ISSUE IV : Sweat equity: Alternate way to reward employees

INTRODUCTION

Compensating employees for the services rendered by them which add value to the company is important in the present economic situation when human effort has become the key to success. In India the practice of compensating employees for their continuous service with the company has been in existence since a long time. However, such practice was selective and depended on the will and discretion of the management, which left a bad taste to the employees not selected for such favors.

This was changed with the addition of the provision related to the issuance of sweat equity in the Companies Act (“the Act”).1 As per Indian laws, the employees or directors are compensated by means of sweat equity2 which is defined as equity shares issued to employees or directors either at a discount or for consideration other than cash i.e. for providing know-how or making available intellectual property rights to the company. Sweat equity can be issued by listed as well as the unlisted companies.3 For listed companies the issuance is governed by SEBI4 (Issue of Sweat Equity) Regulations, 20025 (“the Regulations”).

As Indian companies turn increasingly competitive and global, they are devising different ways of retaining employees. Our fourth issue of the capital markets bulletin deals with issue of sweat equity to the employees or directors of the listed companies including purpose and procedure involved in the issue of sweat equity, penalties and general tax implications for the company and for the beneficiary.

1. Procedure for issuance of sweat equity

The Act specifies a limitation for the issue of sweat equity. A listed company which is a public company can commence business only after the Registrar of Companies issues a certificate to commence business and sweat equity can be issued only after one year from the date of commencement of business.6

Sweat equity can be issued to either an employee or a director of the company. Employee means a permanent employee of the company working in India or abroad or a director of the company whether a whole-time director or not.7 This definition makes it clear that the definition of the employee does not change even if he relocates to a foreign country. Further, director means any person holding the post of director, by whatever name called.8

If the issue is at a discounted price, there is no need to seek recourse to the other provisions of the Act.9 This saves the company from taking approvals from the Central Government and the company can initiate the process on its own. The company can give discount of any amount as it deems fit.10

Corporate authorizations in case of employees/directors: The sweat equity can be issued pursuant to a special resolution11 passed by the company in a shareholders meeting, also called an Extraordinary General Meeting (“EGM”). Before the shareholders meeting the board of directors should approve the proposal for the issuance of sweat equity. The board should send a notice to the shareholders in regard to conducting the EGM. An explanatory statement must be annexed to the notice which should clearly specify all the material facts concerning items, in respect of which the EGM has been called.12 The special resolution passed in the EGM should specify (1) the number of the equity shares to be issued, (2) current market price, (3) consideration, if any; payable by the allottee and (4) the class of the employees or directors or employees to whom the shares are proposed to be issued.13 After the special resolution is passed the company can proceed with the process of issuing the sweat equity.

Corporate authorizations in case of promoters: The Regulations prescribe different procedures for the issue of the sweat equity in case of a promoter, the possible reason could be that presumably, usually the promoters with their relatives, associates hold majority of shares. If the issue is in favor of the promoters then an ordinary resolution14 of the shareholders in the EGM is sufficient.15 In order to pass the resolution, voting by postal ballot is required16 which is governed by the (Passing of the resolution by Postal Ballot) Rules, 2001 (“the Postal Rules”). The postal ballot includes voting by postal or electronic mode instead of voting personally.17 The notice for postal ballot can be by:18

  • a registered post acknowledgement due; or
  • certificate of posting and with an advertisement stating that the ballot papers are dispatched, published in a leading English newspaper and in one vernacular newspaper circulated in the state in which the registered office of the company is situated.

The procedure for the passing of resolution for the issue of sweat equity involves the following:

  • The company should make a note below the notice of general meeting of the shareholders for the understanding of the members that the transaction requires the consent of the shareholders through postal ballot.19
  • The board of directors should appoint a scrutinizer who, in the opinion of the board, could conduct the postal ballot process in a fair and transparent manner.20
  • The scrutinizer is required to submit its report after the last date of the receipt of the postal ballot.21
  • The scrutinizer should be willing to be appointed and should be available at the registered office of the company for the purpose of ascertaining the requisite majority.22
  • The scrutinizer is duty-bound to maintain a register to record the consent of the shareholders. The postal ballot and all other papers should be under its safe custody till the chairman of the company considers, approves and signs the minutes of the meeting. Thereafter, the scrutinizer shall return the ballot papers and other related registers to the company so as to preserve such papers till the resolution is given effect.23

If the shareholders do not vote within 30 days of the issue of notice, the law considers that the shareholder has acquiesced.24 The promoter is not allowed to vote in the resolution for the issue of sweat equity to him.25

Pricing: The price of the sweat equity offered to the employee or the manager should not be less than average of the weekly high and low of the closing prices of the related equity shares during the last six months preceding the relevant date26 or higher than the average of weekly high and low of the equity shares during the two weeks preceding the relevant date.

2. Post issue compliances

After the allotment of the sweat equity shares, the Board of Directors are obliged to place in the annual general meeting the auditor’s certificate stating that the issue of the sweat equity has been made in accordance with the Regulations and the shareholders resolution.27 The company is required to send a statement to the stock exchange disclosing the following:

  • the number and price of issued sweat equity shares;
  • the total amount invested in sweat equity;
  • details of the person to whom the sweat equity is issued;
  • the consequent change in the capital structure and the shareholding pattern after and before the issue of the sweat equity.

3. Non-cash consideration

The condition precedent to issue sweat equity for non-cash consideration is that an employee must provide know-how or make available intellectual property rights.28

Valuation of non-cash consideration: In case of allotment for non-cash consideration, the important issue which arises is the valuation of the consideration. The Regulations prescribe that the value of the intellectual property rights or of know-how is to be carried out by the merchant banker who must consult experts and valuers who the merchant banker consider fit for the purpose.29 The merchant banker is under an obligation to provide a certificate from an independent chartered accountant confirming that the valuation is in accordance with the relevant accounting standards. After the valuation is complete, attention must be paid to the accounting treatment of the non-cash consideration. If the non-cash consideration takes the form of a depreciable asset it is carried to the balance sheet of the company.30 However, if it does not take the form of depreciable asset then it must be expensed as provided by the relevant accounting standards.31 If non-cash consideration takes the form of an asset, which cannot be transferred to the balance sheet then it is treated as managerial remuneration.32 However, for this purpose the issue of sweat equity must be made in favor of the director or manager.

4. Penalties

The Securities and Exchange Board of India (“SEBI”) has the authority to conduct an investigation or to inspect the books or accounts of the company in respect of any contravention of the provisions of the Regulations.33 SEBI is also authorized to initiate criminal prosecution by filing a complaint in writing in a court.34 If it is found that the company has contravened the provisions in regard to the issuance of sweat equity, it can be restrained from issuing further sweat equity.35 SEBI also has the authority to ask the person to whom the sweat equity is issued to be divested of it.36

5. Tax liability

Tax liability for income is determined by the Income Tax Act, 1961 (“the Tax Act”) Usually, the liability is of the beneficiary while, in case of a company, it is important to evaluate whether sweat equity falls under the purview of the Fringe Benefit Tax (“FBT”). The Finance Act, 2007-2008 has added sweat equity to the definition of fringe benefits.

Fringe benefits mean any consideration of employment by way of any privilege, service or any free concessional ticket provided to the employee or any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer free of cost or at a concessional rate to his employees (including former employee or employees).37 Sweat equity shares are defined in the Tax Act as equity shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing the know-how or making available rights in the nature of intellectual property rights or value addition.38 The inclusion of sweat equity within the ambit of fringe benefits means that the company will be taxed at the rate of 33.99%39 for issuing the sweat equity.

Calculation of tax liability under the Tax Act starts with ascertaining the value of the fringe benefits provided to the employees. The Tax Act provides that the value of sweat equity for ascertaining the FBT liability is its fair market value.40 On October 23, 2007 the government issued a notification41 (“the Notification”) explaining the method to calculate the fair market value of the sweat equity shares. The Notification inserts rule 40C to the Income Tax Rules, 1962 (“the Rules”) and prescribes that the fair market value of the sweat equity should be the average of the opening42 and closing price43 of the equity on the recognised stock exchange. If the stocks are listed on more than one stock exchange then the average of the opening and the closing prices in the stock exchange where the shares have shown the highest trading must be considered.44 If there is no trading on any stock exchange on the day of the vesting of the sweat equity, the closing price will be determined by considering the date closest to the date of vesting of the option and similarly the opening price will be considered on the date closest to the date of vesting of the option.45

CONCLUSION

The issue of sweat equity allows the company to retain the employees by rewarding them for their services. Sweat equity rewards the beneficiaries by giving them incentives in lieu of their contribution towards the development of the company. Further, it enables greater employee stake and interest in the growth of an organization as it encourages the employees to contribute more towards the company in which they feel they have a stake. However, with the recent addition of sweat equity as part of FBT will mean additional tax burden on the company as until now a company had nil tax liability on issuance of sweat equity and, possibly, many companies will re-visit the need to issue sweat equity.

1 The Act was amended to insert section 79A by the Companies (Amendment) Act, 1999 incorporating the provision for the issuance of sweat equity.

2 Section 79A of the Act defines sweat equity and stipulates the mode for its issuance.

3 For unlisted companies the issue of sweat equity is governed by the Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003.

4 Securities and Exchange Board of India.

5 Section 79A(1)(d) stipulates that the issue of sweat equity for a company listed on a recognised stock exchange is governed by the regulations made by SEBI.

6 Section 79A(1)(c) of the Act.

7 Regulation 2(g) of the Regulations.

8 Section 2(13) of the Act.

9 Section 79A of the Act starts with a Non-Obstante Clause which clearly says that notwithstanding anything contained in section 79 of the Act.

10 Section 79(ii) of the Act requires that if the company intends to give discount beyond 10% it has to take permission from the Central Government. Since section 79A starts with an non-obstante clause in regard to section 79, the provision of section 79 which fixes a ceiling of 10% on discount of the price of shares is not applicable in case of the issue of sweat equity.

11 Section 189 of the Act lays down the features of a special resolution. It specifies that the special resolution requires the votes in favor to be more than three time the votes against the resolution.

12 Section 173(2) of the Act.

13 Section 79A of the Act stipulates the decisions to be made in the general meeting and the subject matter to be covered in the special resolution.

14 Section 189 of the Act defines ordinary resolution as the resolution when the votes cast in favor of the resolution exceeds the votes cast against the resolution.

15 Regulation 6(1) of the Regulations specifies the method for issue of sweat equity to the promoters.

16 Proviso to Regulation 6(1) of the Regulations.

17 Rule 2(a) of the Postal Rules.

18 Rule 2A of the Postal Rules.

19 Rule 5(a) of the Postal Rules. 20 Rule 5(b) of the Postal Rules. 21 Rule 5(c) of the Postal Rules. 22 Rule 5(d) of the Postal Rules. 23 Rule 5(e) of the Postal Rules. 24 Rule 5(f) of the Postal Rules.

25 Proviso to Regulation 6(1) of the Regulations.

26 Explanation to Regulation 7 stipulates that the relevant date is the date, 30 days prior to the date on which the meeting of the general body of shareholders is convened.

27 Regulation 10 stipulates the placing of the auditor’s report in the Annual General Meeting.

28 Explanation II to section 79A(1) of the Act stipulates the consideration for which the sweat equity can be issued.

29 Regulation 8 of the Regulations.

30 Regulation 9(a) of the Regulations. 31 Regulation 9(b) of the Regulations. 32 Regulation 11 of the Regulations.

33 Regulation 17 of the Regulations.

34 Proviso to section 621(1) of the Act. 35 Regulation 20(e) of the Regulations. 36 Regulation 20(b) of the Regulations.

37 Section 115WB (1)(d) of the Tax Act includes sweat equity issued within the meaning of fringe benefits.

38 Explanation (ii) to section 115WB of the Tax Act defines sweat equity.

39 Section 115WA of the Tax Act lays down that the tax for providing fringe benefits is levied at the rate of 30%. However, a surcharge of 105 and education cess of 3% is also levied, which takes the net tax payable to 33.99%.

40 Section 115WC (1)(ba) of the Tax Act provides the meaning of the term value in case of sweat equity.

41  Notification number 264/2007.

42 Rule 40C (4) (b) of the Rules states this to be the price of the first settlement on such date on such stock exchange.

43 Rule 40C (4) (a) of the Rules defines closing price as the price of the last settlement on such date on such stock exchange. 44 Proviso to Rule 40C(2) of the Rules prescribes the guidelines when the shares are listed on more than one stock exchange. 45 Proviso to Rule 40C(2) of the Rules.

Archives

 

DISCLAIMER

The Bar Council of India restricts advocates from maintaining a website as a source of advertising. This site contains general information for informative purposes only. The reader should not consider / construe information on this site to be an invitation for any attorney-client relationship.