Introduction and Meaning

Sweat equity is when someone or a company contributes to a business on non-monetary grounds. This usually means giving their time, work, or ideas instead of investing money like regular equity does.

Through this method, employees can gain ownership in the company by contributing their time, effort, and expertise and making a financial investment.

As per Section 2(88) of the Companies Act 2013, SWEAT Equity Shares are shares that a company issues to its directors or employees at a discount or for consideration.

This is done in exchange for their know-how, intellectual property rights, or other value additions. These shares can be issued for money or as non-cash consideration.

Eligible individuals for SWEAT Equity Shares include permanent employees of the Company who have been working for at least a year in or outside India, directors of the Company (whole-time directors or not), and employees or directors of the Company’s holding or subsidiary company in or outside India.

Sweat Equity Shares Issuance in India are governed under the following Regulations:

1. As per section 54 of the Companies Act, 2013 and SEBI (Share Based Employee Benefits and SWEAT Equity) Regulations, 2021, a listed company shall issue SWEAT equity shares to its employees.
2. Sections 39, 54, 96, 100, and 173 of the Companies Act, 2013;
3. Rule 8 of Companies (Share Capital and Debentures) Rules, 2014;
4. SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 – Regulations 31, 32, 34, 36, 37, and 41;
5. SEBI (Listing Obligation and Disclosure Requirement) Regulations, 2015 – Regulations 30 and 46(3);
6. Rule 12 of Companies (Prospectus and Allotment of Securities) Rules, 2014; and Provisions of Secretarial Standards-1 (SS-1).

Companies can give their employees or directors sweat equity shares, including managing and whole-time directors. There are limits to how many they can issue:

1) For unlisted companies:

They can’t give out more than 15% of their existing paid-up equity share capital in a year or shares worth Rs 5 crore, whichever is higher. At any given time, the total sweat equity shares issued can’t exceed 25% of the paid-up equity capital.

2) Startups:

Startups can only issue up to 50% of their paid-up capital within 10 years of incorporation or registration.

3) Listed companies:

Listed companies can issue up to 15% of their existing paid-up equity share capital in a year.

Companies must get shareholder approval to issue sweat equity shares through a special resolution. To ensure transparency and protect the interests of all stakeholders, these shares are also subject to a three-year lock-in period from the date of allotment.

Mandatory requirements for issuance of Sweat Equity Shares in India are as follows:

1. The company must get approval from its shareholders or members by passing a special resolution in a meeting.

2. It must get a merchant banker’s know-how or intellectual property rights valuation.

3. It should obtain a certificate from the secretarial auditor stating that the issue of SWEAT equity shares complies with applicable laws and resolutions passed.

4. SWEAT equity shares issued to directors or employees must be non-transferable for six months from the date of trading approval.

5. The company cannot issue more than 15% of the current paid-up equity share capital in a year and 25% of the paid-up equity share capital at the time as SWEAT Equity Shares.

6. Additionally, the company must maintain a Register of SWEAT Equity Shares in Form SH 3.

Note: The company can issue SWEAT equity shares within twelve months of passing the special resolution authorizing the share issue.

Procedure:

1) The company will hire a merchant banker to determine the fair price before issuing SWEAT equity shares. The merchant banker will assess the value of intellectual property rights or know-how associated with the shares. An independent chartered accountant will then certify the valuation according to accounting standards. The shareholders will receive a copy of the valuation report and the notice of the general meeting.

2) Call a Board of Directors meeting to approve the proposal for issuing SWEAT equity shares, including the quantity and ratio of the issue, share allocation, and record date. Authorize the Company Secretary to send the meeting notice and circulate the approved proposal’s minutes.

3) When a company’s board meeting results in a decision regarding the issuance of SWEAT equity shares, the company must promptly inform the relevant stock exchange(s) where its shares are listed. This information should also be updated on the company’s website within two working days.

4) Next, the company needs to organize a general meeting of its members to vote on a special resolution to approve the issuance of SWEAT equity shares. The guidelines provide detailed procedures for conducting the general meeting.

5) After the resolutions are passed in both the board meeting and the general meeting, the company is required to submit a copy of the resolutions, along with the necessary documents and fees, to the Registrar of Companies (ROC) using Form MGT-14 within 30 days.

6) The company must send a statement to the stock exchange within seven days after issuing SWEAT equity shares. This statement should include the number of shares issued, issuance price, total amount received, details of recipients, and any resulting changes in the capital structure and shareholding pattern.

7) When a company allots shares, it must submit Form PAS-3 to the Registrar within 30 days. The form should include a copy of the special resolution, board resolution for allotment, list of allottees, valuation report, PAS-5, and any other necessary attachments.

8) The company will provide shareholders with a share certificate, including a statement about the lock-in period, within 2 months from the date the shares are allotted. Stamp duty will apply to each share certificate as per the regulations of the Indian Stamp Duty Act of the state where the issuer is located.

9) The company should record the allocation of SWEAT equity shares in register SH-3 kept at the company’s registered office or as the Board decides. The company secretary or an authorized person should verify the entries.

Valuation of Sweat Equity Shares

Valuing sweat equity can be complex due to the intangible nature of the contributions involved. There are various methods available to determine the value of sweat equity, each with its advantages and considerations:

1) Comparable company analysis (CCA): This method involves evaluating the valuation metrics of similar companies within the same industry. Comparing these metrics provides a practical way to estimate the value of sweat equity and can be a valuable benchmark for assessing an individual’s contributions.

2) Discounted cash flow (DCF): The DCF method projects the company’s anticipated future cash flows and then discounts them back to their present value. After assessing an individual’s contributions, the value of their sweat equity can be calculated as a percentage of the overall company value.

3) Market approach: This method entails evaluating the market value of comparable positions within the industry. This data can then be utilized to determine the value of an individual’s sweat equity.

It is important to select a valuation method that aligns with the specific circumstances and the nature of the individual’s contributions to the company. Each method has its strengths and limitations, and choosing the most appropriate one can ensure a fair and accurate assessment of sweat equity.

Taxation Provisions Relating to Sweat Equity Shares – Income Tax Act, 1961

According to the Income Tax Act of 1961, Sweat Equity shares are subjected to two main aspects: Salaries and Capital Gains.

Salaries:

When an employee receives sweat equity shares, the value of these shares is taxable as a perquisite under the head Salaries as per section 17.

The taxable perquisite value for shares allotted to the employee is determined as the fair market value (FMV) of the shares on the date the option is exercised, reduced by the amount paid or recovered from each employee.

The FMV is calculated as the average of the opening price and closing price of the share on the stock exchange with the highest trading volume.

Capital Gains:

The Transfer of Sweat Equity Shares is subject to Capital Gains Tax. This includes factors such as the “holding period” and “acquisition cost.”

Period of Holding:

The holding period for sweat equity shares is calculated from the date of allotment or Transfer of such shares.

Cost of Acquisition:

The FMV value is computed to determine the prerequisite of salaries. The capital gains are determined based on the cost of acquisition.

Key Points to Note:

– If the shares are transferred within 12 months from the date of allotment, gains are treated as Short-term Capital Gains.

– If the shares are transferred after being held for over 12 months, gains are treated as long-term capital gains (LTCG). However, if the shares are listed and chargeable to securities transaction tax, they are exempt from LTCG.

Tax Planning with Sweat Equity Shares:

When a company allots shares, they are taxed under the heading Salaries. Upon Transfer, they are taxed under Capital Gains.

To mitigate the impact of Capital Gains Tax, employees can consider gifting the shares to family members without incurring taxable income, as there is no gift tax levy.

When family members transfer the shares, they will not suffer capital gains tax to the extent of their basic exemption limit. However, this benefit does not apply to shares allotted under the ESOP option, as the employee’s gift of such ESOP is treated as a transfer and is subject to capital gains tax.

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