Sweat equity shares: meaning, merits, taxation

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You may have probably heard or read this a thousand times: finance is the lifeblood of a business. So are employees. Meaning they are critical to a business’ wellbeing as their efforts and hard work go a long way in its growth. That is why some companies reward their employees—in addition to paying remuneration—just to retain talented folks that contribute extraordinarily to the growth of the business.

One such way they do this is offer sweat equity share. Read what they mean, how they benefit the issuing company and employees, and recent developments in the space here.

This article covers

What are sweat equity shares?

Which law governs the issue of sweat equity shares?

Conditions applicable to the issue of sweat equity shares

Who can issue sweat equity shares?

Which employees are covered under the sweat equity shares scheme?

How does the law define employees?

How is value addition defined?

How many sweat equity shares can a company issue?

Valuation of sweat equity shares

Significance of sweat equity share

Taxability of sweat equity shares

Calculation of fair market value of the issue of sweat equity shares

Recent developments

Conclusion

What are sweat equity shares?

Section 2(88) of the Companies Act, 2013 defines ‘sweat equity shares’. Simply put, these are equity shares offered to select employees and directors of a company for their:

  • Extraordinary contribution and hard work of an employee or director in completion of a project
  • Technical know-how or expertise in an area of the business
  • Value addition made to business or contribution towards gaining intellectual property rights

Further, sweat equity shares are issued either by way of discount or consideration other than cash. They allow employees/directors to participate in a part of the company’s profits as a return on their investment. Now that you know what are sweat equity shares, read the laws that govern these.

Which law governs the issue of sweat equity shares?

The issuance of sweat equity shares is governed by the Companies Act, 1956 and the Companies Act, 2013. In case of an unlisted company, the entity has to abide by Section 54 read along with The Companies (Share Capital and Debentures) Rules, 2014. And in case of a listed company, the entity has to comply with the SEBI Regulations besides the Companies Act, 2013.

Conditions applicable to the issue of sweat equity shares

Section 54 of the Company Act, 2013 lays down conditions that a company has to comply with while issuing sweat equity shares. They include:

  • The company has to pass a special resolution with the approval of 3/4th members
  • Sweat equity shares have to be allotted within the 12 months from the date when the special resolution was passed
  • The special resolution has to mention details including the number of shares to be issued, consideration price, current market price, and employees and class of directors
  • In case the entity is a listed company, it has to abide by the SEBI Regulation, 2002 to issue sweat equity shares
  • In case the entity is a non-listed company, it has to abide by the rules prescribed in Section 54(1)(d)
  • The company has to be incorporated for at least a year
  • The company has to furnish proper justification for the value of sweat equity shares
  • The sweat equity shares are locked in for 3 yrs from the date of allotment
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On meeting the above conditions and receiving the required approvals from the board and employees, the company can go ahead and make a private offer of sweat equity shares to the eligible employees.

Who can issue sweat equity shares?

Following companies can issue sweat equity shares:

  • One person company
  • Pubic company
  • Private company
  • Section 8 company
  • Listed or unlisted company

Which employees are covered under the sweat equity shares scheme?

As per Section 2(88) of the Companies Act, 2013, employees covered under the scheme are:

How does the law define employees?

As per Rule 8(1) of the Companies (Share Capital and Debentures) Rules, 2014, an “Employee” means:

  • An individual who is a permanent employee of the company and has been working in or outside India for at least a year, OR
  • A director of the company, regardless of being a whole-time director or not, OR
  • An employee or a director as defined above of the entity’s holding or subsidiary company in or outside India

How is the value addition defined?

As per Rule 8(1) of the Companies (Share Capital and Debentures) Rules, 2014, “Value addition” means actual or anticipated economic benefits that are created by the employees or directors and are either derived or are yet to be derived by the company.

How many sweat equity shares can a company issue?

A company can issue sweat equity shares up to the higher of the following:

  • 15% of its existing paid-up equity share capital in a year
  • Equal to the value Rs 5 cr

Further, the sweat equity shares shouldn’t exceed 25% of the paid-up equity capital of the issuing company at any point in time. However, there is an exception for startups. They can issue sweat equity shares of up to 50% of the paid-up capital within 5 yrs from the date of registration or incorporation.

Valuation of sweat equity shares

A registered valuer is appointed to determine the value of the intellectual property rights/know-how/value additions created with respect to which the company is considering the issue of sweat equity shares. The fair price of such equity shares to be issued is ascertained by a registered valuer, who is also required to justify their valuation.

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Significance of sweat equity shares

Now that you have read the legal part of sweat equity shares, understand how this type of equity is beneficial to the issuing company and employees/directors receiving them.

  • Start-ups being fairly new in the business may be cash-strapped and unable to offer monetary rewards to their deserving employees. Thus, offering sweat equity shares can come in handy. They can simply reward employees by issuing them sweat equity instead of paying in cash. Not only start-ups, but well-established companies can also enjoy this benefit
  • To the employees, sweat equity shares act as a reward for the sweat that they invest in a business and encourage them to stick with the company for longer
  • Sweat equity negates the need to raise funds by taking on debt
  • If an employee who has taken a pay cut in the initial days of the business, sweat equity shares make up for the loss they had faced earlier

Taxability of sweat equity shares

Sweat equity shares are taxable in the hands of employees when allotted or transferred if the following conditions are met:

  • The shares held by the employee are as defined in Section 2(h) of the Securities Contract (Regulation) Act, 1956
  • These securities are allotted or transferred on or after 1st Apr 2009. Any shares allotted or transferred before 1st Apr 2009 fall under the ambit lie of Fringe Benefit Tax
  • These shares are directly or indirectly allotted to an employee or former employee
  • Such shares are allotted by the employer or former employer
  • The shares were allotted free of cost or at a concessional rate

If the above conditions are met, sweat equity shares—perquisite—will be taxed in the hands of the employee in the year in which such equity shares were allotted or transferred.

Calculation of fair market value of the issue of sweat equity shares

If the above conditions are met, the taxable amount on the sweat equity shares is calculated based on their fair market value on the date when the shares were allotted or transferred by the employee. For this purpose, the fair market value of such equity shares is calculated as:

Quoted sweat equity shares

  • In case the sweat equity shares are listed on 1 stock exchange: Average of opening and closing price of the shares
  • In case the sweat equity shares of the company are listed on more than 1 stock exchange: Average of opening and closing price as per the stock exchange where the share is traded in the highest volume
  • In case the share is not traded on the date of allotment or transfer: the closing price on any stock exchange as on a date closest to the date of transfer

Unquoted sweat equity shares

In case the shares are not listed on a stock exchange then the fair value of such sweat equity shares as on the specified date is required to be determined by the merchant bankers. For this purpose, the ‘specified date’ is either:

  • The date on which the option shares are transferred OR
  • Any earlier date, which doesn’t fall before 180 days when the shares were transferred
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Recent developments

The nation-wide lockdown announced by the Centre was a double-edged sword. On one hand, closure of the country allegedly helped contain the spread of the coronavirus. On the other hand, businesses, both small and large, crippled and cash-strapped. That said, small businesses and start-ups were among the ones who sustained the severest of the brunt. Their valuations and revenues declined drastically, which made way for hostile takeovers.

There’s no denying that businesses have hundreds or even thousands of bills to pay including working capital, wages, and salaries. With no revenue, they just can’t survive. And with no commercial activities for over a month, a crippled supply chain, and decimated demand, commercial activities picking up smoothly and rapidly was unrealistic. At such a time, startups had very few funding options. One among them was to sell a significant stake to bigger businesses looking to buy them. But this invited hostile takeovers, to prevent which, the centre came up with various measures to create a safe space for the startups to survive.

One among them was the change in FDI policy that discourages neighbouring nations from exploiting domestic startups and small businesses.

Another notable development in this regard was in the space of sweat equity shares. In Jun 2020, the centre extended the window period to issue sweat equity shares by 5 yrs. By virtue of this, Indian startups—those that qualify under the Department for Promotion of Industry and Internal Trade’s 2019 policy—can now issue sweat equity shares to eligible employees and directors within 10 yrs from incorporation or registration. The government also allowed startups to issue sweat equity shares of up to 50% of their paid-up capital instead of 25% earlier.

Thus, the amendment would help cash-strapped startups attract and retain talented employees and directors, who could have otherwise fled to other businesses that offered better monetary remuneration. Also, the additional leeway to issue sweat equity shares would help startups to access critically needed funds without raising debt.

Conclusion

All in all, sweat equity shares are beneficial to both the issuing company and the employee or directors who receive them. It helps the business retain its talented human resources and also raise funds in its initial stages without availing debt. To the employees, their sweat is rewarded appropriately and in case the company grows by leaps and bounds over time, as they can reap handsome returns.

Aradhana Gotur

Content Writer at Tickertape

Lives in both, own and parallel universes and loves nature, music, and words (that turn into actions)

Aradhana Gotur

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