[Amika and Simran are students at Institute of Law, Nirma University and Gujarat National Law University, Gandhinagar, respectively.]
India is the upcoming hub for global investments, and this has resulted in soaring valuations leading to an increased demand for executive talent with continuous exploration of incentive schemes in order to retain skilled employees.
The most common form of employee incentive is employee stock option plans (ESOPs), which ensures that all employees work towards improving the profitability of the company. To elucidate, if a share is at a certain price at the beginning of the employment period of a person, then at the end of a stipulated holding period, in the desirable event that the company goes into profit and the price of the share rises, the employee can purchase the share at the previous lower price and make a profit by selling it at the current price. Despite being the most common form of employee incentive scheme, ESOPs have adverse issues. From diluting the shareholders’ holdings to limitations regarding issuance to promotors, ESOPs put a cap on companies, compelling companies to experiment with other schemes which suit the commercial Indian backdrop.
A stock appreciation right (SAR) is one such framework that the companies prefer. SAR is not defined under the Companies Act 2013, but the Securities and Exchange Board of India (Share Based Employee Benefits) Regulations 2014 defines it. SAR is an entitlement given to the SAR grantee allowing them to receive the value or growth of a specific number of shares in a company. When the SAR is exercised, the grantee may choose to receive the value of appreciation in either cash or additional company shares. The precise intricacies of these rights may vary, contingent upon the stipulations given in the SAR plan / grant agreement. Thus, while the entities still await its regulatory clarifications, the brighter side is that no law in India bars or puts any restrictions on companies adopting this scheme. This article thus aims to delve into studying the legality of SARs as an alternative option to ESOPs.
ESOP v/s SAR: Finding the Alternative Trade-off
ESOPs are given to permanent employees of the company as per the Companies Act 2013, removing from its ambit the option of issuance to promoters, whereas SARs may be issued to third parties, covering advisors and consultants of group companies. While the issuance of SARs to unlisted companies is not regulated, to surmount the issues of restrictions imposed on ESOP by the Companies Act 2013, companies often resort to issuing SARs instead. Furthermore, with the Companies (Amendment) Act 2017, Section 194 of the Act was omitted, thus permitting the issuance of the said option to independent directors or promotors. When issued by unlisted companies, SARs mandate no minimum vesting period and need no mandatory administration from the compensation committee. They are equity based and they provide the employee with the price of appreciation of the company stocks over an established time period, without the employee requiring to pay any exercise price.
Unlike ESOPs, companies issue SARs to give appreciation in the value of equity shares, leaving the shareholding pattern unaltered. From the perspective of an employee, ESOPs might lose their value if there is no buyer but in case of SARs, the value is offered by the company itself thus qualifying as a cash bonus. Thus, in times after the global pandemic where attrition level is at an all-time high across all sectors, companies are focusing on incentivising employees and experimenting with alternatives such as SARs being one of them.
Aligning SARs in line with Global Best Practices: Will the Move Suffice?
Regulation 2(1)(gg) of SEBI (Share Based Employee Benefits Sweat Equity) Regulations 2021 defines SARs as “a right given to a SAR grantee entitling him to receive appreciation for a specified number of shares of the company where the settlement of such appreciation may be made by way of cash payment or shares of the company”. This resolution is applicable to the listed entities and it states that all employee benefit schemes must be offered after the passing of a special resolution by the shareholders. However, a grey area is present in terms of issuance of SARs by unlisted companies which is recognised by the Ministry of Corporate Affairs in the Company Law Committee (CLC) Report published in March 2022. It notes:
“The Committee was of the opinion that RSUs and SARs should be recognised under CA-13 through enabling provisions. If these schemes require the issue of further securities by the company, their issuance must be allowed only after approval of the shareholders through a special resolution."
"However, where the settlement of such rights does not involve offer or conversion into securities, approval by shareholders need not be mandated.”
The said report also proposed to amend Section 62(1) of the Companies Act 2013 to permit additional employee compensation schemes which are linked to the company’s equity. Thus, it aims to give legal recognition to the issuance of SARs. It proposed that cash-settled SARs can be aligned with the existing law and its issuance should be subject to board approval. Further, while issuing SARs settled in cash, the approval of the shareholders of the company by way of special resolution would be required. It was also recommended by the CLC that for offering and issuance of SARs, a general offer on an annual basis should be allowed which would remove the need for multiple approvals every time such a scheme is proposed.
However, CLC only provided a mechanism to remove the prevailing ambiguity regarding its legality and failed to propose any scope under the prevailing provision. The report narrowly emphasised on the regulation of equity linked/ settled SARs rather than providing recommendations on SARs settled by way of cash. It must also be emphasised that the proposed recommendations were silent on the details of transferability and the minimum vesting term of SARs which would further limit the scope of listed companies from issuance of SARs. Further, the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations 2021 put forth that the employees holding an SAR cannot have the entitlement to receive dividends or vote or enjoy the benefits available to a shareholder in respect of an SAR.
It is also pertinent to note that after the amendment to the Foreign Exchange Management (Non-debt Instruments) Rules 2019 (NDI Rules), equity settled SARs are given recognition, and they must comply with the NDI Rules. The changes in the definition of 'share based employee benefits' pave the way for SARs to be recognised as an incentive scheme as well.
Tax Implications
Considering that the suggested amendments are brought into effect, there could potentially be a higher occurrence of unlisted companies issuing SARs. Nevertheless, the frequency of such issuances is also heavily affected by the activities and responsibilities undertaken by the grantee within the company since the tax implications of SARs differ depending upon the same. In case of equity settled SARs, “the value of equity shares issued or transferred to the employee as on date of exercise” minus “the amount recovered from the employee” will be considered as perquisite value as per the Income Tax Act 1961 and shall be taxed as the salary of the employee. This tax is calculated based on the applicable salary tax rate for the individual employee at the time when SARs are exercised. Furthermore, upon the sale of the equity shares, the employee must pay tax on the capital gain made on this sale. In case of cash-settled SARs, the appreciated value maybe be given the treatment equivalent to a bonus payment being subject to withholding taxes at the applicable rates. Section 36 of the Income Tax Act 1961 provides that bonus payment is eligible for tax deduction from the company’s income when it is actually paid and not on an accrual basis. In situations wherein the cash payment is received from a person not being the beneficiary's employer, be it a consultant or an advisor, the amount received upon SARs settlement will still be taxable, albeit classified as income from other sources.
The Way Ahead
The dynamic nature of law and society is directly proportional, therefore formulating and accommodating new legislation is only natural and imperative. In today’s highly volatile market, it is pertinent to realise strategies that would aid in keeping things stable while benefitting each involved party. Companies want to be more flexible with their incentive schemes to attract employee loyalty and in turn, the welfare of the company. Given the benefits of SARs, the authors concur with the widely opined statement that the SARs should be recognised under the Companies Act 2013 as well as regulated according to the requirement of the Indian industry.
The requisition of implementation of such a scheme in India is abundance of time. To eliminate any hardships that the corporate world would face in this shift to new regulations, a two-year transition period is recommended. In addition to this, it is also recommended that one umbrella regulation encompassing all employee benefit schemes, namely ESOPs, SARs, employee stock purchase scheme, and employee welfare schemes, should be formulated. While we realise that this is a new concept in India, SAR has been prominently accepted and implemented globally which could further assist the formulation of requisite regulations by taking inspiration from such countries.
Conclusion
Despite certain discrepancies at an early stage, incorporating SARs into the legal framework of the Companies Act 2013 would constitute a beneficial stride, fostering increased investment in new and small companies. It is well-known that the Indian industry may display a certain interest in exploring the effectiveness and adoption of the relatively underutilized SARs. If implemented wisely, it can be potentially used as an effective instrument to achieve objectives related to the companies’ as well as the employees’ well-being.
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