Introduction

The concept of Employee Stock Options Plans (ESOPs) has not been of any ancient origin in India. It is only recently that the companies have adopted such mechanism. The philosophy behind the ESOP is that employees are best cared for, when they have a sense of belongingness to the company and are able to participate in its growth and prosperity. This could be achieved by inviting them to become part owners of the company. Employee Stock Options Plans (ESOPs) are used to compensate, retain, and attract employees. These plans are contracts between a company and its employees that give employees the right to buy a specific number of the companys shares at a fixed price within a certain period of time. Employees who are granted stock options hope to profit by exercising their options at a higher price than when they were granted. Traditionally, stock option plans have been used as a way for companies to reward top management and "key" employees and link their interests with those of the company and other shareholders. However these days more and more companies believe all of their employees as "key." As a result, there has been an increase in the popularity of broadbased stock option plans, particularly since the late 1980s.

What Is a Stock Option?

Section 2 (15A) of The Companies Act, 1956 defines Employees' Stock Options Schemes (ESOSs) as under: "employees stock option" means the option given to the whole-time directors, offices or employees of a company, which gives such directors, officers or employees the benefit or right to purchase or subscribe at a future date, the securities offered by the company at a pre-determined price; However on www.incometaxindia.gov.in, there is a simple description of ESOP as "the www.incometaxindia.gov.in, generic term for a basket of instruments and incentive schemes that find favour with the new upward mobile salary class and which are used to motivate, reward, remunerate and hold on to achievers."

ESOP is intended to benefit a company by enabling the company to attract and retain the best available talent by enabling them to contribute and share in the growth of the company1. It can be called as a compensation package for the key employees of a company, which is designed to attract, motivate, and retain the people who can help the business succeed. Employees' Stock Options Schemes (ESOSs) are one of the most exciting and innovative ways, developed in the post-liberalization period, by which a company can design a compensation package that helps it to achieve these goals at the lowest possible cost. ESOS is another abbreviation, to mean Employees Stock Option Scheme, and there can be ESPS, or Employee Stock Purchase Plan. An ESOS of a Company has to be in accordance with SEBI Guidelines in this regard 2. It pertinent to note that the J.R. Varma Committee Report says: A widely acknowledged method of securing greater employee participation, giving the right incentive signals and rewarding loyalty as well as years of service is through an ESOP. In today's competitive world only the most myopic will insist on making seal tight distinction between employees "who should be paid only wages, salaries and bonus and shareholders who should get dividends. There is hardly any global corporate giant that does not have an ESOP". A stock option gives an employee the right to buy a certain number of shares in the company at a fixed price for a certain number of years. The price at which the option is provided is called the "grant" price and is usually the market price at the time the options are granted. Employees who have been granted stock options hope that the share price will go up and that they will be able to "cash in" by exercising (purchasing) the stock at the lower grant price and then selling the stock at the current market price. For example in case of a typical employee stock option plan: an employee is granted the option to purchase 1,000 shares of the companys stock at the current market price of Rs.5 per share (the "grant" price). The employee can exercise the option at Rs.5 per share typically the exercise price will be equal to the price when the options are granted. Plans allow employees to exercise their options after a certain number of years or when
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Infosys Technologies Ltd. v. Deputy Commissioner of Income Tax MANU/IT/0331/2002. SEBI (Employee Stock Option Scheme & Employee Stock Purchase Scheme) Guidelines, 1999.

the companys stock reaches a certain price. If the price of the stock increases to Rs.20 per share, for example, the employee may exercise his or her option to buy 1,000 shares at Rs.5 and then sell the stock at the current market price of Rs.20. ESOP can take place in many ways. The company may directly allot its shares to employees at market price, or at a concession. Or, the company may give its employees the option to acquire the shares or debentures at an agreed price that may be attractive; but the option may be permitted to be exercised after a waiting period or `vesting period', after which would comes the `exercise period' during when the employee can exercise his option, and that may be followed by a `lock-in period' when the employee cannot sell the shares. A third type of ESOP is to give `stock appreciation rights'; shares are only notionally allotted and at the end of an agreed period, an employee is paid difference in price. Yet another type is offer `staggered options' that the employee can exercise over a period.

The Purpose of ESOS:

The purpose of Employee Stock Options Scheme (ESOS) is to advance the interests of the company and its shareholders by offering to those employees of the company who will be responsible for the long-term growth of the companys earnings the opportunity to acquire or increase their equity interests in the company, thereby achieving a greater harmony of interest between shareholders and employees, enhancing the Companys ability to retain and attract highly qualified employees and providing an additional incentive to such employees to achieve the Companys long-term business plans and objectives. A Companys intention in introducing the Employees Stock Option Scheme is objectives. to reward those employees who are and who shall be responsible for the long-term growth and profitability of the Company, thereby enabling them to acquire an equity stake in the Company. The purpose of the scheme is also to enable the employees to acquire shares of the Company at a price lower than the market price of shares and at the same time give the employees an opportunity to participate in the profits of the Company.

Also as a result of introduction of such a scheme, the Company shall be in a position to retain the employees as well as attract new talent and professionals. The stock options scheme will be an integral part of the Compensation package of the Company. The Company can also introduce a Performance management System that will enable it to monitor and reward the performing employees. These objectives are aimed to be achieved through the use of a very potent instrument, namely the Equity Stock Option Scheme (ESOS).

Advantages of ESOS
The benefits of ESOS to employees are that they are given a chance to become the shareholders of the company at a discounted price to the market price. Thus the employees are given a chance to share the profits of the company by making them shareholders. Research in the US shows that when employee ownership is combined with a management style that encourages employees to share ideas and information, companies grow 6 % to 11 % per year faster than would be expected otherwise and total shareholder returns increase by about two percentage points relative to other firms. Profit levels go up about 14%. However there has been a disadvantage of ESOS. A common complaint lodged against ESOS. the ESOPs is that, like unions, the employees elect the leaders, but the leaders are not necessarily responsible to the employees. Also, employee-owned corporations often have troubles with slow decision making. It can also make an unhealthy share of an employee's finances dependent on one source, if they have not spread their investing to other areas.

Various Versions of ESOSs

1. Employee Retention Scheme: The idea of this type of scheme is that employees Scheme: who are consistent performers are retained and available to the Company. The employees who are consistently performing in their relevant fields are eligible for incentives under this type of scheme. The incentives shall be over and above their

salaries. The incentives can be provided at the end of each year. The employees can be rewarded as under: a.) On completion of year-1 an eligible employee shall receive X no of shares b.) On completion of year-2 an eligible employee shall receive 2X no of shares. c.) On completion of year-3 an eligible employee shall receive 3X no of shares, and so on The benefit of the above shall be that the longer the employee continues to benefit the Company the more he shall be rewarded 2. Achievement Incentive Scheme: The objective of this type of scheme is to reward significant achievements and also to encourage the employees of the Company to make achievements with a view to earn rewards and perform better for their own as well as for the Company 3. Knowledge Retention Scheme: The Idea of this type of scheme is to benefit those employees who have made a significant contribution to product development (e.g. for employees who have contributed to software development in a software company) and have all the knowledge of the same. The employees in the above scheme can be rewarded in a manner similar to that of the Employee retention Scheme 4. Employee Performance Incentive Scheme: The idea of the scheme lies in Scheme: having a performance index for the employees of the Company and than multiplying the same by Annual appreciation on the Companys Equity share price during the year. 5. Defined Contribution Plan: This type of scheme can be an alternative to pension plan. Under This scheme the employer as well as the employee makes a contribution as a percent of annual salary of the Employees to the scheme. The total amount of contribution is invested in the shares of the Company. The value of pension of employee can be determined by ratio of present value of contribution collected for the employee to present value of total contribution.

6. Profit sharing scheme: Under the scheme the profits of the Company can be shared with the employees in the form of shares where the bonus given to the employees shall take form of shares. The amount of bonus payable shall be fixed as a percentage of Profit after Tax, but the payment for the same shall be made in form of shares of the Company. The amount of Bonus can be utilized to buy shares from the market or otherwise for fresh issue of shares. 7. Variable Earnings Related to Stock Options: Under this scheme the number of shares offered to each employee will be related to his "annual variable pay earnings", basis of which shall includes parameters likes the performance of the company, performance of the strategic business unit, individual's performance. An employee can receive 50% of his variable pay in cash and rest 50% can be offered in the form of shares at a discount. In case the employee leaves the organization he can encash his variable options. 8. Economic Value Added (EVA) based scheme: The EVA criteria is also one of the modes of judging the employee performance and the employees can be rewarded in the form of stock options on the basis of value added to the Company.

SEBI Guidelines on ESOS

The Government of India realizing the potential of the benefits that can be conferred through an ESOP mechanism constituted the J.R. Varma Committee. The Committee laid down the guidelines for a statutory framework for an ESOP. These guidelines are called SEBI (Employee Stock Option Scheme & Employee Stock Purchase Scheme) Guidelines, 1999. The Companies are allowed to offer stock option scheme to their employees subject to these guidelines, which provide: 1. No ESOS shall be offered unless the disclosure, specified in

Schedule IV, are made by the company to the prospective option guarantees and the company constitute a Compensation Committee for administration and superintendence of ESOS.

2.

Issue of Stock Options at a Discount to the market price would be

regarded as another form of Employee Compensation and would be treated as such in the financial statements of the company regardless of the quantum of discount on the exercise price of options. 3. 4. Subject to the aforesaid financial treatment the pricing provisions The issue of ESOS would be subject to approval by shareholders of SEBIs preferential allotment guidelines shall not cover ESOS. through a special resolution in the general meeting. The explanatory statement to the notice and the resolution proposed to be passed in general meeting for ESOS shall, inter alia, contain the information as given under clause 6 of the guidelines. 5. There would be no restriction on the maximum number of shares to be issued to a single employee. However separate resolution in the general meeting shall be obtained in case of: grant of option to employees of subsidiary or holding company, and ii. grant of option to identified employees, during any one year, equal to or exceeding 1% of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant of option. 6. A minimum period of one year between grant of options and its vesting has been prescribed. After one year, the company would determine the period during which the option can be exercised. Company may specify a lock in period. 7. 8. The option of ESOS would have to be under superintendence and ESOS would be open to all permanent employees (whether directions of the compensation committee of the Board of Directors. working in India or abroad) and to the directors (whole time or part time) of the company but not to (i) employer who is a promoter or belongs to a promoter group; (ii) a director who either by himself or through his relatives or through anybody corporate holds more than 10% of the outstanding equity shares of the company. Within the specific approval of the shareholders, the scheme would be allowed to cover the employees of the subsidiary or holding company. 9. Directors Report shall contain following disclosures:

The total number of shares covered by ESOS as approved by the shareholders, ii. iii. The pricing formula; Options granted, options vested, options excercised, options

forfeited, extinguishments or modification of options, money realised by exercise of options, total number options in force, employee-wise details of options granted to senior managerial personnel and to any other emplyee who receive a grant in any one year of options amounting to 5% or more of options granted during that year; iv. 10. Fully diluted earnings per share (EPS) computed in Company may vary the terms of ESOS by passing a special accordance with international accounting standards. resolution provided variation: i. Relates to option not yet exercised; ii. Is not prejudicial to the interest of option holders. Again a company may reprice the options, which are exercised if ESOSs were rendered unattractive due to fall in the price of the shares in the market. However, the company must ensure that such repricing shall not be detrimental to the interest of employees and approval of shareholders in General Meeting has been obtained for such repricing. 11. person. 12. 13. 14. 15. Options granted cannot be pledged, hypothecated, mortgage or In the event of death, options granted to an emplyee shall vest in In case of permanent incapacity, all options granted shall vest in Auditor to certify that the scheme has been implemented as per otherwise alienated in any other manner. the legal successor/nominee. him as on the date of incapacitation. guidelines. Certificate of the auditor to be placed AGM. Options granted to an employee shall not be transferable to any

Amendments to the SEBI Guidelines on ESOS

The Securities and Exchange Board of India has amended its guidelines on Employee Stock Option and Purchase Schemes (ESOP and ESPS) to provide for mandatory disclosures, pricing and appointment of merchant bankers. The board, after considering the recommendations of the J R Verma panel on ESOP and the public comments approved certain modifications to the guidelines. Under the amended norms, a.) The market price would mean the latest available closing price, prior to the date of the meeting of the company board in which options are granted or shares are issued, on stock exchanges. If the shares are listed on more than one stock exchange, then the stock exchange where there is highest trading volume on the said date should be considered. b.) The company should appoint a registered merchant banker for the implementation of ESOS and ESPS till the stage of framing the ESOS/ESPS and obtaining in-principal approval from the stock exchanges. c.) In case these schemes are administered through a Trust, the accounts of the company should be prepared as if the company itself is administering the ESOS/ESPS. d.) The accounting value of shares, issued under ESPS, should be equal to the aggregate of price discount over all shares issued under scheme during any accounting period. The price discount would mean difference between the issue price and the market price of the shares. e.) The shares arising after the initial public offer, from options granted under any ESOS framed prior to its IPO, should be listed immediately upon exercise on stock exchanges where the equity shares of the company are listed and no listed company should make fresh grant of options under ESOS framed prior to IPO and prior to the listing of its equity shares, unless such pre-IPO scheme is in conformity with guidelines and ratified by shareholders.

Taxability of shares issued under ESOS

The provisions to tax benefit arising under an ESOP were introduced for the first time by the Finance Act, 1999 w.e.f. 1st April 2000. However the Finance Act, 2000, w.e.f, 1st w.e.f. April 2001 deleted these provisions.. The benefit to an employee from participating in provisions. ESOP plan is now taxable only under the head 'Capital gains', provided the ESOP fulfils the guidelines laid down by the Central Government. The amendment brought about by the Finance Act, 1999, in our opinion, is not retrospective. Most important issue in this regard is that whether the employee stock option received by an employee would have been taxable in his hands when the allotment is made. It would be taxable as a perquisite if the allotment is not in accordance with the guidelines issued by the Central Government. And in such a case such income would be taxed as a perquisite under the head `salaries'. If it had been in accordance with the guidelines issued by the Government, it would not have been taxable as salary at the time of allotment. The taxability at the time of sale will depend on whether the shares are listed and sold through a recognised stock exchange or sold otherwise than through a recognised stock exchange. If sold through a recognised stock exchange, the securities transaction tax would be levied at the time of sale. And if the share is held for more than 12 months, the gain would be long-term and therefore be exempted under Section 10(38). But if the sale has not been made through a recognised stock exchange, the gain would be taxable. The cost of acquisition will be taken as the price at which the shares were allotted to the employee if no tax was suffered at the time of allotment. If it were taxable at the time of allotment to the employee, the cost of acquisition would be the market price as on the date of allotment. Infosys Technologies Ltd. v. Deputy Commissioner of Income Tax MANU/IT/0331/2002 Facts: 1.) Infosys Technologies Ltd., a public limited company formulated an Employee Stock Option Plan (ESOP). For this purpose it set up a trust. The trust was allotted warrants of Re. 1 each, each warrant entitling the holder thereby to apply for and be allotted one equity share of face value 10

of Rs. 10 each for a total consideration of Rs. 100. The trust is to hold the warrant and transfer the same to the employees of the company under the terms and conditions of the scheme governing the ESOP. 2.) During the years under consideration viz., the asst. yrs. 1997-98, 199899 and 1999-2000, warrants were offered to the employees. These warrants were offered to the employees at Re. 1 each by the Infosys Technologies Ltd. Employees Welfare Trust (trust). The consideration recommended by the Board of Directors of Infosys in the present rate is rupees one hundred per share. The right of exercise is available at the defined times subject to the employee being in the service of the company during the said period of five years. In case the employee were to leave the services of the company or be removed from service for whatever reason, his rights under the warrants would lapse and he would be obliged to transfer the warrant back to the trust for the same consideration of rupee one per warrant as paid by him originally. During the lock-in period the custody of the shares will be with the trust and the shares allotted on the conversion of the warrants shall not be capable of being transferred/charged/mortgaged/ hypothecated/assigned or in any manner alienated or otherwise disposed of. 3.) The company did not deduct tax at source on the benefits conferred through the ESOP and therefore a notice under Section 192 r/w Section 201(1) was issued to the company seeking reasons for the same and, also as to why it should not be regarded as an assessee-in-default. 4.) After hearing the assessee-company, an order under Section 201(1) was passed for the various years raising demands for the tax and interest there upon. Aggrieved by the order passed by the AO, the company filed an appeal before the CIT (A). However CIT (A) dismissed the appeals preferred by the company. And therefore it approached ITAT.

Contentions: The contentions of the company were that no perquisite arises to an Contentions: employee, as a result of his participation in ESOP. The company also submitted reasons as to why the provisions of Section 192 are not attracted in the case. However the counsel for the Department argued that for the reason that the employee has participated in the ESOP a benefit has been conferred. This benefit is liable to be taxed as a part of salary. Held: The Tribunal came to the conclusion that since the provisions for taxing benefits arising from ESOP were deleted by the Finance Act, 2000, w.e.f. 1st April, 2001, such benefits are now taxable only under the head 'Capital gains', provided the ESOP fulfils the guidelines laid down by the Central

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Government. And further such an amendment brought about by the Finance Act, 1999, is not retrospective. The Tribunal also held that the physical custody of shares is not with the employees. It lies with the trust. The trust is empowered to retransfer the same to its name in situations where the condition precedent of an ESOP are not fulfilled, Thus the possessory right, being the most important attribute of ownership is not available with the employees. And thus, no real income is enjoyed by the employees and also there is a risk of forfeiture of shares in the event of discontinuation of the services of the employee. Income Tax Officer v. Television Eighteen India Ltd. MANU/IT/0511/2005 Facts: The assessee company approved an Employee Stock Option Scheme and created a trust namely, Senior Professional Trust for the welfare of the employees. The company through this trust transferred certain shares to its senior employees and directors. The company did not considered the value of these shares as perquisite in the hands of the recipients while deducting tax at shares. Therefore, the Assessing Officer imposed penalty on the company for the financial years under consideration for short-deduction of TDS. The penalty was imposed under Section 271C of the IT Act of 22,90,050 for financial year 1998-99 and of Rs. 13,38,683 for the financial year 1999-2000. Being aggrieved, the assessee filed appeals before the first appellate authority. The CIT (A) accepting the contentions of the company removed the penalties for both the financial years under consideration. Hence, the Department is in further appeals before the Tribunal. Contentions: The company again raised the contention that the benefit arising out of ESOS were not taxable perquisites in the financial years under consideration. It was also argued that if the benefit arising out of ESOS were not taxable perquisites in the financial years under consideration, the question of levy of penalty under Section 271C does not arise. Held: the Tribunal upholding the decision of the CIT (A) held that shares given under ESOS are perquisites under Section 17(2)(iiia) only from asst. yr. 2001-02. Since the financial years under consideration before us are financial years 1998-99 and 1999-2000, we hold that no benefits had accrued to the employees on account of participation in the scheme of ESOS. Accordingly, it was further held that no tax was to be deducted at source in the financial years under consideration and therefore the question of levy of penalty under Section 271C does not arise.

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Employee Stock Options through Trusts

Employee Stock Options are also implemented through creation of Trusts. Trusts are formed under the Indian Trust Act and registered under the relevant Trust Act of the state in which the Trust's activities are to be based. The objectives of the Trust are to administer the Scheme for the employees of a certain organization. The Company issues a certain number of shares at par to the Trust. The Trust then issues these shares to the Company employees in accordance with pre-set guidelines. Under such an arrangement, the employees receive shares from the Trust. The Trust can also buy back the shares from employees in circumstances, which may be specified in the Trust Deed. This arrangement imparts liquidity in the scheme and is suited to companies whose shares are not listed

Conclusion
ESOPs are slightly different from other employee benefit plans offered by companies to motivate their employees. ESOPs are seen as an essential tool by companies to retain their employees, particularly those at higher levels. However, ESOPs have come to be seen more as a part of employee expectations in an intensively competitive job market, particularly in knowledge-based industries, than a tool that companies can use to their advantage. With employees owning stocks in the companies they work in, their performance would directly result in better prices for the stock. This can, thus, be a major source of capital gains for them. Establishing a successful ESOP and tailoring it to a particular company's needs is a challenge. Under a well-designed scheme, there can be major benefits for both the company and its employees. Stock option plans are flexible ways for companies to share ownership with employees, reward them for performance, and attract and retain a motivated staff. For growthoriented smaller companies, options are a great way to preserve cash while giving employees a piece of future growth. They also make sense for public firms whose benefit plans are well established, but who want to include employees in ownership. -------------------------------------

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BIBLIOGRAPHY 1. Avtar Singh, Company Law, Eastern Book Company, 2005. Law, 2. DR. GK. Kapoor, A.K Majumdar; Students Guide to Company Law; TAXMAN, Law; 2006. 3. Report of J.R. Varma Committee regarding Guidelines for Employees stock Options Schemes. 4. Cilliers H. S. et al, Corporate Law, Butterworths, Durban, Second Edition, Law, (1992).

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