Startups in India have many questions on how to give advisor equity, i.e. shares to advisors, mentors, and consultants. First, you must know that under the provisions of the Companies Act, 2013 and Companies (Share Capital & Debentures) Rules, 2014, a private or an unlisted public company cannot issue ESOPs or sweat equity shares to consultants and advisors who are not employees or directors of the company, its subsidiaries in or outside India or its holding company. It’s also important to reiterate that sweat equity as per Section 54 of the Companies Act can be given only to employees or directors (including independent ones) or promoters.
Having cleared the air on that, let’s discuss advisor equity and what options you have to give out advisor equity in India.
How it works is that the advisor raises an invoice to the company for, say, ₹1,50,000 (150 shares x FMV of ₹1000 per share). The company, in turn, allows them 150 shares. Also, note that the company needs to pay TDS on the compensation amount of ₹1,50,000 at 10% and may choose to recover this amount from the advisor. Otherwise, the TDS amount could be borne by the company itself.
There is no GST charged for an individual unless the annual income (from all services) crosses INR 20 lakh. If the advisor equity allotment is done in the name of a company (instead of an individual), then that company needs to pay GST at the rate of 18% of this amount. Either the startup, which allots advisory equity, needs to reimburse the company for the GST amount, or that company can pay from its own balance sheet. Do consult your tax advisor for more details.
Legal speak on advisor equity
A company can issue its shares to consultants and advisors, whether resident in India or outside if such an issue is authorized by a special resolution passed in a general meeting. Such an issue of shares can be made either for cash or consideration other than cash if the price of such shares is determined based on a valuation report of a registered valuer. Section 62 (1)(c) of the Companies Act, 2013 and Rule 13 of the Companies (Share Capital and Debentures) Rules, 2014 provide the regulatory regime for the issue of shares on a preferential offer. The expression “Preferential Offer” means an issue of shares or other securities by a company to any select person or group of persons on a preferential basis and does not include shares or other securities offered through a public issue, rights issue, employee stock option scheme, employee stock purchase scheme or an issue of sweat equity shares or bonus shares or depository receipts issued in a country outside India or foreign securities. The expression “shares or other securities” means equity shares, fully convertible debentures, partly convertible debentures, or any other securities that would be convertible into or exchanged with equity shares later.
Partly Paid-up Shares
This is another popular approach for advisors, mentors, and consultants. In this case, the entire GST/TDS issue, as in the case above, can be postponed to a later date. Going by the above example, at the end of the first year of engagement, the advisor is allotted 150 partly paid-up shares of the company at a nominal price, say ₹10 per share. Note that the shares are allotted immediately, except that the money paid to the company is only ₹1,500 (for 150 shares). At a later date (maybe mutually decided by both parties), say after 5 years, the advisor can pay the balance amount of the current FMV – ₹1,500 to make the shares fully paid up. Since the shares are allotted (fully paid-up) at the current FMV, there is no tax consideration when partly paid-up shares are allotted. However, note that since the share price may have appreciated since the time he got the partly paid-up shares, the advisor may need to be compensated in cash for him to be able to pay the money for acquiring the fully paid-up shares.
Similar to partly paid-up shares, warrants allow the advisor or mentor or consultant the right to purchase the company’s shares at a later date but at a pre-determined price. However, the share allotment happens later, unlike the partly paid-up shares. Note that the tax treatment of share allotments is similar to the advisor equity case whenever the share allotment occurs.
As the name suggests, these are not real shares. Instead, the advisor, mentor, or consultant gets the upside of the value of shares directly as a means of cash compensation. Again, taking the same example as above, the advisor signs an agreement with the company whereby the company promises to pay him the upside of the equivalent of 150 shares after they complete one year of engagement. Note that this amount due to the advisor may be given at a pre-decided timeframe, say after 5 years of him getting the phantom shares. Unlike any share-based scheme (advisor equity or partly paid-up shares), using Phantom Shares involves a direct cash outflow from the company’s bank account. So, due care must be given if the company chooses this mode of compensation for advisors. Also, note that there are no rules and regulations around Phantom Shares; it is just a commercial contract between the company and the advisor. So, any conditions, restrictions, timeframes, etc., can be put into the Phantom Share agreement based on mutual agreement between the two parties.
Income tax treatment
The income tax impact at the time shares are allotted to the advisor is similar in all the cases except for Phantom Shares, where there is no share allotment in fact. Income to the tune of FMV minus the price paid by the advisor is treated as taxable income for the advisor. Issue of advisory shares are taxed in two phases:
- At the time of allotment of advisory shares:
- The Companies (Share Capital and Debentures) Rules, 2014 requires that the price of the shares or other securities to be issued on a preferential basis, either for cash or for consideration other than cash, shall not be less than the price determined based on a valuation report of a registered valuer. However, in the case of the issue of listed shares or securities on a preferential basis, a valuation report from a registered valuer is not required since the value is easily ascertainable.
- Where shares or other securities are to be allotted for consideration other than cash, the valuation of such consideration shall be done by a registered valuer who shall submit a valuation report to the company giving justification for the valuation.
- Where the preferential offer of shares is made for non-cash consideration and such non-cash consideration takes the form of a depreciable or amortizable asset, the asset’s value, as determined by the valuation report, shall be carried to the balance sheet of the company in accordance with the accounting standards.
- Where the accounted value of the shares is in excess of the value of the asset acquired, as per the respective valuation reports, such excess value shall be treated as a form of compensation to the consultant or advisor. The value of such compensation shall be taxable in the hands of the consultant or advisor as income for services rendered.
- Where the preferential offer of shares is made for a non-cash consideration not resulting in the acquisition of an asset, the accounted value of the shares shall be treated as a form of compensation to the consultant or advisor. Accordingly, such compensation shall be taxable in the hands of the consultant or advisor as income for services rendered.
- The company is required to deduct income tax at source on the compensation value and recover the amount of withholding tax from the consultant or advisor. If the amount of withholding tax is not recovered from the consultant or advisor, the withholding tax amount will be grossed up for tax purposes and borne by the company.
- At the time of sale of the shares by the consultant or advisor:
- When the consultant or advisor sells the company shares at a future date, the consultant or advisor may be subject to capital gains taxation on the difference between the sale price and the allotment price. 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 allotment 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. 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 company when the consultant or advisor sells the company shares.
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