an existing plan, the following guide will ensure you stay compliant and avoid common pitfalls.
The Legal Framework for ESOPs in India
- Companies Act, 2013: In India, the Companies Act of 2013 serves as the primary legislation governing the operation of companies and relating to Employee Stock Ownership Plans (ESOPs).
- Section 62(1)(b)–This section allows companies to offer shares to employees through ESOPs, with a condition. Issuing shares through ESOPs would require the passing of a special resolution by the shareholders at a general meeting. This essentially means that shareholders are consulted to what extent and in what percentages their holdings are likely to be diluted because of issue of shares upon exercise of the options.
- Definition of ‘Employee’– The term “employee” is defined broadly in the Act, encompassing permanent/ full-time employees working in or outside India for the Company and directors. However, it is important to note that independent directors are excluded from eligibility for ESOPs under the Companies (Share Capital and Debentures) Rules, 2014.
- Other Provisions: Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, applies to unlisted companies issuing ESOPs. It outlines essential conditions, including the need for shareholder approval via a special resolution, restrictions on eligibility, and detailed compliance requirements.
- SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021: These regulations provide for the compliance requirements which listed companies must adhere to, for granting ESOPs or other share based benefits.
- Key Points:
- Regulation 6: It is obligatory for shareholders to pass a special resolution adopting the ESOP scheme. The scheme should include, the pool, the eligibility of employees, the price of options and the timeline for exercising the options.
- Regulation 10: The Company is required to secure an ‘in-principle’ approval for listing of the shares to be issued pursuant to exercise of the stock options.
- Key Points:
- Income Tax Act, 1961: This Act significantly influences how both employees and employers approach taxation on ESOPs.
- Key Points:
- Section 17(2)(vi): This section addresses the taxation of shares acquired through ESOPs; specifically, at the time of the exercise, the difference between fair market value (FMV) and the exercise price is taxed as salary income.
- Section 192: Companies must deduct tax at source on the perquisite value of exercised options by employees.
- Key Points:
- Foreign Exchange Management Act (FEMA) 1999
If a company grants ESOPs to its foreign employees, it must comply with the Foreign Exchange Management Act (FEMA) of 1999. Under FEMA regulations, any investment received from foreign employees is treated as FDI, and such investments are subject to entry routes (Automatic or Government route), sectoral caps, investment limits, and pricing guidelines. For the Government route, prior approval from the Government of India (GoI), Ministry of Finance, and Foreign Investment Promotion Board (FIPB) is mandatory before granting these ESOPs to foreign employees. However, no approval from the GoI or RBI is required for the Automatic route.
Compliance:
Reporting requirements under FEMA in case of issuance of ESOPs by an Indian Company to a foreign employee are:
- At the time of issue and allotment of capital instrument, the Form FC GPR shall be filed within 30 days from allotment of shares to the employees.
- Form FC-TRS to be filed within 60 days from the date of receipt or payment of the amount of consideration in case of sale of shares granted under ESOPs.
- Accounting Standards
Proper accounting practices are crucial for managing ESOPs:
Indian Accounting Standard (Ind AS 102): This accounting standard deals with the issue of share-based payments, which recognises expenses over the vesting period. Companies must measure fair value at the grant date and report it in financial statements.
- Filing and Reporting Requirements
It’s essential for organisations to stay updated on Tax Deducted at Source (TDS) regulations and similar obligations to ensure accurate record-keeping, which is crucial for audits and compliance purposes.
- Communication and Training Employees
- Conducting seminars and training sessions aimed at making the employees understand what ESOPs are and their benefits.
- Provide comprehensive documentation outlining rights and obligations to enhance employee understanding of their participation in the plan.
- Legal Issues and Dispute Settlement
Even with well-defined rules, legal issues may arise concerning ESOPs.
- Strategies to Prevent Problems:
- Ensure clear documentation that accurately describes the terms and conditions associated with the ESOPs.
- Implement an internal grievance mechanism to resolve complaints related to ESOPs efficiently.
Conclusion
The legal framework governing ESOPs in India is complex yet crucial for balancing the interests of both employees and the company. For successful implementation, it is essential to ensure compliance with the provisions of the Companies Act, SEBI regulations, and relevant tax laws.
If you’re ready to leverage ESOPs to boost employee participation without jeopardising the long-term health of your company, it’s essential to stay updated on the constantly evolving regulations. While ESOPs may seem complex, they can certainly deliver significant benefits when done correctly.
Looking to implement an ESOP and have questions about how to structure it effectively? Book a call with us using this link for FREE guidance on this.
