Xerxes Antia and Aanchal Merchant
In today’s rapidly evolving global business landscape, foreign entities are increasingly turning their strategic focus towards India, recognizing it as a dynamic and promising market for growth and expansion. Additionally, in contrast to several other countries which are struggling with an aging population crisis, India has a large and highly skilled working-age population. Naturally, the Indian labour market is becoming increasingly attractive as a destination for foreign companies. As talent wars intensify, companies are getting innovative in their retention strategies. Competitive salaries are no longer sufficient to retain talent or ensure the long-term commitment of such employees. Companies are now focused on designing comprehensive incentive structures, customised based on the unique needs of the company and the contours of the Indian legal framework.
We have recently come across several instances of foreign companies that are exploring diverse incentive structures, including equity in the company, annual bonuses, and incentive-based payment structures. However, India being a foreign exchange controlled jurisdiction, subject to restrictions and controls in relation to the inflow and outflow of money, navigating the legal landscape for structuring such incentives can often be confusing.
We have therefore set out below three broad methods that are employed by foreign entities to incentivise employees of / consultants of / individuals working with, their group companies in India.
ESOP: Empowering Employees Through Ownership
Probably the most common tool that is used would be issuing employee stock options (“ESOPs”) to employees. We have seen ESOPs used as a hiring incentive by including such options in an employee’s compensation package as well as a retention tool to retain critical employees. Companies may explore different structures depending on their objective and taking the current legal framework into account.
If a company incorporated outside India (“Foreign Company”) issues ESOPs, such ESOPs would not be subject to the provisions set out in the Companies Act, 2013 (including the rules issued thereunder) (“Companies Act”) governing ESOPs issued by Indian companies. These options would however have to be compliant with the regulatory framework issued under the Foreign Exchange Management Act, 1999 (including the rules and regulations issued thereunder) (“FEMA”).
The key regulatory framework governing ESOPs issued by Foreign Companies to resident Indian individuals is outlined under the Foreign Exchange Management (Overseas Investment) Rules, 2022 (“ODI Rules”), the Foreign Exchange Management (Overseas Investment) Regulations, 2022 (“ODI Regulations”), the Foreign Exchange Management (Overseas Investment) Directions, 2022 (“ODI Directions”) as well as the Master Direction on Liberalised Remittance Scheme issued by the Reserve Bank of India (“RBI”) (“LRS Scheme”) (the ODI Rules, the ODI Regulations, the ODI Directions and the LRS Scheme are collectively referred to as the “ODI Legal Framework”).
It is worth noting that the ODI Rules[1] prescribe certain conditions that need to be met for an individual resident in India to exercise ESOPs and receive shares of a Foreign Company, namely: (i) the resident individual must be an employee or director in an office, branch, or subsidiary of the Foreign Company in India, or in a company in which the Foreign Company holds direct or indirect equity, and (ii) the Foreign Company needs to offer the ESOP offering in question on a uniform basis globally.
Some of the challenges that we have seen faced by Foreign Companies while structuring issuance of ESOPs to Indian residents have been mentioned below.
i) Scope of professional role of the recipient
As mentioned above, under the ODI Rules there are certain conditions that need to be met for a resident individual to acquire shares of a Foreign Company under the ESOP route. One of these conditions is that the Indian resident in question needs to an ‘employee’ or a ‘director’ of an office, branch or subsidiary, in India of the Foreign Company or in which the Foreign Company has an equity (direct or indirect) holding. Whilst the terms ‘employee’ or ‘director’ have not been defined under the ODI Legal Framework, from a plain reading, only individuals who have an employer-employee relationship with a company (including such a relationship with the Indian office or branch of a Foreign Company) or an individual appointed as a director on the board of directors on an Indian subsidiary of the Foreign Company in question, would be covered. An individual retained on a consultancy basis would not be entitled to use the ESOP route under the ODI Rules and neither would an individual who was a partner in a limited liability partnership set up by a Foreign Company in India. In addition, the language used in the ODI Rules limits the acquisition of shares under the ESOP route to individuals who are current employees or directors and does not provide for a mechanism to acquire shares under the ESOP route for individuals who are not either employees or directors at the time of exercise of the ESOP. This leads to a strange situation where a resident individual seeking to exercise any options post their employment, would not be entitled to exercise the options and acquire the shares in question under the ESOP route (but could still acquire the shares under the LRS Scheme).
ii) Uniform basis offering
The ODI Rules provide that the issue of the ESOPs is to be “offered by the issuing overseas entity globally on a uniform basis”. However it is not clear what this would exactly entail, for example whether India specific amendments could be made to a global ESOP or not. It appears to be intended to ensure that the ESOPs being issued to the Indian employee(s)/director(s) are part of an overall employee incentive scheme being employed by the Foreign Company, and are not specifically designed as a means to reward a particular employee/employee group/director(s) in India. Therefore, so long as the Foreign Company can establish that the ESOPs being issued to the identified recipients in India are part of a global incentive scheme on identical terms with only a few India specific amendments/conditions, this condition may be deemed to be satisfied.
iii) Subscription Amount
While there is no cap on the value of the ESOPs which can be granted, an employee/director can only remit up to USD 250,000 under the LRS Scheme in the relevant financial year to purchase ESOPs as per the ODI Directions. This can lead to a peculiar situation where options that are vested in a resident individual under an ESOP cannot be exercised by the individual as such individual’s USD 250,000 annual quota would not cover the cost of the shares to be issued against the exercised options.
Although we have not explored this in detail under this Article, a Foreign Company can also route an ESOP issuance through its Indian subsidiary with the Indian subsidiary issuing the options in question to the relevant resident employee/director. Whilst this would not be subject to the restrictions and reporting requirements under the ODI Legal Framework, this route will however be subject to additional compliances under the Companies Act and, in case the Indian subsidiary is a listed company, the provisions of the Securities and Exchange Board of India Act, 1992 (and the rules and regulations issued thereunder).
Share Subscription: Aligning Interests for Sustainable Company Growth
In the event that the ESOP route under the ODI Legal Framework is not available, it would still be possible for a resident individual to acquire shares in a Foreign Company's equity through direct subscription. Whilst such a subscription would be also subject to the ODI Legal Framework, it would not be necessary to comply with the provisions governing ESOPs. To be clear, this route could be used by individuals who have received options from a Foreign Company but who would not be eligible to acquire shares under the ESOP route stipulated under the ODI Legal Framework.
Pricing guidelines for ESOPs and Share Subscription: Issue of equity capital pursuant to these options are required to be in accordance with the pricing guidelines mandated under FEMA. Therefore, the Foreign Company is required to ensure that the price payable by the Indian resident for subscription to the shares should not exceed the fair value of such shares (determined using an internationally accepted methodology), as outlined in a report from a chartered accountant or a SEBI-registered Category I merchant banker. There is no specific method of valuation prescribed under applicable Indian laws.
Shadow Stock Options: Capturing the Upside Without Diluting Ownership
Shadow stock options, also sometimes referred to as stock appreciation rights or phantom stock options, are a mode of incentivising individuals wherein no shares/securities are actually issued to the individual under either the ESOP route or pursuant to the LRS Scheme, and the relevant individual is only entitled to the economic benefit of the equity shares of the Foreign Company and not to the actual shares of the Foreign Company. It is a form of a bonus linked to the appreciation in the value of the shares of a company.
The legislation in India does not prescribe any specific requirements for issuance of shadow stock options to Indian employees / consultants by a Foreign Company. The terms of the issuance of the shadow stock options and the grant of the economic benefits pursuant to such issuance would be agreed upfront, usually by way of an employment / consultancy agreement. Payment of the cash benefit pursuant to the exercise of the shadow stock option may be linked to specific conditions like lock-in for employees, performance, revenue targets, etc. Upon the occurrence of the trigger event (identified in the agreement), the amount payable to the individual is generally structured as a bonus payment and would need to be remitted into India through authorised banking channels.
To give a brief overview of the key differences between the three models set out above, we have created a quick view comparative chart[2] below.
Companies must consider various factors before selecting an appropriate incentivization method. A detailed analysis of processes, procedures, tax implications, reporting requirements, divestment routes, and related procedures must be conducted on a case-by-case basis. Additionally, it is crucial to understand the specific needs of the Foreign Company in question to design the most effective payment model. While the Indian legal landscape can be complex, it is also fast evolving, and therefore, Foreign Companies and their Indian subsidiaries should seek legal counsel to ensure they structure the most efficient and compliant compensation package.
[1] Paragraph 3 of Schedule III to the ODI Rules.
[2] The chart assumes a generic model of each of the employee incentive routes; these would have to be analyzed on a case-by-case basis, for better advice.
[3] This will be possible only after vesting of the shares pursuant to the ESOPs.
[4] Although not required under law, a valuation exercise is generally done by the recipient for tax purposes.