Understanding Employee Share Schemes: Section 14 Explained

Employee Share Schemes (ESS), also known as Stock Option Schemes or Equity-Based Compensation Plans, are an excellent way for companies to reward their employees while aligning their goals with organizational success. This article will break down the key aspects of ESS under Section 14 of the Income Tax Ordinance 2001, making it easier for employers and employees to understand its tax implications, benefits, and structure.

What is an Employee Share Scheme?

An Employee Share Scheme allows employers to issue company shares to their employees either free of charge or at a discounted rate. These schemes are often introduced as a form of employee compensation to motivate staff and retain top talent.

Key Features:

• Grant Price or Exercise Price: The amount an employee pays for the shares, which is often less than the Fair Market Value (FMV).
• Employment Benefit: Any discount on the FMV is considered an employment benefit.

Understanding Taxation Rules for ESS

Employee Share Schemes can be tricky when it comes to taxation. Here’s a breakdown:

1. Right or Option to Acquire Shares

• The mere grant of a right or option to acquire shares is not taxable.
• Tax is triggered only when:
  • The option is exercised.
  • The employee disposes of the shares at a profit.
• Any gain is taxed under “Salary” as the difference between the selling price and the FMV or the grant price.

2. Issuance of Shares

Shares can be issued to employees with or without restrictions on transfer. Here’s how taxation works:

Market Value and Valuation Concepts

Listed Companies:

For listed companies, the market price is the closing price of the shares on the stock exchange on the given date.

Unlisted Companies:

The Break-up Value is used for shares in unlisted companies. This is calculated as:

Break-up Value = (Paid-up Capital + Reserves – Losses) ÷ Number of Shares

Capital Gains on Shares

Once the shares are sold, any gain is treated as a capital gain. The taxable amount is the difference between the sale price and the original purchase price (grant price plus any tax already paid).

Why Employee Share Schemes are Beneficial

1. For Employees: They provide ownership in the company and financial growth.
2. For Employers: They motivate employees to work toward the company’s success and improve retention rates.

Notes Professionals

1. Tax treatment may vary based on jurisdiction.
2. Understanding the nuances of “grant price,” “FMV,” and “transfer restrictions” is essential for accurate tax compliance.

FAQs About Employee Share Schemes (ESS)

1. What is an Employee Share Scheme?

An Employee Share Scheme allows companies to grant shares to their employees as part of their compensation or incentive plans, often at a discounted rate or for free.

2. How does an ESS benefit employees?

Employees gain ownership in the company, which can lead to financial benefits through share appreciation and dividends. It also fosters a sense of belonging and motivation.

3. How does an ESS benefit employers?

Employers use ESS to attract, retain, and motivate talent by aligning employee interests with company performance.

4. What is the Fair Market Value (FMV) in an ESS?

FMV is the current market value of the company’s shares at a specific date, used to calculate the taxable benefit for employees.

5. Are shares granted under ESS taxable?

Taxation depends on the type of ESS:

• Shares issued without restrictions are taxable in the year of issuance.
• Shares with restrictions are taxable when restrictions are lifted or when sold.

6. What is the difference between “grant price” and “exercise price”?

• Grant Price: The price at which the company offers shares to employees.
• Exercise Price: The price employees pay to acquire the shares when exercising an option.

7. When are taxes due on shares received under an ESS?

Taxes are typically due:

• At the time of issuance (if no restrictions exist).
• When transfer restrictions are lifted or shares are sold (if restrictions exist).

8. What is the “right to acquire shares”?

This refers to the option given to employees to purchase shares in the future at a predetermined price. Simply receiving this right is not a taxable event.

9. How is FMV determined for unlisted companies?

FMV is calculated using the Break-up Value formula:
(Paid-up capital + reserves – losses) ÷ number of shares.

10. What happens if an employee sells their ESS shares?

If the shares are sold, any profit is taxed as a capital gain. The taxable gain is the sale price minus the cost of acquiring the shares (grant price + any taxed benefit).

11. What are transfer restrictions in an ESS?

Transfer restrictions limit the employee’s ability to sell or transfer shares for a specified period, such as during a lock-in period.

12. Are all employees eligible for ESS?

Eligibility criteria vary by company. Typically, ESS is offered to key employees, senior management, or all permanent staff based on the employer’s policies.

13. What is the tax treatment of restricted shares?

Restricted shares are taxed when the restrictions are lifted or when the shares are sold, whichever occurs earlier.

14. How is “market price” determined for listed companies?

For listed companies, the market price is the closing price of the shares on the stock exchange on a given date.

15. What is the main difference between listed and unlisted company ESS?

Listed company shares use the stock exchange price for valuation, while unlisted company shares use the Break-up Value.

16. Can employees refuse to participate in an ESS?

Yes, participation in an ESS is voluntary. Employees can choose to decline the offer.

17. What are the risks of participating in an ESS?

• Share prices may fall, leading to a financial loss.
• Taxes are payable even if the employee does not sell the shares immediately.

18. Can ESS shares be transferred to family members?

This depends on the company’s policy and the legal framework. Many schemes have restrictions on transferring shares to non-employees.

19. How is an ESS different from a performance bonus?

An ESS provides shares, creating ownership, while a performance bonus is a one-time monetary reward.

20. What happens to ESS shares if an employee leaves the company?

This depends on the terms of the scheme. Some companies allow departing employees to retain their shares, while others may require them to sell back their shares.