Employee Share Based Payment Arrangement

What is Employee Share Based Payment (SBP) arrangement ?

As defined under Ind AS 102/ IFRS 2, a Share Based Payment arrangement is an agreement between an entity (or another group entity or a shareholder of a group entity) and another party (including an employee) which entitles the other party to receive,

-         Equity instruments (including shares or share options) of the entity (or another group entity); or

-         Cash (or other assets) for amounts based on the price (or value) of equity instruments of the entity (or another group entity),

Provided specified vesting conditions (if any) are met.

In common parlance, a Employee Share Based Payment arrangement is a form of compensation often offered as incentives or rewards by employers to their employees. This compensation is over and above the regular remunerations in the form of salaries, reimbursements, perks or any other form of cost to the employer.

Important terminologies and definitions

Equity instrument: A contract that gives a residual interest in the assets of an entity after deducting all its liabilities.

Exercise Period: It is the time period after vesting within which the employee should exercise his right to apply for shares against the option vested in him in pursuance of the ESOS.

Exercise Price: It is the price payable by the employee for exercising the option granted to him in pursuance of ESOS.

Fair Value: It is the amount for which stock option granted or a share offered for purchase could be exchanged between knowledgeable, willing parties in an arm’s length transaction.

Grant: Grant of the option means giving an option to the employees to subscribe to the shares of the company.

Intrinsic Value: It is the excess of the market price of the share under ESOS over the exercise price of the option (including up-front payment, if any).

Option: Option means a right but not an obligation granted to an employee in pursuance of ESOS to apply for shares of the company at a pre-determined price.

Share-based payment transaction: A transaction in a share based payment arrangement in which the entity,

-         Receives goods or services from a supplier (including an employee); or

-         incurs an obligation (to the supplier) when another group entity receives those goods or services.

Share option: A contract that gives the holder the right, but not the obligation, to subscribe to the entity’s shares at a fixed (or determinable) price for a specified period of time. 

Vesting: It is the process by which the employee is given the right to apply for shares of the company against the option granted to him in purchase of shares in pursuance of employee stock option scheme (ESOS).

Vesting Period: It is the time period during which the vesting of the option granted to the employee on pursuance of ESOS takes place.\

Vest: means to become an entitlement. A party’s right to shares of an entity may be free or at a pre-arranged exercise price.

Vesting conditions: The conditions that must be satisfied for a person to become entitled to receive cash, other assets or equity instruments under a share-based payment arrangement.

Benefits of SBP arrangements

SBPs are the best and most frequently used tools to retain top notch employees in a company. Apart from this, SBPs have various other advantages like:

- It instills a sense of ownership and belongingness amongst the employees and can get employees highly inspired and focused for their jobs.

- It helps aligning the interest of the managers with those of the owners.

- It is a non-cash compensation tool to compete for the best human resources at affordable consideration.

- It gives an opportunity to corporate to pay without a reduction in book profits.

- SBPs is the most regular international tool that is used for granting retirement benefits to employees and as succession plan for owners.

#        Owner’s perspective

Although employee retention, motivation and awarding hard work are all the benefits that come out of SBP for an employer, there are various other notable advantages too, especially for start-ups. With SBP, one can avoid cash compensations as a reward, thereby saving on the immediate outflow of cash. For startups especially, when they are on the verge of expanding, or beginning their operations on a larger scale, awarding employees in the form of stock options will work out to be a feasible method than cash rewards. SBPs are given as a motivation to the employees. Since the employees will be benefitted in turn, when the share prices increase, it will be an incentive enough for the workers to put in their 100%. Similarly, SBPs can also help you attract the best talent in the market.

#         Employee’s perspective:

Employees have the benefit of acquiring shares at a nominal rate, and also selling it (after a suitable tenure set by the employees) and gaining the profit. If, for instance, the share prices shoot up, as it is bound to happen when a company grows over the years, a good deal of profit is gained by selling the shares. Certain companies set SBP arrangements as a separate entity other than the salary options, and hence, it adds on to the benefits received by an employee.

Employee Share Based Payment Schemes

a.      Employee Stock Option Plan (ESOP)

A stock option granted to specified employees of a company. ESOPs carry the right, but not the obligation, to buy a certain amount of shares in the company at a predetermined price. An employee stock option is slightly different from a regular exchange-traded option because it is not generally traded on an exchange, and there is no put component. Furthermore, employees typically must wait a specified vesting period before being allowed to exercise the option.

b.      Employee Stock Purchase Plan (ESPS)

A company-run program in which participating employees can purchase company shares at a discounted price. Employees contribute to the plan through payroll deductions, which build up between the offering date and the purchase date. At the purchase date, the company uses the accumulated funds to purchase shares in the company on behalf of the participating employees. The amount of the discount depends on the specific plan but can be as much as 15% lower than the market price.

c.       Stock Appreciation Rights (SAR)

Stock Appreciation Rights (SARs) entitle the participant to a payment in cash or shares equal to the appreciation in the company’s stock over a specified period. Similar to employee stock option plans, SARs gain value if your company’s stock price rises. However, unlike stock options, you are not required to pay the exercise price, and may just receive the amount of any increase in price, deliverable in cash or stock upon exercising, depending on your company’s plan guidelines.

d.      Share-based payment transactions with cash alternatives

Share-based payment transactions in which the terms of the arrangement provide either the entity or the counterparty with the choice of whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments.

Accounting Methods for ESOP

There are 2 principal methods for accounting of ESOPs,

a.   Intrinsic Value Method

In Indian scenario, the accounting for ESOPs under the Intrinsic Value Method is governed by Guidance Note on Accounting for Employee Share-based Payments issued by the Institute of Chartered Accountants of India.

As defined earlier, Intrinsic Value is the excess of the market price of the share under ESOS over the exercise price of the option (including up-front payment, if any).

Recognition & Measurement:

An enterprise should recognise an expense equal to the IV of the grant (except where service received qualifies to be included as a part of the cost of an asset) for 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'.

-         If the shares or stock options granted vest immediately i.e. the employee is not required to complete a specified period of service before becoming unconditionally entitled to those instruments, the enterprise should recognise an expense equal to the IV of the grant with a corresponding credit to the equity account.

-         If the shares or stock options granted do not vest until the employee completes a specified period of service, the enterprise should recognise an expense equal to the IV of the grant over the vesting period on a time proportion basis, with a corresponding credit to the equity account.

The recognition of expense during the vesting period should represent the best estimates of the management regarding the number of options that will actually vest at the end of the vesting period.

An enterprise should measure the intrinsic value of shares or stock options granted at the grant date, based on market prices if available taking into account the terms and conditions upon which those shares or stock options were granted (i.e. taking into all the Vesting Conditions). If market prices are not available, the enterprise should estimate the market value of the shares or stock based on a valuation report from an independent valuer

Vesting Conditions can be classified into 2 sub categories,

-         Market conditions - an example of a market performance condition is a specified increase in the entity's credit rating. Market conditions are included in the estimation of the fair value on the grant date.

-         Non-Market conditions – an example of a non-market performance condition is achieving a specified growth in revenue. Non-market conditions are taken into account in determining the quantity of the instruments that will be issued and not in the fair value of the instrument on the grant date.

b.   Fair Value Method

In Indian scenario, the accounting for ESOPs under the Fair Value Method is governed by Ind AS 102, while internationally it is governed by IFRS 2.

As defined earlier, Fair Value is the amount for which stock option granted or a share offered for purchase could be exchanged between knowledgeable, willing parties in an arm’s length transaction.

Recognition & Measurement:

Under the Fair Value method, the recognition criteria is the same as set out in the Intrinsic Value method. However, the measurement criteria set out under Ind AS 102/ IFRS 2 differs from that set out in the Guidance note for Intrinsic Value method.

Under this method, an entity needs to evaluate and calculate the fair value of the ESOP as at the grant date over and above the intrinsic value of the shares or stock.

What is “Fair Value of an Option”?

Let us first understand an option - Options are financial instruments that are derivatives or based on underlying securities such as stocks. An options contract offers the buyer the opportunity i.e. a right but not an obligation to buy or sell—depending on the type of contract they hold—the underlying asset.

An ESOP is in substance a call option to buy the shares of the entity at an agreed price (exercise price) exercisable at a future date subject to satisfaction of the vesting conditions. So, even if the Intrinsic Value of the grant or the difference between the Market Price on grant date and the exercise price is Nil, the ESOP still has a value since it gives the holder an option to purchase the shares at a future date at a price agreed today. This value of the option is nothing but the Fair Value of the Option.

Calculating the “Fair Value of an ESOP”

The fair value of an ESOP can be calculated using an Option Pricing Model such as the Black & Scholes Model or the binomial option-pricing model

Let us get an understanding of the factors determining the value of an option. These include the current stock price, the strike price, time to expiration or the time value, volatility, interest rates, and cash dividends paid.

Current stock price is fairly obvious – it is the price at which the stock is trading at the time of valuation. The movement of the price of the stock up or down has a direct, although not equal, effect on the price of the option.

Strike price is the Price at which the .

Time to expiration is the time between calculation and option’s exercise date. It is basically the risk premium that the option seller requires, to provide the option buyer the right to buy/sell the stock up to the date the option expires. It is like an insurance premium for the option; the higher the risk, the higher the cost to buy the option – the more the time to expiry the greater the risk and thus greater the premium.

Volatility is a measure of how much the security prices will move in the subsequent periods. Volatility is the trickiest input in the option pricing model as the historical volatility is not the most reliable input for this model.

Interest rates is the risk-free interest rate.

Cash dividends paid or Dividend yield is the expected dividend payment by the entity until the option’s exercise date.

Out of the above mentioned factors, the only factors that is unobservable or that needs to be estimated is Volatility.

Volatility is usually expressed in two ways: historical and implied.

-         Historical volatility describes volatility observed in a stock over a given period of time. Price movements in the stock (or underlying asset) are recorded at fixed time intervals (for example every day, every week, or every month) over a given period. More data generally leads to more accuracy.

-         Implied volatility relates to the current market for an option. Volatility is implied from the option’s current price, using a standard option pricing model. Keeping all other inputs constant, you can put the current market price of an option into any theoretical option price calculator and it will calculate the volatility implied by that option price.

Income Tax Provisions

Prior to amendments vide the Finance Act, 2009, the ESOPs were under the ambit of Fringe Benefit Tax (FBT) in the hands of the employee. From then on, ESOPs are taxed in two stages in the hands of the employee – one as a ‘perquisite’ and two as capital ‘gains’.

When the option is exercised after the vesting period is over, the perquisite value will be added to income and taxed at the slab rate. This perquisite value is the difference between fair market value on the date of exercise of the share and the exercise price. This difference calculated is eligible for TDS deduction by the company and forms part of salary of the employee which is shown in Form 16 of the employee.

When employee sells the shares which were allotted to him under ESOP, tax is levied on any amount of profits or gains arising from such transaction. Such profit is taxable under the head ‘Capital Gains’. Capital gains can further be classified as ‘Short Term Capital Gains’ and ‘Long Term Capital Gains’ depending upon the period of holding of such shares.

-         In case of listed shares, if the holding period is more than 12 months, capital gains will be treated as Long-term capital gains and no tax will be levied if such capital gains doesn’t exceeds Rs. 1 lakh. However, in case the amount of capital gains is more than Rs. 1 lakh then tax shall be levied @ 10% without indexation benefit. If holding period is less than or equal to 12 months, then such gains will be treated as short-term capital gains & will be taxable @ 15%.

-         In case of unlisted shares, gains will be treated as long-term if shares are held for more than 24 months. Tax will be levied @ 20% with indexation benefit and @10% without indexation benefit. If holding period of such shares is less than or equal to 24 months, gains will be treated as short-term and will be taxable as per slab rates of the taxpayers.

Companies are not liable to pay any tax when they give ESOPs. However, there lies an ambiguity in tax deductibility expenses debited to P&L in respect of ESOPs issued by companies to its employees.