The Hindu Business Line : Sweat equity, an overview

NOW that Mr Mukesh Ambani has decided to renounce his 12 per cent sweat equity or 50 crore shares in Reliance Infocomm, valued at Rs 5,000 crore, the concept of `sweat equity' has come into focus.

The phrase `sweat equity' refers to equity shares given to the company's employees on favourable terms, in recognition of their work. Sweat equity usually takes the form of giving options to employees to buy shares of the company, so they become part owners and participate in the profits, apart from earning salary.

The Companies Act defines `sweat equity shares' as equity shares issued by the company to employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called.

ESOP or employee stock option plan, or employee share ownership plan, is how sweat equity may often operate. ESOS is another abbreviation, to mean Employees Stock Option Scheme, and there can be ESPS, or Employee Stock Purchase Plan. On www.incometaxindia.gov.in, there is a simple description of ESOP as "the 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 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 aim of ESOP or sweat equity is simple: retain your best employees by offering a good enough carrot. So, there is no limit to how discounted the share can be for employees. However, Section 79A of the Companies Act lays down conditions for the issue of sweat equity shares. Accordingly, a company may issue sweat equity shares of a class of shares already issued after passing a special resolution in the general meeting, specifying the number of shares, current market price, consideration, if any, and the class or classes of directors or employees to whom such equity shares are to be issued.

Also, it is necessary that not less than one year has, at the date of the issue, elapsed since the date on which the company was entitled to commence business. For listed companies, there are regulations made by the Securities and Exchange Board of India such as prescribing the price of sweat equity shares not to be less than the higher of the following: the average of the weekly high and low of the closing prices of the related equity shares during last six months preceding the relevant date; or the average of the weekly high and low of the closing prices of the related equity shares during the two weeks preceding the relevant date.

SEBI also prescribes the accounting treatment for sweat equity. Thus, sweat equity is expensed, unless it issued in consideration of a depreciable asset, in which case it is carried to the balance sheet. The Institute of Chartered Accountants of India has recently finalised a Guidance Note on "Accounting for Employee Share-Based Payments" intended to be more elaborate than what the SEBI prescribes. A sign of dynamism in this area is that the Financial Accounting Standards Board of the US too revised this month its standard on `share-based payment', and it runs to about 300 pages.

Taxmen across the world look at sweat equity keenly and differently. For instance, in Germany and Australia, sweat equity is taxed on the grant of the option. In the Netherlands and Switzerland, tax arises on irrevocable vesting of the option, while in Singapore and France tax is when there is exercise or disposal of the options.

In India, there has been yo-yoing about taxing ESOPs as perquisites, till Mr Yashwant Sinha conceded to taxing for capital gains at the time of sale of ESOPs, rather than imposing the levy of tax at the time when the shares are issued to the employees. Finance Act, 2001, however, accorded beneficial tax treatment for ESOPs framed in accordance with Central Government Guidelines.

ESOP is no unmixed blessing. If the company tanks, as did Enron, employees may end up burdened with worthless paper in the form of sweat equity that's no longer sweet. On the contrary, when the company performs too well, and so the options appreciate in value, there can be criticism that the employees have been benefited the most. For Mukesh, however, sweat equity seems to have become a sudden burden.

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