ESOP - Accounting, Tax and Valuation Aspects Finger on ESOP Pulse - - PowerPoint PPT Presentation

ESOP - Accounting, Tax and Valuation Aspects “Finger on ESOP Pulse”

Accounting Tax

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Contents

Particulars ESOP Overview Planning and Strategy Implementation Financial aspects of ESOP Key Driver of ESOP

• Accounting
• Tax
• Valuation

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ESOP Overview

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ESOP

• Flexible financial and equity incentive instrument
• Compensation tool
• Rewarding Existing Employees and attracting new Talent

“The flowers of tomorrow are in the today’s seeds”

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Planning and Strategy

Just another Investment Plan Thinking Like Owners

Stages in Deciding ESOP Plan

• Valuation of Company
• Discount Offered
• Tax Implications
• Accounting

Compensation cost

• Regulatory implications viz,

Company Law, SEBI regulation, FEMA regulations, Income Tax

• Shareholding Dilution
• Industry Practice
• No. of shares to offer
• Administrative aspect

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Implementation

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Stages in Implementation of ESOP Plan

Formulation of Incentive Plan Grant Vesting Exercise Sale Commercial Legal Financial

Formulation of Strategy to Compensate Employees Generation of Future Cash Flows Inflow of Funds Amortization of Compensation Cost Section -45 read with Section – 49(2AA) of Income Tax Act, 1961 Calculation of Capital Gain Perquisite Valuation Section -17 (2)(vi) Income Tax Act, 1961 read with Rule 3(8)(i) of Income Tax Rules 1962 Book of Compensation cost – SEBI (ESOS and ESPS Guidelines), 1999 Accounting Valuation Compliance to Companies Act and SEBI Guidelines Vesting Period Exercise Period Lock in Period Exit

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Financial Aspects of ESOP

Accounting Tax

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Accounting Perspective

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Accounting aspect of ESOP in India

Stages Tax Treatment

Grant of Options

• Valuation

is required to amortize the Employee Compensation Cost during the vesting period;

• Graded Vesting: Each vest consider as a separate

grant;

• Straight

Line Accounting: Amortization

• f

Employee Compensation cost on time proportionate basis

• In case of lapse of unvested / Vested option, the accounting

to be reversed

ESOP Accounting

To determine the compensation cost which is required to be amortized over the vesting period and detailed disclosure regarding option statistics including disclosure of stock

• ption compensation cost computed by applying Fair value method and impact of non

recognition of Fair Value compensation cost on basic and diluted EPS. APPLICABLE LAW

Intrinsic Value method allowed with disclosure as per Fair Value Method

US GAAP SFAS 123 (Revised):

INDIA: SEBI (ESOS and ESPS) Guidelines, 1999 ICAI Guidance Note Fair Value Method Mandatory

International GAAP IFRS 2: Share Based Payment

Fair Value Method Mandatory

Tax Perspective

Tax Implications of ESOP in India

Stages Tax Treatment

Grant of Options Nil Vesting of Options Nil till Exercised Exercise of Options Taxed as perquisite in the hands of Employees which is computed as the difference between the FMV of the share

• n the date of exercise and the exercise price.

The employer is required to withhold tax at source in respect of such perquisite. Sale of Options The incremental gain (i.e. difference between sale consideration and the FMV on the date of exercise), on sale of shares is considered a capital gain for the employee. For computing capital gains, the FMV on the date of exercise becomes the cost base. During the period April 2007 to March 2009, employer was required to pay Fringe Benefit Tax (FBT) on benefit derived by employee from ESOPs. The employer was allowed to recover such FBT from the employees. After FBT has been abolished benefits under ESOP taxed as perquisites in the hands of employees

ESOP Valuation

Accounting

Tax

Key Driver of ESOP

Valuation

Accounting Tax

Intrinsic Value

ESOP Valuation

Fair Value

Market Price (-) Exercise Price Option Pricing Model

Listed Company on Recognized Stock Exchange Unlisted Company

Average of Opening and Closing Market Price On Exercise Date No Method has been prescribed

Intrinsic Value method allowed with disclosure as per Fair Value Method Shares of foreign companies listed on foreign stock exchange are regarded as unlisted shares

Intrinsic Value

Intrinsic Value” is the excess of the market price of the share under ESOP over the exercise price of the Option (including upfront payment, if any)

Suppose : Current Market Price is Rs 100 Exercise price is Rs 70 Then Intrinsic Value is Rs 30 However if the CMP was Rs.50 instead, there would be no intrinsic value of the option since the exercise price is more than CMP and in this case options could not be exercised and instead stand lapsed

Fair Value Method – Black Scholes Method

Suppose : Exercise price is Rs 100 Fair Value per share Rs 200 Volatility 10% Dividend yield zero Risk Free rate 8.76 % Expected life of option 3 Years Differential value or value of perquisite is = Rs 200- 100 = Rs 100 in normal parlance. However when we use the black scholes calculator the value that shall be coming to Rs 123 which is the compensation cost or loss to a company which it shall be booked on a notional basis in its books of account.

Under this methodology we shall be calculating the call price of options and this basically calculates the compensation cost. The benefit of this model is takes into consideration the factors like volatility, dividend yield ,Risk free rate and expected life of options.

ESOP Tax

APPLICABLE LAW: Income Tax Act – 1961 and Notification no. 94/2009 dated 18.12.2009 issued by CBDT To determine the value of perquisite taxable in hands of employees

Particulars Listed on Recognized Stock Exchange Unlisted Company Situation Market Price on Exercise Date is available Market Price on Exercise Date is Not available Method of Valuation Average of Opening and Closing Price of the share on the Exercise Date Latest Closing Price of the share immediately preceding the Exercise Date No Method has been Prescribed Valuer SEBI Registered Category – I Merchant Banker

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Valuation guidelines under erstwhile FBT regime

• Shares of foreign companies listed on foreign stock exchange are regarded as unlisted shares
• Foreign company shares to be valued by SEBI registered Category I Merchant Banker (“MB”)
• Listed price of foreign company may be considered by MB as one of the basis for valuation
• MB to determine the value on the basis of alternative methods and recommend the most appropriate

value

• Shares with multi-vesting dates allotted at one shot, with total shares allotted are less than the shares

vested - Follow FIFO method

• Valuation may be carried out anytime as long as specified security is valued on the specified date
• Valuation by more than one MBs - the value on the date closest to the vesting date to be considered*
• Valuation by a MB on different occasions - the value on the date closest to the vesting date to be

considered*

• No FBT if value on the date of vesting is less than the exercise price*
• Assessing Officer is bound by valuation unless the valuation is perverse

*(at the time of FBT vesting date was relevant)

Grey Area ESOP cost is tax deductible for company ??

High Court of Madras (HC) in the case of PVP Ventures

• Ltd. (Taxpayer) [TC(A) No. 1023 of

2005] held that there was no error in Tribunal’s ruling which held that ESOP cost was allowable as expenditure as the Taxpayer had debited ESOP cost to profit and loss account (P&L) as per the directions of Securities and Exchange Board of India (SEBI). Recently in July 2013, the Special Bench of the Bangalore Income Tax Tribunal in the case of Biocon Limited held that discount on issue of ESOP is deductible business expenditure.

ESOP Valuation Vs Equity Valuation

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Discounts in ESOP Valuation

• Discount for Entity Level

Discounts & Premiums come into picture when there exist difference between the subject being valued and the Methodologies applied. As this can translate control value to non-control and vise versa , so these should be judiciously applied.

– Impact on entity as a whole

• Key Person Discount
• Discount for Contingent Liability
• Discount for diversified company
• Discount for Holding Company
• Discount for Shareholders Level – Impact on specific ownership interest
• Discount Lack of Control (DLOC)
• Discount Lack of Marketability (DLOM)
• Size of distribution or dividends
• Dispute
• Revenue / Earning – Growth / Stability
• Private Company
• Tax Payout
• % stake & special rights
• Shareholders Agreement caveats

Global Studies over the years on diversified companies and holding companies has shown that companies trade at a discount in the range

• f 20%. to 40% each.

DLOM: As per CCI Guidelines, 15% discount has been prescribed; however practically DLOM and DLOC depends upon following factors:

Tricky Issues

Excess Cash and Non Operating Assets

Excess cash is defined as ‘total cash (in balance sheet) – operating cash (i.e. minimum required cash) to sustain operations (working capital) and manage contingencies Key Issue: Estimation of Excess Cash ? Non operating Assets are the Surplus assets which are not used in operations of the business and does not reflect its value in the operating earnings of the company. Therefore the fair market value of such Assets should be separately added to the value derived through valuation methodologies to arrive at the value of the company.

One

• f

the solutions is to estimate average cash/sales

• r

total balance sheet size

• f

the company’s relevant Industry and then estimate if the company being valued has cash in excess of the industry’s average.

What is an asset is not yielding adequate returns ?

Cross Holding and Investments

Holdings in other firms can be categorized into:

Types of Cross Holding Meaning Minority, Passive Investments If the securities or assets owned in another firm represent less than 20% of the overall ownership of that firm Minority, Active Investments If the securities or assets owned in another firm represent between 20% and 50% of the overall ownership of that firm Majority, Active Investments If the securities or assets owned in another firm represent more than 50% of the overall ownership of that firm

Investment Value

Ways to value Cross Holding and Investments:

Dividend Yield Capitalization or DCF based on expected dividends Seperate Valuation (Preferred) By way

• f

Shareholders Agreement even less % holding may command control value

Intangible Valuation

Identification of Intangible Assets:

• Market Related : Trade Marks, Service Marks etc.
• Customer Related : Customer Lists, Order backlogs etc.
• Artistic Related : Plays, Books, Pictures, Music, Video etc.
• Contract Related : Licensing, Royalty, Lease agreements etc.
• Technology Related : Patented Technology, Databases,

computer software's etc.

Company Specific Factors

• Management, Promoter Group

It is the alignment of Company’s value via-a- vis to its external environment

• Operating, Capital and Corporate Finance Strategies
• Competitive advantages and cost position
• Product / Service offering / differentiation / pricing power
• Scale & Diversification
• Customer / Supplier concentration
• Corporate Governance
• Future prospects / Growth potential
• Industry peer group
• Regulatory environment

Industry Risk Analysis

• Good vs. Difficult industry
• Porter’s 5 forces
• Industry life cycle (growth)
• Industry cyclicality (earnings quality)
• Leading indicators
• Competition (ROIC)
• Pricing dynamics; Demand vs. Supply (ROIC)
• Changing business environments
• Regulation (ROIC)
• Product characteristics (earnings quality)
• Capital intensity and cost base (ROIC)
• Event risk

Following factors are required to be considered:

Valuation Methodologies and Value Impact

Major Valuation Methodologies Ideal for Result Net Asset Value Net Asset Value (Book Value) Minority Value Equity Value Net Asset Value (Fair Value) Control Value Comparable Companies Multiples (CCM) Method Price to Earning , Book Value Multiple Minority Value Equity Value EBIT , EBITDA Multiple Enterprise Value Comparable Transaction Multiples (CTM) Method Price to Earning , Book Value Multiple Control Value Equity Value EBIT , EBITDA Multiple Enterprise Value Discounted Cash Flow (DCF) Equity Control Value Equity Value Firm Enterprise Value

• Mr. Chander Sawhney

Partner & Head – Valuation & Deals M: +91 9810557353 D: +91 11 40622252 E: chander@indiacp.com

• Mr. Maneesh Srivastava

AVP – Valuation & Biz Modelling M: +91 9871026040 D: +91 11 40622255 E: maneesh@indiacp.com

• Mr. Gaurav Kumar Barick

Manager – Valuation & Biz Modelling M: +91 8130141874 D: +91 11 40622241 E: gaurav@indiacp.com

• Mr. Sameer Verma

Deputy Manager – Valuation and Biz Modelling M: +91 9911945607 D: +91 11 40622216 E: sameer@indiacp.com

Our Valuation Team