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ESOP - Accounting, Tax and Valuation Aspects
“Finger on ESOP Pulse”
Accounting Tax
1
Contents
Particulars
ESOP Overview
Planning and Strategy
Implementation
Financial aspects of ESOP
Key Driver of ESOP
• Accounting
• Tax
• Valuation
2
ESOP Overview
3
ESOP
Flexible financial and equity incentive instrument
Compensation tool
Rewarding Existing Employees and attracting new Talent
“The flowers of tomorrow are in the today’s seeds”4
Planning and Strategy
Just
another
Investment
Plan
Thinking
Like
Owners
Stages in Deciding ESOP Plan
Valuation of Company
Discount Offered
Tax Implications
Accounting
Compensation cost
Regulatory implications viz,
Company Law, SEBI regulation,
FEMA regulations, Income Tax
Shareholding Dilution
Industry Practice
No. of shares to offer
Administrative aspect 6
Implementation
7
Stages in Implementation of ESOP Plan
Formulation of Incentive
Plan
Grant
Vesting
Exercise
Sale
Commercial Legal Financial
Formulation of
Strategy to
Compensate
Employees
Generation of
Future Cash
Flows
Inflow of Funds
Amortization of
Compensation
Cost
Section -45 read
with Section –
49(2AA) of Income
Tax Act, 1961
Calculation of
Capital Gain
Perquisite
Valuation
Section -17 (2)(vi)
Income Tax Act,
1961 read with
Rule 3(8)(i) of
Income Tax Rules
1962
Book of
Compensation
cost – SEBI
(ESOS and ESPS
Guidelines), 1999
Accounting
Valuation
Compliance to
Companies Act
and SEBI
Guidelines
Vesting
Period
Exercise
Period
Lock in
Period
Exit
8
Financial Aspects of ESOP
AccountingTax
9
Accounting Perspective
10
Accounting aspect of ESOP in India
Stages Tax Treatment
Grant of Options Valuation is required to amortize the Employee
Compensation Cost during the vesting period;
Graded Vesting: Each vest consider as a separate
grant;
Straight Line Accounting: Amortization of
Employee Compensation cost on time proportionate
basis
In case of lapse of unvested / Vested option, the accounting
to be reversed
ESOP Accounting
To determine the compensation cost which is required to be amortized over the vesting
period and detailed disclosure regarding option statistics including disclosure of stock
option compensation cost computed by applying Fair value method and impact of non
recognition of Fair Value compensation cost on basic and diluted EPS.
APPLICABLE LAW
Intrinsic Value method allowed with
disclosure as per Fair Value Method
US GAAP
SFAS 123 (Revised):
INDIA:
SEBI (ESOS and ESPS) Guidelines, 1999
ICAI Guidance Note
Fair Value Method
Mandatory
International GAAP
IFRS 2:
Share Based Payment
Fair Value Method
Mandatory
Tax Perspective
Tax Implications of ESOP in India
Stages Tax Treatment
Grant of Options Nil
Vesting of Options Nil till Exercised
Exercise of Options Taxed as perquisite in the hands of Employees which is
computed as the difference between the FMV of the share
on the date of exercise and the exercise price. The
employer is required to withhold tax at source in respect of
such perquisite.
Sale of Options The incremental gain (i.e. difference between sale
consideration and the FMV on the date of exercise), on
sale of shares is considered a capital gain for the employee.
For computing capital gains, the FMV on the date of exercise
becomes the cost base.
During the period April 2007 to March 2009, employer was required to pay Fringe
Benefit Tax (FBT) on benefit derived by employee from ESOPs. The employer was
allowed to recover such FBT from the employees. After FBT has been abolished
benefits under ESOP taxed as perquisites in the hands of employees
ESOP Valuation
Accounting Tax
Key Driver of ESOP
Valuation
Accounting Tax
Intrinsic Value
ESOP Valuation
Fair Value
Market Price
(-)
Exercise Price
Option Pricing Model
Listed Company on Recognized Stock
ExchangeUnlisted Company
Average of Opening
and Closing Market
Price
On Exercise Date
No Method has been
prescribed
Intrinsic Value method allowed with
disclosure as per Fair Value Method
Shares of foreign companies listed on
foreign stock exchange are regarded as
unlisted shares
Intrinsic Value
Intrinsic Value” is the excess of the market price of the share under ESOP over
the exercise price of the Option (including upfront payment, if any)
Suppose :
Current Market Price is Rs 100
Exercise price is Rs 70
Then Intrinsic Value is Rs 30
However if the CMP was Rs.50 instead, there would be no intrinsic value of the option
since the exercise price is more than CMP and in this case options could not be
exercised and instead stand lapsed
Fair Value Method – Black Scholes Method
Suppose :
Exercise price is Rs 100
Fair Value per share Rs 200
Volatility 10%
Dividend yield zero
Risk Free rate 8.76 %
Expected life of option 3 Years
Differential value or value of perquisite is = Rs 200- 100 = Rs 100 in normal parlance.
However when we use the black scholes calculator the value that shall be coming to
Rs 123 which is the compensation cost or loss to a company which it shall be
booked on a notional basis in its books of account.
Under this methodology we shall be calculating the call price of options and this basically calculates
the compensation cost. The benefit of this model is takes into consideration the factors like volatility,
dividend yield ,Risk free rate and expected life of options.
ESOP Tax
APPLICABLE LAW:
Income Tax Act – 1961 and Notification no. 94/2009 dated 18.12.2009 issued by CBDT
To determine the value of perquisite taxable in hands of employees
Particulars Listed on Recognized Stock Exchange Unlisted Company
Situation Market Price on Exercise
Date is available
Market Price on Exercise
Date is Not available
Method of
Valuation
Average of Opening and
Closing Price of the share on
the Exercise Date
Latest Closing Price of the
share immediately
preceding the Exercise Date
No Method has been
Prescribed
Valuer SEBI Registered Category – I
Merchant Banker
19
Valuation guidelines under erstwhile FBT regime
Shares of foreign companies listed on foreign stock exchange are regarded as unlisted shares
Foreign company shares to be valued by SEBI registered Category I Merchant Banker (“MB”)
Listed price of foreign company may be considered by MB as one of the basis for valuation
MB to determine the value on the basis of alternative methods and recommend the most appropriate
value
Shares with multi-vesting dates allotted at one shot, with total shares allotted are less than the shares
vested - Follow FIFO method
Valuation may be carried out anytime as long as specified security is valued on the specified date
Valuation by more than one MBs - the value on the date closest to the vesting date to be considered*
Valuation by a MB on different occasions - the value on the date closest to the vesting date to be
considered*
No FBT if value on the date of vesting is less than the exercise price*
Assessing Officer is bound by valuation unless the valuation is perverse
*(at the time of FBT vesting date was relevant)
Grey Area
ESOP cost is tax deductible for company ??
High Court of Madras
(HC) in the case of PVP Ventures
Ltd. (Taxpayer) [TC(A) No. 1023 of
2005] held that there was no error
in Tribunal’s ruling which held that
ESOP cost was allowable as
expenditure as the Taxpayer had
debited ESOP cost to profit and
loss account (P&L) as per the
directions of Securities and
Exchange Board of India (SEBI).
Recently in July 2013, the Special
Bench of the Bangalore Income
Tax Tribunal in the case of Biocon
Limited held that discount on
issue of ESOP is deductible
business expenditure.
ESOP Valuation
Vs
Equity Valuation
22
Discounts in ESOP Valuation
• Discount for Entity Level
Discounts & Premiums come into picture when there exist difference between the
subject being valued and the Methodologies applied. As this can translate control value
to non-control and vise versa , so these should be judiciously applied.
– Impact on entity as a whole
Key Person Discount
Discount for Contingent Liability
Discount for diversified company
Discount for Holding Company
•Discount for Shareholders Level – Impact on specific ownership interest
Discount Lack of Control (DLOC)
Discount Lack of Marketability (DLOM)
•Size of distribution or dividends
•Dispute
•Revenue / Earning – Growth / Stability
•Private Company
Tax Payout
•% stake & special rights
•Shareholders Agreement caveats
Global Studies over the years on diversified
companies and holding companies has shown
that companies trade at a discount in the range
of 20%. to 40% each.
DLOM: As per CCI Guidelines, 15%
discount has been prescribed; however
practically DLOM and DLOC depends upon
following factors:
Tricky Issues
Excess Cash and Non Operating Assets
Excess cash is defined as ‘total cash (in balance
sheet) – operating cash (i.e. minimum required cash)
to sustain operations (working capital) and manage
contingencies
Key Issue: Estimation of Excess Cash ?
Non operating Assets are the Surplus assets which are not used in operations of the business and does not
reflect its value in the operating earnings of the company. Therefore the fair market value of such Assets should be
separately added to the value derived through valuation methodologies to arrive at the value of the company.
One of the solutions is to estimate average
cash/sales or total balance sheet size of the
company’s relevant Industry and then estimate if
the company being valued has cash in excess of the
industry’s average.
What is an asset is not yielding adequate returns ?
Cross Holding and Investments
Holdings in other firms can be categorized into:
Types of Cross Holding Meaning
Minority, Passive Investments If the securities or assets owned in another firm represent less
than 20% of the overall ownership of that firm
Minority, Active Investments If the securities or assets owned in another firm represent
between 20% and 50% of the overall ownership of that firm
Majority, Active Investments If the securities or assets owned in another firm represent more
than 50% of the overall ownership of that firm
Investment Value
Ways to value Cross Holding and Investments:
Dividend Yield Capitalization or DCF based on expected dividends
Seperate Valuation (Preferred)
By way of Shareholders
Agreement even less %
holding may command
control value
Intangible Valuation
Identification of Intangible Assets:
• Market Related : Trade Marks, Service Marks etc.
• Customer Related : Customer Lists, Order backlogs etc.
• Artistic Related : Plays, Books, Pictures, Music, Video etc.
• Contract Related : Licensing, Royalty, Lease agreements etc.
• Technology Related : Patented Technology, Databases,
computer software's etc.
Company Specific Factors
• Management, Promoter Group
It is the alignment of
Company’s value via-a-
vis to its external
environment
• Operating, Capital and Corporate Finance Strategies
• Competitive advantages and cost position
• Product / Service offering / differentiation / pricing power
•Scale & Diversification
•Customer / Supplier concentration
•Corporate Governance
•Future prospects / Growth potential
•Industry peer group
•Regulatory environment
Industry Risk Analysis
• Good vs. Difficult industry
• Porter’s 5 forces
• Industry life cycle (growth)
• Industry cyclicality (earnings quality)
• Leading indicators
• Competition (ROIC)
• Pricing dynamics; Demand vs. Supply (ROIC)
• Changing business environments
• Regulation (ROIC)
• Product characteristics (earnings quality)
• Capital intensity and cost base (ROIC)
• Event risk
Following factors are required to
be considered:
Valuation Methodologies and Value Impact
Major Valuation Methodologies Ideal for Result
Net Asset Value
Net Asset Value (Book Value) Minority ValueEquity Value
Net Asset Value (Fair Value) Control Value
Comparable Companies Multiples (CCM) Method
Price to Earning , Book Value MultipleMinority Value
Equity Value
EBIT , EBITDA Multiple Enterprise Value
Comparable Transaction Multiples (CTM) Method
Price to Earning , Book Value MultipleControl Value
Equity Value
EBIT , EBITDA Multiple Enterprise Value
Discounted Cash Flow (DCF)
Equity Control Value Equity Value
Firm Enterprise Value
Mr. Chander Sawhney
Partner & Head – Valuation & Deals
M: +91 9810557353
D: +91 11 40622252
Mr. Maneesh Srivastava
AVP – Valuation & Biz Modelling
M: +91 9871026040
D: +91 11 40622255
Mr. Gaurav Kumar Barick
Manager – Valuation & Biz Modelling
M: +91 8130141874
D: +91 11 40622241
Mr. Sameer Verma
Deputy Manager – Valuation and Biz Modelling
M: +91 9911945607
D: +91 11 40622216
Our Valuation Team