ESOPs in a Private Company: The Section 62(1)(b) Route and the Two Tax Events

Employee stock options are the standard currency of early-stage hiring in India, and the standard source of unpleasant surprises three years later. The surprises are not usually about the Companies Act procedure, which is well defined. They are about the tax event at exercise, which creates a liability in cash on a shareholding that cannot be sold.

Both halves are worth understanding before the first grant letter goes out.

The Companies Act route

A company issues shares to employees under an employees' stock option scheme under Section 62(1)(b) of the Companies Act, 2013, read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014.

Who is eligible

"Employee" for this purpose means:

• a permanent employee of the company who has been working in or outside India;
• a director of the company, whether a whole-time director or not, but not an independent director;
• an employee or director of a subsidiary, in or outside India, or of a holding company or an associate company.

Excluded, under the general position in Rule 12:

• an employee who is a promoter or belongs to the promoter group;
• a director who, directly or indirectly, holds more than 10% of the outstanding equity shares.

That exclusion has mattered enormously to founder-led companies, and relief has been provided for recognised start-ups for a defined period from incorporation. Verify the current terms of that relief against the rule rather than against a secondary source, because it has been amended and extended.

The procedure

1. Draft the scheme. Pool size, eligibility, grant mechanics, vesting schedule and conditions, exercise price, exercise period, treatment of a leaver — good leaver and bad leaver — treatment on a change of control, and the lapse provisions.
2. Board approval of the scheme and of the explanatory statement.
3. Special resolution of the members approving the scheme. The explanatory statement must disclose the particulars Rule 12 requires, including the total number of options, the identification of classes of employees, the appraisal process for determining eligibility, the vesting requirements and maximum period, the exercise price and the pricing formula, the exercise period and process, the lapse conditions, the maximum number of options per employee and in aggregate, and the method of valuation.
4. A separate special resolution where options are to be granted to employees of a subsidiary, a holding company or an associate company, and where a variation of an existing scheme is proposed.
5. Grant letters to individual employees. There must be a minimum of one year between grant and vesting.
6. Maintain the register of employee stock options in Form SH-6, at the registered office or wherever the board decides.
7. On exercise, allot the shares, file PAS-3, issue share certificates, and update the register of members.
8. File MGT-14 for the special resolution, and disclose the scheme's particulars in the board's report each year.

Two features of the statutory framework are often misunderstood. Options carry no dividend and no voting rights until the shares are issued on exercise, which is worth stating in the grant letter. And the options are not transferable — they cannot be pledged, hypothecated, mortgaged or otherwise encumbered, and only the employee may exercise them.

Direct grant or a trust

Two structures, and the choice has consequences that are hard to reverse.

Direct grant. The company grants options to employees and issues fresh shares on exercise. Simple, cheap, and the default for most early-stage companies. Every exercise is a fresh allotment with its own PAS-3, and the cap table acquires a new shareholder each time.

Trust route. The company settles an ESOP trust, the trust acquires or subscribes to shares, and transfers them to employees on exercise. More administration and cost, but it keeps the cap table tidy, allows shares surrendered by leavers to be recycled without a buy-back, and gives a cleaner mechanism for secondary liquidity in later rounds. It needs careful attention to the funding of the trust and to the Section 67 restrictions on a company providing financial assistance for the purchase of its own shares.

For a company with fewer than twenty option holders, the direct route is usually right. Beyond that, the administrative case for a trust strengthens.

The two tax events

This is the part to explain to employees before they sign, not after.

At exercise — a perquisite

On exercise, the difference between the fair market value of the share on the date of exercise and the exercise price actually paid is a perquisite, taxable as salary under Section 17(2), at the employee's slab rate. The employer must deduct TDS on it.

For unlisted shares, fair market value for this purpose is determined by a merchant banker on the specified date, in accordance with the prescribed rules.

The practical problem is stark. An employee exercising options at ₹10 on shares valued at ₹1,010 has a perquisite of ₹1,000 per share. On 10,000 shares that is ₹1 crore of salary income, perhaps ₹30 lakh of tax, payable in cash, on a shareholding in a private company that cannot be sold. The employee has to fund the exercise price and the tax out of their own pocket, against an asset with no market.

This is why ESOPs lapse unexercised in Indian private companies far more often than founders expect, and why exercise windows should be aligned with liquidity events — a secondary sale, a buy-back, a funding round with an ESOP cash-out component. A scheme that forces exercise within ninety days of leaving, with no liquidity, is a scheme that mostly produces lapsed options and bad feeling.

Section 192(1C) — deferral for eligible start-ups

Where the employer is an eligible start-up as defined for Section 80-IAC purposes, Section 192(1C) allows the TDS on the perquisite to be deferred to the earliest of:

• five years from the end of the relevant financial year;
• the date the employee sells the shares; or
• the date the employee ceases to be an employee.

Two cautions. The tax is deferred, not reduced. And eligibility runs off the 80-IAC definition of an eligible start-up, which is narrower than DPIIT recognition — so a recognised start-up that has not obtained Inter-Ministerial Board certification should not assume it qualifies.

On sale — capital gains

When the employee sells, the gain is the sale consideration less the fair market value that was taken as the perquisite — not less the exercise price, which would double-count. The holding period runs from the date of allotment, not the date of grant, which is a point worth making to employees who assume their four years of vesting counts.

For unlisted shares the long-term threshold is a holding period of more than twenty-four months. Rates and indexation treatment for capital gains have been changed by recent Finance Acts, so compute against the current provisions rather than an older summary.

The mistakes we see

• No special resolution. Options granted on a board resolution and a spreadsheet, discovered in diligence years later, with every grant open to question.
• SH-6 never maintained. A statutory register, and its absence is a default in itself.
• Grant letters with no leaver provisions. When someone leaves acrimoniously, the scheme is silent and the negotiation happens from zero.
• Vesting inside one year. Rule 12 requires a minimum of one year between grant and vesting, and a scheme that promises a cliff at six months is unenforceable in that respect.
• Exercise windows with no liquidity. The single biggest cause of wasted pools.
• No merchant banker valuation at exercise, leaving the perquisite computation unsupported and the TDS exposed.
• PAS-3 not filed on exercise. Each exercise is an allotment, with the full allotment procedure behind it.
• Promoters included without checking whether the start-up relief applies.
• Nothing explained to employees. An option granted to someone who believes it is a bonus, and who then faces a tax bill to convert it, is worse than no option at all.

A defensible sequence

Write the scheme, get the special resolution, keep SH-6 live, set vesting at least a year out, align exercise with a liquidity event, get a merchant banker valuation before every exercise, file PAS-3 and MGT-14 on time, and put the tax position in writing in the grant letter. None of that is expensive. Reconstructing it during a Series A diligence is.