“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 use ESOPs (Employee Stock Option Plans) rather than Sweat Equity to attract and reward employees. This is because, in the case of ESOPs, employees must be allotted actual shares of the company at the time of exercise or a liquidity event. However, in the case of Sweat Equity, the shares are immediately allocated to the employee.
Significant differences between ESOP Schemes & issue of Sweat Equity shares:
Allotment: ESOP is a grant of options for employees to purchase future shares 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 one year after 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 the 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 be free to specify the lock-in period of the shares issued under 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 one year.
No such restriction for the issue of ESOPs. ESOPs cannot be issued to an independent director, whereas sweat equity can be given to an independent director.
ESOPs cannot be issued to the promoters, a person belonging to the promoter group, or to a director who, through trica equity or his relative or any corporate body, directly or indirectly, holds more than 10% of the outstanding equity shares of the company. The only exception is for founders/promoters of DPIIT-recognized startups, who 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 its incorporation or registration date. These restrictions do not apply to the issue of equity shares under the ESOP scheme.
Exercise: For ESOPs, companies can 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 purchasing 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 in two phases
Phase I: As a prerequisite when sweat equity shares are issued
A company generally issues Equity Shares to its employees or directors at a discount or for consideration other than cash for providing know-how, 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 instead 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 a 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 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—
When 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, when 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 sections 197 and 198 of the Companies Act 2013.
If the shares are issued under 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 is more than the asset acquired shall be treated as compensation to the employee or the director in the company’s financial statements. These remunerations shall be taxable in the hands of the employee as a prerequisite.
Suppose the sweat equity shares are not issued under the acquisition of an asset. In that case, the accounting value of sweat equity shares shall be treated as compensation to the employee or the director in the company’s financial statements. Accordingly, such remuneration shall be taxable in the hands of the employee as a prerequisite.
The employer must 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, and the employer is only required to deduct income tax at source on the perquisite value from the employee’s salary. The determination of the 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 holding period 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 to learn the tax implications of ESOPs in India.
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