Who Is an “Employee” for ESOPs?

A Unified View Across Companies Act, SEBI Regulations, and Tax Laws. One of the most underestimated risks in ESOP design is not valuation, dilution, or vesting; it is misalignment of employee eligibility across laws.

As companies move through their lifecycle from unlisted to listed, and sometimes back to unlisted, the definition of who qualifies as an “employee” for ESOP purposes changes materially. Add tax treatment into the mix, especially where consultants or non-traditional roles are involved, and the risk multiplies.

This blog brings together company law, securities regulation, and tax into a single, connected framework, because ESOPs do not operate in silos, even though regulations often do.

The core problem: One ESOP, three legal lenses

An ESOP grant simultaneously touches:

1. Company law (who can be issued options)

2. Securities law (who is eligible for equity-linked instruments in Listed Companies)

3. Tax law (how the benefit is taxed and what TDS rate applies)

Most implementation errors occur when companies optimise for one lens and ignore the others.

Before diving into the implications of listing or delisting, it is essential to clearly compare how each framework defines “employee”.

Employee eligibility & tax treatment – At a glance

Why this comparison matters in real life

On paper, the table looks straightforward. In practice, these regimes collide during corporate transitions, especially listing and delisting.

Let us now connect the dots.

When an unlisted company plans to list

ESOP schemes are drafted when the company is unlisted, following the Companies Act framework. The problem arises because SEBI eligibility is not a continuation of the Companies Act, it is a reset.

What breaks during IPO preparation

1. Eligibility misalignment

• Consultants, advisors, or non-permanent employees not covered earlier may become eligible overnight

• Startup exemptions for promoters cease to be relevant post listing

2. Scheme migration risk

• Existing ESOP schemes must be amended to comply with SEBI

• Fresh shareholder approval is required for any further grants, and often needs in-principle approval from stock exchanges

3. Disclosure exposure

• SEBI requires detailed disclosures  

• Any aggressive interpretation of “employee” is visible to regulators and investors

Consulting insight:

IPO-ready companies should design ESOPs as if SEBI already applies, even when legally unlisted.

When a listed company delists

Delisting is often misunderstood as a compliance relief. From an ESOP standpoint, it is anything but.

What changes and what does not

• SEBI regulations stop applying prospectively

• Companies Act becomes the governing framework

• However:

• If Group Companies employees are covered earlier are now not eligible.

• Employee expectations created during listing do not disappear

• Liquidity assumptions collapse unless proactively addressed

Common post-delisting challenges

• Employees holding vested options with no exit path

• Exercise windows without liquidity

• Absence of buyback or cash-settlement mechanisms

Key lesson:

Delisting plans must include an ESOP exit and liquidity strategy, not just a shareholder one.

The most misused area: Covering consultants under ESOPs

This is where company law optimism meets tax reality.

Regulatory position

• Neither the Companies Act nor SEBI truly encourages ESOPs for consultants

• SEBI permits coverage only where the relationship mirrors employment and exclusivity exists

Tax reality (especially for listed companies)

If consultants are granted equity-linked benefits:

• They are not employees under tax law, hence benefits are taxed as professional income

• Which TDS section will apply, whether Section 194J or Section 192? (Not clear in tax laws). Perquisite taxation under Section 17(2) generally does not apply to Consultants.  

Risk areas

• Incorrect salary TDS.  

• Disallowance of expense

• IPO diligence red flags

• Re-characterisation by tax authorities

Conclusion

The question “Who is an employee?” is the question every Company Must Ask?

Defining who qualifies as an “employee” for ESOP purposes is no longer a drafting exercise; it is a strategic decision with legal, regulatory, and tax consequences that unfold over time.

As companies grow, list, delist, or reconfigure their workforce models, the real challenge is not whether ESOPs are offered, but whether the framework can withstand regulatory transitions and scrutiny.

Before finalising or continuing with any ESOP structure, it may be worth pausing to ask:

• Is our current definition of “employee” aligned only with today’s status, or also with where the company is headed?

• If we were to list tomorrow, which ESOP grants would become non-compliant and why?

• If liquidity disappears post-delisting, what does ownership really mean for our employees?

• Are we stretching regulatory definitions to reward consultants, or choosing the right instrument altogether?

• And finally, are we designing ESOPs for intent, or for execution across the company’s full lifecycle?

There are no universal answers. But asking the right questions early is often the difference between an ESOP that builds trust and one that has to be reworked under pressure.