insights

Stock Appreciation Rights and its Nuances

Last Updated on

Stock Appreciation Rights is a scheme under which the participants, being directors, officers or employees of the company, are entitled to receive cash on account of appreciation in stock prices of the company, subject to fulfilment of certain vesting conditions.

 

1. Introduction

SARs are frequently awarded to employees according to a vesting schedule that is tied to performance goals set by the company. After the fulfilment of such goals, an exercise period is allocated within which the participants can claim the cash allocable toward their SARs.

The cash to be paid is calculated on the basis of the Intrinsic value of the SARs, being the difference between the grant price and the fair market price of the shares as on the exercise date.

Participants also receive the benefit of not having to spend cash to buy stock options. They further benefit from the flexibility of SARs in that they can choose when to exercise their rights at any point between the time it vests and until the time it expires. The only logical case when a participant may not exercise his SAR is if the net gain is nil or negative.

Key Features

A. Grant Price: The cash bonus is paid based on how much the stock has increased over the grant price. The grant price is usually the fair market value on the date the appreciation rights were granted.

B. Vesting Period: It represents the period during which the vesting conditions are to be fulfilled, and it starts from the grant date.

C. Exercise Period: This is the period during which the participants must exercise their SARs. It starts after the vesting period ends, and runs until the expiry date.

D. Expiry date: This is the date when the scheme ends. Beyond this period, no SARs can be exercised by the participants.

For example, if an employee is granted a SAR of 1,000 shares of the company’s stock, where grant price being the FMV as on date is Rs. 10 per share. The vesting conditions are achievement of a 9% average sales p.a. in the next 3 years, being the vesting period. The exercise period will begin once the vesting period ends, and will last for 3 months, during which the employee can exercise his right to receive cash. Assuming that the vesting conditions are fulfilled, on the exercise date if the FMV is Rs. 25 per share, then the employee shall be entitled to Rs. 15,000 in total [1,000 x (25-10)].

Difference between SAR and ESOP
As compared to ESOPs, SARs provide employers with a means of providing equity-linked compensation to participants without the need to materially dilute their stock. Legal concerns, excess compliance requirements, unwillingness to issue additional shares or shift partial control of the company can cause companies to use an alternative form of compensation that does not require the issuance of actual stock shares

Stock Appreciation Rights Employee Stock Option Plan
No obligation of an upfront payment by the employee Employee is usually required to subscribe at current value
No taxation in the hands of the participants on granting or vesting Participants are taxed on vesting without any cash receipt.
No dilution and no shareholding related protective covenants required Diluted EPS to factor in equity dilution at maximum potential
No obligation to issue actual shares Actual shares to be issued and shareholders protection rights need to be built in
No voting or interference in management Shares carry voting rights
Participants taxed as Perquisites Participants taxed as part Perquisites and part Capital Gains
Generally, a higher accounting charge Generally, a lower accounting charge

 

2. Process of SAR scheme deployment:

The first issue is figuring out how many SARs the company plans to give out and identifying the participants of the scheme. Second, the equity of the company must be valued in a defensible, careful way. Finally, availability of funds to finance the SARs during the exercise period must be managed.

The SAR scheme shall proceed in the following manner:

1. Consideration and approval of the SAR scheme by the Board, and setting up of a “Compensation Committee” (‘CC’) empowered by the Board to make decisions relating to the SAR plan.

2. The CC shall make the following decisions:

a. Identifying the participants to whom the SAR scheme will be offered, total number of SARs to be offered, and the ratio in which they will be offered to the individual participants.

b. Establishing performance goals to be achieved by the participants as vesting conditions and setting up objective parameters or performance measurement tools to evaluate them.

c. Determining the grant price, vesting period, exercise period and the expiration date.

d. Methods of arranging funds to finance the scheme, and temporary investment of the same if required. A condition can also be put into the scheme that if the fund-raising rounds are not successful, then the SAR scheme will not be paid out.

3. The CC shall draft the SAR scheme, Grant Letters, etc. The SAR scheme is a statutory document which defines the holistic SAR plan including the scope, applicable regulations, legal obligations, etc. The Grant Letters are used to enter into agreements with the participants under the scheme. They shall specify the various conditionalities based on which the scheme shall vest in their favour, such as performance-based goals, service time requirements, or any combination thereof as the CC may curate.

4. Once the vesting period ends, the CC shall determine whether the performance obligations have been met and if SARs have vested in favour of the respective participants.

5. As and when the participants exercise their rights during the exercise period, cash will be paid out towards the same.

Note: In case SARs are being issued to participants who have already fulfilled their obligations, then for such employees the grant date and the vesting date shall be the same. For example, the company wishes to grant SARs to employees who have achieved their targets in FY 17-18 already, and no other conditions are required to be fulfilled, then the grant date and vesting date of such employees will be the same. In such a case, an exit or time-based conditionality may be drawn up to ensure that liability for payment arises in future years and not on the grant date.

The issue of SAR scheme must be done judiciously, taking care to avoid giving out too much to existing participants and not leaving enough for later employees. For instance, if the CC decides that the total SARs the company can give out is 10,000 SARs, then one plan may be entered into in 2019 with 5,000 SARs, and the balance 5,000 SARs can be kept as a reserve for new employees in 2021.

3. Taxability from the perspective of the Employee:

Instance Tax Position
Grant of Options No income tax in the hands of the employee
Vesting of Options No income tax in the hands of the employee
Exercise of Options Taxed as Perquisites – difference between the FMV and Grant Price

 

* – Contingencies in vesting and exercising shall further mitigate potential challenges by tax authorities.
* – Obligation to deduct tax at source on perquisite income under section 192 of Income Tax Act

Since the Provision made in the books of account each year for the potential SARs expenses cannot be specifically targeted or broken down on an employee-wise basis, TDS cannot be deducted on the same until the SARs are actually exercised.

4. Deductibility from the perspective of the Employer:

Although the law does not specifically envisage the deductibility of SAR expenses in the hands of the company, the same should be allowable u/s 37 of the Income-tax Act, 1961. This notion is further supported by the fact that the company actually incurs those said expenses in cash as on the exercise dates. Further, there are also some judgments that back this up.

Religare Commodities Ltd. v. ACIT [ITAT – New Delhi, 2017]

In the above case, keeping in mind the various quoted precedents involving ESOP wherein ESOP related expenses were deemed to be allowable expenses, the ITAT noted how SARs are akin to ESOPs, and held that SAR expenses qualify as revenue expenditure, and are thus allowable as a deduction.
In view of the above judgment, SAR expenses will be deemed to be allowable expenses from the company’s perspective.

5. Pros and Cons of SARs:

Advantages Disadvantages
Gives employees incentives without giving up equity Employees may not be incentivized by potential future cash bonuses without ownership
Saves employees from having to buy stock options Lack of additional cash infusion when employees buy stock
Lesser compliance required as compared to ESOPs and ESPPs Funds are required to finance rights being exercised which may cause liquidity issues
Offer a lot more flexibility as compared to other options Flexibility also means more decisions need to be made about who gets what, vesting rules, etc.

 

6. Accounting Treatment:
ICAI has not issued any Accounting Standards (AS) for ESOP and SAR. However, a guidance note has been issued where the accounting part has been explained.

In SAR, the company will recognise the expected expenditure every year either on the basis of Fair value or Intrinsic value, which will be calculated at the end of each year of the scheme. However, SAR payments will be made only on the basis of intrinsic value.

The expense will be recognised not only during the vesting period, but till the time the employee exercises his rights. Thus, expenditure will also have to be recognised during the exercise period. As such, a valuation exercise for the SAR alongwith with a probability study of them being exercised subsequently will need to be carried out at each year end.

In case Ind AS standards are applicable, Ind AS 102 will provide guidance in relation to the accounting treatment.

Tags:

  Potential, Project, Social,