Sweat Equity shares
ESOP for EmployeesESOP for Founders

How Does Sweat Equity Work?

“Sweat Equity” shares mean equity shares issued by a company to its employees or directors at a discount or for consideration other than cash. In other words, it refers to the allotment of equity shares to employees as compensation for the efforts and hard work (aka sweat) in providing intangibles, like growth or success, for the company. The issuing of “sweat equity” allows the company to attract and retain its employees by rewarding them for their contributions.

Startups generally use ESOPs (Employee Stock Option Plan) rather than Sweat Equity to attract and reward employees.  This is because, in the case of ESOPs, employees need not be allotted actual shares of the company until the time of exercise or a liquidity event. However, in the case of Sweat Equity, the shares are immediately allotted to the employee.

Significant differences between ESOP Schemes & issue of Sweat Equity shares:

  • Allotment: ESOP is a grant of options to employees to purchase shares in the future at a predetermined price. The shares are allotted to the employee only after the exercise of the ESOP grant. On the other hand, Sweat equity is the direct allotment of shares at a discount or for consideration other than cash.
  • Timelines: A company can issue sweat equity only after one year from the date of commencing business. However, there is no such restriction on the issue of ESOPs.
  • Cliff & Lock-in: For ESOPs, there is a minimum period of one year between the grant and vesting of options. For Sweat Equity, there is a lock-in period of three years from the date of allotment of sweat equity shares. But there is no compulsory lock-in period for the allotment of equity shares under the ESOP scheme. For ESOPs, the company shall have the freedom to specify the lock-in period of the shares issued pursuant to the exercise of stock options.
  • Qualification Criteria: The definition of employee is different for ESOPs and sweat equity shares- Sweat equity can be issued to a permanent employee of the company who has been working in India or outside India for at least the last year. No such restriction for the issue of ESOPs- ESOPs cannot be issued to an independent director, whereas sweat equity can be issued to an independent director- ESOPs cannot be issued to the promoters, a person belonging to the promoter group, or to a director who either hitrica equitylf or through his relative or any corporate body, directly or indirectly, holds more than 10% of the outstanding equity shares of the company. The only exception to this is for founders/promoters of DPIIT recognized startups where they are eligible to receive ESOPs for up to 10 years from the date of incorporation. This restriction does not apply to the issue of sweat equity.
  • Dilution: The company cannot issue Sweat Equity for more than 15% of the existing paid-up equity share capital in a year or shares of the issue value of INR 5 crore, whichever is higher. Also, the issuance of Sweat Equity in the Company cannot exceed 25% of the paid-up equity capital of the company at any time. A startup may issue Sweat Equity shares not exceeding 50% of its paid-up capital up to five years from the date of its incorporation or registration. These restrictions do not apply to the issue of equity shares under the ESOP scheme.
  • Exercise: For ESOPs, companies have the freedom to determine the exercise price in conformity with the applicable accounting policies. For Sweat Equity, a registered valuer will determine the fair price for the shares and justify such a valuation.
  • Consideration for the purchase of shares under the ESOP scheme can be done only in cash. A company can issue sweat equity shares to its employees at a discount or as a consideration other than cash.

Taxation of Sweat Equity shares

Issue of Sweat Equity shares are taxed at two phases

Phase I: As a prerequisite when sweat equity shares are issued

Equity Shares are generally issued by a company to its employees or directors at a discount or for consideration other than cash for providing know-how or intellectual property or other value additions to the business.

    • When shares are issued at a discount to the FMV of the equity shares:
      • Under the Income-tax Act, salary includes perquisites or profits in lieu of or in addition to any salary or wages. Perquisite includes the value of any sweat equity shares allotted or transferred, directly or indirectly, by the employer or former employer, free of cost or at concessional rate to the employee (Sec 17(2)(vi) of the Income-tax Act).
      • The value of sweat equity shares shall be the fair market value of the sweat equity shares on the date on which the option is exercised by the assessee as reduced by the amount actually paid by or recovered from the assessee in respect of such shares (Sec 17 of the Income-tax Act). Thus, the employee is subject to taxation on the amount of discount to the FMV of the sweat equity shares on the exercise date, which is treated as a prerequisite under the head of income “Salaries.”
    • When shares are issued for a consideration other than cash: The valuation of intellectual property rights or of know-how or value additions (defined earlier) for which sweat equity shares are to be issued shall be carried out by a registered valuer, who shall provide a proper report addressed to the Board of directors of the company with justification for such valuation.
      • Where sweat equity shares are issued for non-cash consideration based on a valuation report in respect thereof obtained from the registered valuer, such non-cash consideration shall be treated in the following manner in the books of account of the company—
        • where the non-cash consideration takes the form of a depreciable or amortizable asset, it shall be carried to the company’s balance sheet per the accounting standards; or
        • where the above clause is not applicable, it shall be expensed as provided in the accounting standards. It shall be treated as part of managerial remuneration for the purposes of sections 197 and 198 of the Companies Act, 2013.
      • If the shares are issued pursuant to the acquisition of an asset, the asset’s value, as determined by the valuation report, shall be carried in the balance sheet as per the Accounting Standards. As per the valuation report, such an amount of the accounting value of the sweat equity shares that are in excess of the value of the asset acquired shall be treated as a form of compensation to the employee or the director in the company’s financial statements. Such remuneration shall be taxable in the hands of the employee as a prerequisite.
      • If the sweat equity shares are not issued pursuant to the acquisition of an asset, the accounting value of sweat equity shares shall be treated as a form of compensation to the employee or the director in the financial statements of the company. Accordingly, such remuneration shall be taxable in the hands of the employee as a prerequisite.
      • The employer is required to deduct income tax at the source on the perquisite value. This prerequisite value will be shown in the employee’s Form 16 and included as part of the total income from salary in the tax return.
      • There is no tax impact on the employer at the time of allotment of sweat equity shares. The employer is only required to deduct income tax at source on the perquisite value from the employee’s salary. Determination of Fair Market Value of shares is as per Rule 3 of the Income-tax Rules, 1962 (see below).

Phase II: As capital gains at the time of sale by the employee

When the employee sells the company shares at a future date, the employee is subject to capital gains taxation on the difference between the sale price and the FMV of the shares on the exercise date.

The nature of capital gains could be short-term or long-term depending on the period of holding the shares and the type of shares – listed or unlisted. The period of holding begins from the exercise date up to the date of sale. In the case of private company shares, if the holding period is less than 24 months, STCG (short-term capital gain) tax is applicable as per the income tax bracket of the assessee. On the other hand, if the holding period is more than 24 months, LTCG (long-term capital gain) tax is applicable at 20% with indexation benefits.

Exemption from taxation on reinvestment of sale proceeds

A tax exemption can be availed on the taxable long-term capital gains, if any, arising from the sale of shares by reinvesting the sale proceeds either in specified bonds as per conditions specified in section 54EC of the Income-tax Act, 1961, or in one residential house in India as per the conditions specified in section 54F.

There is no tax impact on the employer when the employee sells the company shares.


Click here for a blog on the tax implications of ESOPs in India.
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Disclaimer: This article has been prepared for general guidance on the subject matter and does not constitute professional advice. The matters described herein are general in nature and have not been evaluated based on applicable laws. You should not act upon the information contained in this note without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this note. LetsVenture Technologies Private Limited, its partners, employees, and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. Without prior permission of LetsVenture Technologies Private Limited, this note may not be quoted in whole or in part or otherwise referred to any person or in any documents.

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