Share Based Payment

1. • Valuation
• Investment Banking
• Advisory Services
Note on
“Share Based Payments”

2. Contents
Definition & Scope – ESOP/ESPP
Guidance note by ICAI
Definition & Scope – SAR
Taxability for Employees & Company
Accounting for Corporates
Determining the Value
Glossary
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3. Definition & Scope: Employee Stock
Options(ESOP's)
• While ESPP and SAR models are prevalent in the global market, the ESOP model is
prevalent in India due to certain legal regulatory framework.
•Employee Stock Option is a plan under which the company
grants options to employeesESOP
•Employee Stock Purchase Plan is a plan under which the
company offers shares to employees as part of a public issue or
otherwiseESPP
•Stock appreciation rights (SARs) is a method for companies to
give their management or employees a bonus if the company
performs well financially.SAR
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4. Definition & Scope: Employee Stock
Options(ESOP's)
• A stock option is defined under the Guidelines as “a right but not an obligation granted to
an employee in pursuance of the employee stock option scheme to apply for shares of
the company at a pre-determined price”.
• In simple terms the consequence of the above definition is that an option can be
converted to shares if the holder of the option fulfils certain conditions. These conditions
are the “vesting criteria” and can be either number of years of continued service after
receiving the option, satisfaction of some performance goals by the option holder, or
both. After the vesting criteria are satisfied the options are said to be “vested”
• A vested option gives the option holder an unfettered right to “exercise” the option and
be allotted shares of the company. But if the employee is terminated for misconduct,
then even his vested options may lapse. Exercise of an option is the process by which a
vested option is converted into shares by payment of the exercise price. The exercise
price is normally determined at the time the option is granted to the employee.
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5. Definition & Scope: Employee Stock
Options(ESOP's)
• The shares received on exercise of the option will rank pari passu with the other shares in
the same class. The option holder is not entitled to either dividend or voting rights until
he exercises his option and is allotted shares. If the company so wishes, it can impose a
lock-in on the shares issued pursuant to the exercise of the options.
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6. Employee Stock Options(ESOP's): Flow of events
Grant of
Options
Vesting of
Options
Exercise of
Options
Sale of Shares
by Employees
Company
Options
Exercise
Price
Shares
• The company grants options to the employees. Once the options gets vested, the
employee gets the right to apply for and be issued shares of the company. Once the
options are exercised, the company issues the granted options and receive exercise
price against it. This exercise results in taxation of perquisite in the hands of
employees.
• Once shares are allotted to employees, they can sell them in the secondary market
which will attract capital gains tax to employees.
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7. Definition & Scope: Stock Appreciation Rights (SAR)
• Stock Appreciation Right (SAR) is one of the alternatives adopted for implementing an
equity based compensation plan like Employee Stock Option Plan (ESOP), Employee
Stock Purchase Plan (ESPP) or Restricted Stock Units (RSU). SARs can be further
structured as either ‘Equity settled–SARs’ or ‘Cash settled–SARs’. The Cash settled-
SARs are known as Phantom Options.
• The mode of settlement generally is defined beforehand at the time of grant of SARs.
There might be any one of the following choices of settlement of appreciation:
I. Settlement only by way of equity shares;
II. Settlement either by way of equity shares or cash payment at the option of the
Company;
III. Settlement either by way of equity shares or cash payment at the option of the
Employee;
IV. Settlement only by way of cash payment (where Company may deal with shares
of the Company through Trust route); and
V. Settlement only by way of cash payment (without Company’s dealing in shares
directly or indirectly).
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8. Definition & Scope: Stock Appreciation Rights (SAR)
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Amount received on redemption of SAR’s is a revenue receipt, liable to tax as income under the head salaries.
SAR’s result in receipt of a reward, though measurable in terms of money by which the share price has gone
up. While ESOPs result in acquisition of an asset at a concessional price by the beneficiary.
The exact quantum of benefit or reward is ascertained at the point of time when SAR’s are redeemed. Whereas
in the case of a stock option, the benefit can be ascertained when shares are actually sold.
Upon exercise, SAR’s provide only for cash payment and not for the issue of shares.
In case of SAR’s. the employee does not have to pay for acquiring an underlying security under the SAR’s
scheme. The employee only receives appreciation in the value of an underlying security.
SAR’s are different from stock options

9. Example: Stock Appreciation Rights
• Say, a Company grants 10,000 SARs today (Y0 ) to an employee with an equal annual
vesting schedule over 4 years (Y1 to Y4 ) with an exercise period of 1 year given the
following market prices over the period. The appreciation can be determined as under:
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S. No. Particulars Y0 Y1 Y2 Y3 Y4 Total
1 Market Price 100
(Base
Price)
150 200 275 350
2 Less: Base
price(SAR Price)
100 100 100 100
3 Annual vesting
percentage
25% 25% 25% 25% 100%
4 Appreciation per
SAR(1-2)
50 100 175 250
5 Annual vesting of
SARs(1000*25%)
2500 2500 2500 2500
6 Cash-for cash
settlement(4*5)
125000 250000 437500 625000 1437500
7 Equity-for equity
settlement
833 1250 1590 1785 5485

10. Example: ESOP/ESPP
Example 2:
• A company announces an ESOP plan under which company will allot 500 shares of
company to certain employees at a price of Rs 100. Those eligible employees will
have option of getting allotment of 100 shares on 1st day of October every year starting
from 1/4/2012 for next five years. Let us say, Mr. X an employee fills out
the ESOP application form on 1.7.2012 for allotment of shares. He is allotted 100 shares on
1/10/2012. The market value on 1/10/2012, (vesting date) is Rs. 600. These 100 shares, let
us think, hypothetically, sold by the employee on 31/3/2013 at a price of RS 1000. Then
Tax 1. On allotment day i.e. 1st October 2012, your employer will deduct TDS or Perquisite Tax
@ the slab rate you fall in, on the amount of FMV minus Exercise Price. The income and the
taxes paid will reflect in the Form 16 and you should report it as part of salary in your personal
tax return.
In our case, let us assume Mr. X falls in highest tax bracket i.e. of 30%, now
(600-100) x 100 x 30.9% = Rs.15,450
Tax 2. On sale day i.e. 31st March, 2013, Short Term Capital Gain will be levied on
the difference between Sale Proceed and FMV at the time of exercise of option, @ 15%, now
(1000-600) x 100 x 15% = Rs.6,000.
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11. Stock Appreciation Rights(SAR’s): Taxability for
Employees
In case of Equity settled-SARs:
a) Perquisite tax: As per Section 17(2)(vi) of the Income Tax Act, 1961 the taxable value of
perquisite refers to ‘value of equity shares issued or transferred to the employee as on date
of exercise’ as reduced by ‘amount recovered from employee’. As per Rule 3(8) of the
Income Tax Rules, 1962 value of listed equity shares refers to average of opening and closing
market price of equity shares on the relevant Stock Exchange. In case of unlisted equity
shares, the value refers to the fair market value of equity share as on date of exercise as
determined by a Category-I Merchant Banker registered with SEBI. This tax is determined as
on date of exercise of SARs at the rate of tax that applies to Salary of that individual
employee.
b) Capital gains tax: Further, at the time of sale of equity shares, the employee is liable to
pay income tax on the capital gain arising out of such sale. The capital gain refers to the
excess of ‘sales consideration of shares’ over the ‘cost of acquisition of shares’. As per
section 49(2AA) of the Income Tax Act, the cost of acquisition refers to the value of such
shares as on date of exercise of SARs which was considered for perquisite tax determination.
Long-term gains are taxed at preferential rates than the short-term capital gains. Even at
times, the long-term capital gains exempt in case of listed shares.
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12. Stock Appreciation Rights(SAR’s): Taxability for
Employees
In case of Cash settled-SARs:
The amount of appreciation received by way of cash payment from the Company is subject
to tax in the hands of the employee as perquisite. It is treated as part of salary and is
accordingly taxed.
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13. Stock Appreciation Rights(SAR’s): Taxability for
Company
• As a consequence of perquisites being taxable at the time of exercise of equity / cash
settled SARs as salary, the Company is liable for tax deduction at source under Section
192 of the Income Tax Act.
• In case of Equity settled-SARs, the Company may claim deduction up to perquisite
earned by the employees on the basis of decision of Special Bench of Income Tax
Appellate Tribunal, Bangalore which was rendered in ESOP context. The principle
upheld was that perquisite earned by an employee is at the cost of the Company
which is a claimable expense. However, in the absence of any supporting provisions in
the Income Tax Act or precedent of Supreme Court, acceptability of such claim by the
Tax Authorities in other Jurisdictions is not certain.
• In case of Cash settled-SARs, the cash compensation made by the Company is
deductible as allowable expenditure under Section 37 of Income Tax Act.
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14. Stock Appreciation Rights(SAR’s): Accounting for
Company
• Equity settled-SARs:
The principle of accounting cost recognition is that there must be some cost (whether
notional or otherwise) to the Company. With the presumption that Equity settled-SARs shall
be granted with reference to the fair market value/ market price of shares as on date of
grant of such SARs (i.e. without any discount), there shall not be any accounting cost with
reference to intrinsic value method prescribed under the Guidance Note issued by ICAI.
However, the scenario would change in case a Company adopts IFRS 2 for accounting of
employee share based payment in which case the fair value of SARs (as per Black Scholes or
other prescribed Binomial Method) shall be accounted for.
For equity settled stock options, an enterprise should recognise as an expense (except where
service received qualifies to be included as a part of the cost of an asset) the services
received in an equity-settled employee share-based payment plan when it receives the
services, with a corresponding credit to an appropriate equity account, say, ‘Stock Options
Outstanding Account’.
• Cash settled-SARs:
As per Appendix-IV of the Guidance Note issued by ICAI, the Company is required to make
provisions for estimated cash requirement for settlement on the basis of estimated Fair
Market Value as at end of each financial year till the estimated life of SARs or actual exercise/
settlement of SARs, whichever is earlier. As and when any cash payment is made on account
of settlement of SARs, the provision is accordingly adjusted.
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15. Share Based Payments: Guidance Note by ICAI
• The guidance note issued by ICAI establishes financial accounting and reporting
principles for employee share-based payment plans, such as ESOP, ESPP and SAR.
For the purpose of accounting, employee share based payment
plans are classified into:
Equity Settled
Employee receives the equity
shares.
Cash Settled
Employee receives cash based
on the price of shares.
Employee share based payment
plans with cash alternatives
There is a choice that settlement
could be in the form of shares or
cash.
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16. Share Based Payments: Guidance Note by ICAI
contd.
• For equity settled stock options, an enterprise should recognise as an expense (except
where service received qualifies to be included as a part of the cost of an asset) the
services received in an equity-settled employee share-based payment plan when it
receives the services, with a corresponding credit to an appropriate equity account,
say, ‘Stock Options Outstanding Account’.
• This account is transitional in nature as it gets ultimately transferred to another equity
account such as share capital, securities premium account and/or general reserve.
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17. Share Based Payments: Guidance Note by ICAI
contd.
• An enterprise might grant rights such as stock appreciation rights(SAR) to employees
as part of their remuneration package, whereby the employees will become entitled
to a future cash payment (rather than shares), based on the increase in the share
price of the enterprise from a specified level over a specified period of time. Or an
enterprise might grant to its employees a right to receive a future cash payment by
granting to them a right to shares (including shares to be issued upon the exercise of
stock options) that are redeemable, either mandatorily (e.g., upon cessation of
employment) or at the option of the employee.
• For cash settled share based payment plans, an enterprise should recognise as an
expense (except where service received qualifies to be included as a part of the cost
of an asset) the services received in a cash-settled employee share-based payment
plan when it receives the services with a corresponding increase in liability by creating
a provision therefor.
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18. Share Based Payments: Guidance Note by ICAI
contd.
• If an enterprise has granted the employees the right to choose whether a share-based
payment plan is settled in cash or by issuing shares, the plan has two components, viz.,
(i) liability component, i.e., the employees’ right to demand settlement in cash, and (ii)
equity component, i.e., the employees’ right to demand settlement in shares rather than
in cash. The enterprise should first measure, on the grant date, fair value of the
employee share-based payment plan presuming that all employees will exercise their
option in favour of cash settlement. The fair value so arrived at should be considered as
the fair value of the liability component. The enterprise should also measure the fair
value of the employee share-based payment plan presuming that all employees will
exercise their option in favour of equity settlement. In case the fair value under equity-
settlement is greater than the fair value under cash- settlement, the excess should be
considered as the fair value of the equity component. Otherwise, the fair value of the
equity component should be considered as zero. The fair value of the equity component
should be accounted for in accordance with the recommendations in respect of ‘Equity-
settled employee share-based payment plan’. The fair value of the liability component
should be accounted for in accordance with the recommendations in respect of ‘Cash-
settled employee share-based payment plan’.
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19. Share Based Payments: Determining the Value
• The manner of determining the value of perquisite differs for shares, which are listed on
a recognised stock exchange in India vis-à-vis shares not listed on a recognised stock
exchange in India (overseas equity shares). In case the shares of a company are listed on
a recognised stock exchange in India, the fair market value (FMV) is to be determined as
the average of the opening price and the closing price of the share on that date.
• In case the shares are not listed, the FMV shall be such value as determined by a
merchant banker (registered with the Securities and Exchange Board of India) on the
specified date. The term ‘specified date’ means
(i) the date of exercising of the option, or
(ii) any date earlier than the date of exercising of the option, not being a date that
is more than 180 days earlier than the date of exercise.
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20. Glossary - Key Definitions: Employee Stock Options
• Grant is a process by which an employee is given an option. It
is the delivering of the options to the employee. The grant shall
specify the number of options given, the time of vesting, etc.
• Exercise means making of an application by the employee to
the company for issue of shares against option vested in him in
pursuance of the employee stock option scheme
Vesting
Exercise
Grant
Lapse
• Vesting means the process by which the employee is given the
right to apply for shares of the company against the options
granted to him in pursuance of the employee stock option
scheme.
• Option may be said to be lapsed on the expiry of the exercise
period or on the happening of the events like separation,
abandonment etc
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