By Poorvi Sanjanwala, Nishtha Mehta & Kashmira Bakliwal
Employees are critical to the growth and success of any organisation. Recent times have witnessed a start-up deluge and booming e-commerce, which coupled with increased opportunities and prevailing competition, have resulted in higher levels of attrition.
This has necessitated companies to offer to their employees, particularly senior and key employees, not only attractive remuneration packages, but incentives so as to retain the employees in the long run, which include employee stock options and stock purchase plans, stock appreciation rights, other general benefits, retirement benefits etc.
ESOPs - A conventional mode of employee incentive
Among the various incentives and benefits offered to the employees, employee stock option and stock purchase plans (Stock Plans) are one of the most effective tools traditionally utilised for retaining employees within an organisation. Stock Plans, as the nomenclature suggests, entitles an eligible employee to equity stake in a company.
Upon fulfilment of defined criteria, the employee becomes eligible to subscribe to, or purchase, specific number of shares at a pre-determined price. While Stock Plans formulated by listed companies in India are governed by the Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014 (SEBI Employee Benefit Regulations), Stock Plans formulated by unlisted companies are governed by Section 62(1)(b) of the Companies Act, 2013 read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 (Companies Act ESOP Provisions). Both these enactments contain detailed provisions on the introduction and implementation of Stock Plans by listed and unlisted companies.
SARs - A contemporary mode of employee incentive
ESOPs have been a conventional mode of a deferred reward plan for employees. However, a number of factors including specific preferences and requirements of companies coupled with the need to evolve traditional concepts to meet the changing pace of time, have led to the introduction of hybrid incentive plans which also include stock appreciation rights (SARs).
SARs entitle an employee to receive appreciation, for a specific number of shares of a company where the settlement of such appreciation may be made either by way of cash payment or shares of the company. Thus, SARs granted to employees results in two forms of underlying entitlements at the time of exercise of SARs by the employees, one form being equity stake in the company and other being a cash entitlement. SEBI Employee Benefit Regulations specifically mentions that SARs which are settled by way of shares of a company are referred to as equity settled SARs.
The concept of Phantom Stock Options
'Phantom Stocks Options' or 'Shadow Stocks Options' (Phantom Stock Options) is a popular nomenclature derived from usage for SARs which are settled by way of cash entitlement. A Phantom Stock Option is a performance-based incentive plan which entitles an employee the right to receive cash payments after a specific period of time or upon fulfilment of specific criteria and is directly linked to the valuation and the appreciated value of the share price of the company. Thus, the underlying entitlement for an employee at the time of exercise of Phantom Stock Options is a cash payment unlike Stock Plans which entitle an employee to equity stake in the company.
Phantom Stock Options are becoming increasingly popular as they enable companies to share a portion of their profits or appreciated valuation, thereby incentivising and retaining employees in such a manner that does not result in a dilution in such companies. However, while Phantom Stock Options may be beneficial to companies and its management (read employers), they may not be an attractive option for employees who may be seeking an equity stake in the company in the form of Stock Plans or equity settled SARs as against a cash incentive.
Tax Implications of Phantom Stocks
The income received by an employee, in the form of cash entitlement at the time of the exercise of Phantom Stock Options, is taxed under the head of salary income as perquisites in the hands of the employee. No incidence of the tax arises in hands of the company (read the employer) at the time of making payment of the cash entitlement to the employee. However, considering that the cash entitlement received by the employee upon the exercise of the Phantom Stock Options is taxed under the head of salary income, the company is required to withhold taxes (read tax deducted at source) just before making payment of the cash entitlement to the employees.
Legal Framework for Phantom Stock Options
Under the Companies Act 2013
While the Companies Act, 2013 has prescribed rules for issuance of shares to employees under Stock Plans, it is silent on the grant and exercise of SARs including issuance of equity settled SARs and Phantom Stock Options.
Under the SEBI Employee Benefit Regulations The SEBI Employee Benefit Regulations read with the Companies Act ESOP Provisions prescribe rules and regulations for formulation of Stock Plans and the grant and exercise of equity settled SARs by listed companies.
It would be interesting to mention here that with respect to SARs, SEBI has, in July 2015, in response to a request for informal guidance sought by Mindtree Limited, clarified that one of the criteria to determine applicability of SEBI Employee Benefit Regulations to an employee benefit scheme is that such scheme should actually involve "dealing in, or subscribing to, or purchasing, securities of the company directly or indirectly".
SEBI has further stated that if the proposed scheme does not involve dealing in securities of the company, directly or indirectly, then the SEBI Employee Benefit Regulations are not applicable to the scheme. The employee benefit scheme of Mindtree did not involve a purchase or subscription of shares by eligible employees at the time of the exercise of the right, but was in the form of cash payments for appreciation in the share prices of the company and SEBI clarified that the SEBI Employee Benefit Regulations would not be applicable to Mindtree employee benefit scheme. However, considering that the views contained in the informal guidance relating to Mindtree are specific to facts and clarifications sought by Mindtree, the views expressed by SEBI in the Mindtree informal guidance cannot be applied generically.
Conclusion
The existing legal framework is silent on the grant and exercise of Phantom Stock Options. Hence, till such time that specific provisions are introduced under the Companies Act or until SEBI amends the SEBI Employee Benefit Regulations to bring Phantom Stock Options within its purview, companies will have the flexibility of formulating schemes for the grant and exercise of the Phantom Stock Options.
(Poorvi Sanjanwala is Partner at Rajani Associates, Nishtha Mehta & Kashmira Bakliwal are Associates at Rajani Associates.)
Employees are critical to the growth and success of any organisation. Recent times have witnessed a start-up deluge and booming e-commerce, which coupled with increased opportunities and prevailing competition, have resulted in higher levels of attrition.
This has necessitated companies to offer to their employees, particularly senior and key employees, not only attractive remuneration packages, but incentives so as to retain the employees in the long run, which include employee stock options and stock purchase plans, stock appreciation rights, other general benefits, retirement benefits etc.
ESOPs - A conventional mode of employee incentive
Among the various incentives and benefits offered to the employees, employee stock option and stock purchase plans (Stock Plans) are one of the most effective tools traditionally utilised for retaining employees within an organisation. Stock Plans, as the nomenclature suggests, entitles an eligible employee to equity stake in a company.
Upon fulfilment of defined criteria, the employee becomes eligible to subscribe to, or purchase, specific number of shares at a pre-determined price. While Stock Plans formulated by listed companies in India are governed by the Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014 (SEBI Employee Benefit Regulations), Stock Plans formulated by unlisted companies are governed by Section 62(1)(b) of the Companies Act, 2013 read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 (Companies Act ESOP Provisions). Both these enactments contain detailed provisions on the introduction and implementation of Stock Plans by listed and unlisted companies.
SARs - A contemporary mode of employee incentive
ESOPs have been a conventional mode of a deferred reward plan for employees. However, a number of factors including specific preferences and requirements of companies coupled with the need to evolve traditional concepts to meet the changing pace of time, have led to the introduction of hybrid incentive plans which also include stock appreciation rights (SARs).
SARs entitle an employee to receive appreciation, for a specific number of shares of a company where the settlement of such appreciation may be made either by way of cash payment or shares of the company. Thus, SARs granted to employees results in two forms of underlying entitlements at the time of exercise of SARs by the employees, one form being equity stake in the company and other being a cash entitlement. SEBI Employee Benefit Regulations specifically mentions that SARs which are settled by way of shares of a company are referred to as equity settled SARs.
The concept of Phantom Stock Options
'Phantom Stocks Options' or 'Shadow Stocks Options' (Phantom Stock Options) is a popular nomenclature derived from usage for SARs which are settled by way of cash entitlement. A Phantom Stock Option is a performance-based incentive plan which entitles an employee the right to receive cash payments after a specific period of time or upon fulfilment of specific criteria and is directly linked to the valuation and the appreciated value of the share price of the company. Thus, the underlying entitlement for an employee at the time of exercise of Phantom Stock Options is a cash payment unlike Stock Plans which entitle an employee to equity stake in the company.
Phantom Stock Options are becoming increasingly popular as they enable companies to share a portion of their profits or appreciated valuation, thereby incentivising and retaining employees in such a manner that does not result in a dilution in such companies. However, while Phantom Stock Options may be beneficial to companies and its management (read employers), they may not be an attractive option for employees who may be seeking an equity stake in the company in the form of Stock Plans or equity settled SARs as against a cash incentive.
Tax Implications of Phantom Stocks
The income received by an employee, in the form of cash entitlement at the time of the exercise of Phantom Stock Options, is taxed under the head of salary income as perquisites in the hands of the employee. No incidence of the tax arises in hands of the company (read the employer) at the time of making payment of the cash entitlement to the employee. However, considering that the cash entitlement received by the employee upon the exercise of the Phantom Stock Options is taxed under the head of salary income, the company is required to withhold taxes (read tax deducted at source) just before making payment of the cash entitlement to the employees.
Legal Framework for Phantom Stock Options
Under the Companies Act 2013
While the Companies Act, 2013 has prescribed rules for issuance of shares to employees under Stock Plans, it is silent on the grant and exercise of SARs including issuance of equity settled SARs and Phantom Stock Options.
Under the SEBI Employee Benefit Regulations The SEBI Employee Benefit Regulations read with the Companies Act ESOP Provisions prescribe rules and regulations for formulation of Stock Plans and the grant and exercise of equity settled SARs by listed companies.
It would be interesting to mention here that with respect to SARs, SEBI has, in July 2015, in response to a request for informal guidance sought by Mindtree Limited, clarified that one of the criteria to determine applicability of SEBI Employee Benefit Regulations to an employee benefit scheme is that such scheme should actually involve "dealing in, or subscribing to, or purchasing, securities of the company directly or indirectly".
SEBI has further stated that if the proposed scheme does not involve dealing in securities of the company, directly or indirectly, then the SEBI Employee Benefit Regulations are not applicable to the scheme. The employee benefit scheme of Mindtree did not involve a purchase or subscription of shares by eligible employees at the time of the exercise of the right, but was in the form of cash payments for appreciation in the share prices of the company and SEBI clarified that the SEBI Employee Benefit Regulations would not be applicable to Mindtree employee benefit scheme. However, considering that the views contained in the informal guidance relating to Mindtree are specific to facts and clarifications sought by Mindtree, the views expressed by SEBI in the Mindtree informal guidance cannot be applied generically.
Conclusion
The existing legal framework is silent on the grant and exercise of Phantom Stock Options. Hence, till such time that specific provisions are introduced under the Companies Act or until SEBI amends the SEBI Employee Benefit Regulations to bring Phantom Stock Options within its purview, companies will have the flexibility of formulating schemes for the grant and exercise of the Phantom Stock Options.
(Poorvi Sanjanwala is Partner at Rajani Associates, Nishtha Mehta & Kashmira Bakliwal are Associates at Rajani Associates.)
( Originally published on May 05, 2016 )
