In recent times, “sweat equity” has been grabbing headlines every now and then. The controversy surrounding the issue of sweat equity by Rendezvous Sports World led-consortium to various stakeholders has raised remarkable levels of nosiness about various legalese involved in the issue.
As one of the most significant contributors to employee satisfaction is their compensation package, companies around the world constantly revisit their employee remuneration structures, in an effort to arrive at the best compensation packages for rewarding their employees. Such remuneration structures comprise not only the basic salary but a host of "perquisites".
Of late, there has been a buzz in regard to the virtues of sweat equity as a perquisite for rewarding employees. Although sweat equity is a popular perquisite as it enables the employees to participate in the profits of the company, it is important to examine all aspects of the issue of sweat equity before concluding that it, in fact, guarantees maximum reward to employees. One aspect, which presently detracts from the feasibility of issuing.The issue of sweat equity by Indian companies is heavily regulated.
There are separate sets of guidelines/rules that govern the issue of sweat equity by a listed company and an unlisted company. These guidelines/rules are required to be complied with by the concerned company, prior to the issue of sweat equity. As per these regulations, any sweat equity issued, under the said guidelines/ rules, is subject to a lock-in of 3 years from the date of allotment. In other words, shares issued as sweat equity by Indian companies cannot be transferred by the concerned employee before the expiry of three years, from the date of their allotment.
Interestingly, the Income Tax Act, 1961, has been amended, by virtue of which, with effect from April 1, 2010, sweat equity is specifically included within the ambit of "perquisite", and is, therefore, subject to tax as part of income of the assessee. As per the amended provision, sweat equity is defined as "equity shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing know how or making available rights in the nature of intellectual property rights or value additions, by whatever name called". Further, the Central Board of Direct Tax, vide its Notification, dated December 18, 2009, had clarified that sweat equity shares, for taxation purposes, would be valued at fair market value as determined by the method prescribed therein, for such equity shares issued by listed companies or unlisted companies.
Although this may be viewed as positive step on part of the authorities, as it clears the ambiguity in the manner of assessment of sweat equity, the extent of tax liability and incidence thereof, but there is a need to evaluate whether taxing sweat equity, in the prescribed manner, detrimentally affect the nature of compensation/ reward being provided to employees?
Customarily, sweat equity is issued to employees as reward for their contributions to the company or for bringing in know-how, intellectual property, etc. However, it is important to remember that when sweat equity is issued to employees, such employees are disabled from deriving immediate monetary benefits from such sweat equity due to the 3-year lock-in period. Further, in case the valuation of the issuing company's shares is high, even a fractional percentage stake (proposed to be allotted by such company as sweat equity to an employee) may potentially result in the employee getting shares worth crores of rupees.
In such circumstances, tax levied on total value of the sweat equity so allotted, would result in the employee having to bear a significant tax liability, and that too during the time when the employee is disabled from deriving immediate monetary gain from such sweat equity. Thus, it is difficult to see a lot of employees favouring the allotment of sweat equity to them as compensation or reward, when such allotment involves a significant tax liability for such employee in the short term.
Therefore, while the logic of tax authorities in treating sweat equity as income cannot be faulted, tax authorities might want to consider adopting a more viable mechanism for "taxing sweat". Perhaps, it may be more feasible to have the assessee employee pay a part of the tax liability on the sweat equity issued in the year of allotment and the balance at the time of sale of such sweat equity.
Alternatively, levy tax only at the time of sale of sweat equity by the assessee employee. One can only hope that the tax authorities will take note of this pitfall that exists with regard to sweat equity, and indeed, it will be interesting to see how they strike a balance between its interests of revenue generation for the Government and the need to make sweat equity as an attractive option for companies and employees! (The views expressed are those of the authors and do not reflect the official policy or position of Amarchand Mangaldas.) sweat equity is the consequent tax liability that falls on the beneficiary, i.e. the employee.
In India, the concept of sweat equity shares is recognized under section 79A of the Companies Act, 1956, which states that sweat equity may be issued, in compliance of certain conditions laid down in the Act, which include that sweat equity must belong to a class of shares already issued; it can be issued by a company only if one year has lapsed since it is entitled to commence business; and such issue has to comply with all other applicable rules and guidelines.