Companies reward their top-performing employees in various ways. While some resort to cash bonuses, others prefer to give ownership rights to their employees. One way to imbibe a sense of ownership in the employees is by offering restricted stock units (RSUs).
One advantage of RSUs is the low tax liability on the employees because no upfront payment for taxes is required while purchasing the shares.
In this blog, we have covered the basic functioning of restricted stock units, their advantages and disadvantages, the applicable taxes and how they differ from ESOPs.
A restricted stock unit is a type of employee compensation in which employees are given the company shares at a future date if they fulfil certain conditions. These conditions can be performance-based, or time-based, or a combination of both.
Usually, companies launch RSU programs to incentivise employees to perform. If the employees achieve the defined targets, their units vest. As they fulfil the obligation, they get the ownership of the shares.
Unlike in an ESOP scheme, they need not purchase the shares post the vesting period or get a deep discount.
Let’s see the various restrictions on RSUs.
RSUs work differently in India and the USA. In India, though the employees may still need to purchase RSUs, the exercise price is very low. On the other hand, in the USA, employees need not purchase the shares. The shares are automatically allocated to the employees as the RSUs vest.
For the rest of the post, we will discuss RSUs as they work in India.
The restrictions on RSUs can arise from employment duration, achievement of a milestone or a combination of both.
Restrictions Based on Time: In a time-based restriction, employees need to serve the company for a minimum duration to get the promised RSUs. Usually, 25% of restricted stocks vest every year.
Imagine an employee needs to complete four years of service to get 800 units of RSUs. These units will not be allotted all at once. Every year, 200 units are transferred to the employees. Gradually, in the last year, employees own 800 shares.
Achievement of a Milestone: The second type of restriction on an RSU can be milestone-based. Employees may need to complete a project before a particular date or achieve their marketing or sales target.
Restricted stock units offer both employees and employers various advantages. Employees get benefits like no/very low upfront payment at the time of vesting, while the employer gets a way to incentivise employees for retention and performance.
RSUs align employees' interests with that of shareholders. Offering ownership in the company boosts the morale of the employees. When employees feel valued and motivated, they give their best to achieve the company goals. Many of them end up staying for an extended period in the organisation.
Further, there is a very low (zero in the case of the USA) upfront cost for employees while exercising.
Another benefit of RSUs is that employees do not need to pay any tax from their pocket as the tax amount gets adjusted in the form of RSU units as TDS.
Pro-Tip: A double-trigger provision may apply when a company gets acquired. During such acquisitions, there is a possibility that some employees may lose their jobs. In such cases, their RSUs automatically fully vest under the provision, and they get the promised equity share.
There are some disadvantages of RSUs as well, such as no dividend payment, market standoff, automatic forfeiting of unvested RSUs, etc.
RSUs convert to common shares after employees exercise them. So, they are subject to market risks. As the share value can decrease, so is the amount employees can make selling it.
RSUs holders don't get dividends or voting rights. However, once RSUs get vested, the employees get both, just like common shareholders.
Another disadvantage is that RSUs don't vest until conditions (restrictions) are fulfilled. Unvested units get forfeited if the employees leave the organisation or fail to achieve the target.
Suppose there is a market standoff provision in the RSU policy. In that case, employees can't sell the vested RSUs for a limited period after the initial public offerings, usually for 90 to 180 days. This stabilises the stock price of the company and prevents a big sell out.
Tax Implications of RSUs
The taxation on restricted stock units (RSUs) occurs at different levels. Initially, when the company grants RSUs to an employee, there is no income tax applicable. At this stage, the employee is still not the owner of the shares.
When the employees exercise the RSUs, they get the company's shares. At that time, the ordinary income tax as per the tax slab is applicable on the perquisite.
Income from perquisite = Market value of shares on the exercise date - Total exercise amount
But the employee need not pay the tax from his pocket as the tax amount gets deducted by the employer in the form of RSU units.
For listed companies, if the employee sells the shares within 12 months, short-term capital gains tax (STCG) applies on the proceeds. If the duration exceeds 12 months, a long-term capital gains tax (LTCG) comes into effect.
Sec 112 A of the Income Tax Act 1961 states an LTCG tax of 10% on gains over Rs 1 lakh. Similarly, Sec 111 A, STCG tax is charged at a flat rate of 15%.
For unlisted companies, if the employees of a company hold the shares for less than 24 months before selling them, it becomes a short-term capital gain. Short-term capital gains are treated as any other income and taxed at the applicable income tax slab rate.
However, if shares are held for more than 24 months before their sale, the gains are taxed as long-term capital gains. Sec 112 A of the IT Act says that long-term capital gains arising from the sale of unlisted shares are taxed at a rate of 20% with indexation. Or you can choose to pay a tax at a flat rate of 10% without any indexation benefits.
Note: Non-payment of advanced Capital Gains Tax can attract penal interest under sec 234 C & 234B.
RSUs are often confused with the ESOPs (Employee stock options) programs. But there are crucial differences concerning taxation, share dilution, voting rights, etc.
Let’s understand the differences in detail.