Sweat equity shares, as defined by section 2(88), are equity shares that a company issues to its directors or employees at a discount or for something other than cash in exchange for their expertise, or in exchange for making available rights in the form of intellectual property rights or value additions, by whatever name called.

The Companies (Share Capital and Debentures) Rules, 2014’s Explanation to Rule 8(1) states that an “Employee” for purposes of this rule is defined as

(a) a permanent employee of the company who has been employed in India or outside of India;

(b) a director of the company, whether a whole-time director or not; or

(c) an employee or a director as defined in subclauses (a) or (b) above of a subsidiary in India or outside India, or of a holding company of the company.

The term “Value additions” refers to actual or anticipated financial gains obtained or to be obtained by the company from a professional or expert for supplying know-how or making available rights in the nature of intellectual property rights, by such person to whom sweat equity is being issued, for which the consideration is not paid or included in the regular compensation due under the employment contract in the case of an employee.

In recognition of their contribution for supplying the aforementioned know-how and other resources, Section 54 enables the issuance of such equity shares to workers or directors. Sweat equity shares offer a unique type of sufficient return since the contribution made by employees/director’s results in higher profitability to the company for a number of years.

Conditions for Issue of Sweat Equity Shares

According to Section 54(1), a corporation may issue sweat equity shares of a class of shares that have already been issued, notwithstanding anything to the contrary in Section 53, if the following requirements are met:

(I) The company’s general meeting approved a special resolution authorizing the issue.

(II) Their solution makes clear mention of the following:

(a) the total shares;

(b) the price in effect today;

(c) any payment received, if any; and

(d) the class or classes of directors or employees who will receive the aforementioned equity shares.

(III) Where shares are listed on a reputable stock exchange, the business issuing sweat equity shares must adhere to the rules established by SEBI in this regard.

(Iv) In accordance with the regulations established in this regard by the Central Government, namely the Companies (Share Capital and Debentures) Rules, 2014, a firm whose shares are not so listed should issue sweat equity shares.

Sweat Equity Shareholders will be pari passu to other Equity Shareholders.

According to Section 54(2), the holders of sweat equity shares issued under this section will rank on pari passu with other equity shareholders and will be subject to the same rights, limitations, restrictions, and requirements as are currently applicable to equity shares.

Validity of Special Resolution authorizing sweat equity shares

According to Rule 8(3), the special resolution authorizing the issuance of sweat equity shares must be passed within a year of the date of the allotment in order for it to be effective.

Limits on issue for sweat equity shares

According to Rule 8(4), the firm may not issue sweat equity shares for more than 15% of the outstanding paid-up equity share capital or for shares with an issue value of Rs. 5 crores in a year, whichever is higher. Twenty-five percent of the company’s paid-up equity capital may not be issued as sweat equity shares at any one time.

Furthermore, a startup business, as defined in notification number [G.S.R. 127(E), dated February 19, 2019 issued by the Department for Promotion of Industry and Internal Trade], Ministry of Commerce and Industry, Government of India, may issue sweat equity shares up to ten years after the date of its incorporation or registration as long as the shares don’t exceed fifty percent of its paid-up capital.

Sweat Equity Shares to be locked for three years

The sweat equity shares granted to directors or workers must be locked for three years after the date of allotment, and the share certificates must include a bold stamp or other clear indication that they are locked in as well as the time remaining before the lock in expires. [Rule 8(5)]

Valuation aspects

The sweat equity shares that will be issued must be valued at a price that is determined by a registered valuer as the fair price and provides rationale for such valuation, according to Rule 8(6).

According to Rule 8(7), a registered valuer must carry out the valuation of intellectual property rights, know-how, or value additions for which sweat equity shares are to be granted. The registered valuer must then submit a proper report to the Board of Directors with the valuation’s reason.

A copy of the gist and important portions of the valuation report received in accordance with Rules 8(6) and 8(7) must be provided to shareholders concurrently with the notice of the general meeting, according to Rule 8(8).

Sweat equity shares for non-cash consideration

According to Rule 8(9), non-cash consideration must be treated as follows in the company’s books of accounts when sweat equity shares are issued for a non-cash consideration based on a valuation report obtained from the registered valuer:

• where the non-cash consideration takes the form of a depreciable or amortisable asset, it shall be carried to the balance sheet of the company in accordance with the accounting standards
• where clause (a) is not applicable, it shall be expensed as provided in the accounting standards.

Sweat equity shares forming part of managerial remuneration

According to Rule 8(10), if the following requirements are met, the number of sweat equity shares granted will be considered part of managerial compensation for the purposes of Sections 197 and 198 of the Act:

• Any director or management is given the sweat equity shares; and
• They are issued in exchange for something other than cash, and that something cannot be recorded as an asset on the company’s balance sheet in line with the applicable accounting standards.

Sweat equity shares and compensation aspects

• If the shares of sweat equity are not issued in connection with the purchase of an asset.

As per Rule 8[11], the accounting value of sweat equity shares (i.e., fair value determined by Registered valuer) issued during an accounting period shall be considered as a form of compensation to the employee or the director in the company’s financial statements.

• If the shares are issued pursuant to acquisition of an asset

According to Rule 8(12), if the shares are issued in connection with the acquisition of an asset, the value of the asset, as determined by the valuation report, shall be carried in the balance sheet in accordance with the Accounting Standards, and any excess over the value of the asset acquired, as determined by the valuation report, shall be treated as an employee or the director in the financial statements of the company. 

 The Board’s Report will include information about sweat equity shares

In accordance with rule 8(13), the board’s report of the company must include information about issues made during the year in which such shares were issued.

Maintenance of the register

According to Rule 8(14), the corporation is required to keep a Register of Sweat Equity Shares in Form No. Immediately input the information about Sweat Equity Shares issued under Section 54 in SH.3. The Register of Sweat Equity Shares must be kept at the company’s registered office or another location determined by the Board. The company secretary or any other individual designated by the board for this purpose must certify the entries in the register.

Disclosure pertaining to Issue of Sweat Equity Shares

According to Section 54(1)(d) of the Act, sweat equity shares are issued in line with SEBI regulations where the company’s equity shares are listed on a recognised stock exchange and in accordance with Rule 8 of the Companies (Share Capital and Debentures) Rules, 2014 when they are not.

In accordance with Rule 8 of the Companies (Share Capital and Debentures) Rules, 2014, the Board of Directors shall, among other things, provide the following information in the Directors’ Report for the year in which such shares are issued:

(a) the category of director or worker to whom sweat equity shares were granted;

(b)the class of shares issued as Sweat Equity Shares;

(c) the number of sweat equity shares issued to the directors, key managerial personnel or other employees showing separately the number of such shares issued to them, if any, for consideration other than cash and the individual names of allottees holding one percent or more of the issued share capital

(d) the reason or justification for the issue;

(e) the principal terms and conditions for issue of sweat equity shares, including pricing formula;

(f) the total number of shares arising as a result of issue of sweat equity shares;

(g) the percentage of the sweat equity shares of the total post issued and paid-up share capital;

(h) the consideration (including consideration other than cash) received or benefit accrued to the company from the issue of sweat equity shares;

(i) the diluted Earnings Per Share (EPS) pursuant to issuance of sweat equity shares.

Case laws-

1. In the order dated 16.02.2012 Future Agrovet Ltd vs. CIT, I.T.A. No. 2654/Mum/2012 the income tax appellate tribunal stated that Disallowance of claim for deduction of Rs. 1.00 crore relating to value of Sweat Equity Shares issued by it to its key persons, having been confirmed by Ld CIT that assessee should pay Fringe Benefit Tax on the value of Sweat Equity Shares allotted to the employees and it has also paid the Fringe Benefit Tax on the said amount of Rs. 1.00 crores. Therefore, it was argued that the Sweat equity shares are a type of fringe benefit provided to its employees and that they may be paid for out of income.

• In the case of Commissioner of Income Tax, Bangalore vs Infosys Technologies Ltd Appeal (civil) 3725 of 2007 on 4 January, 2008 the supreme court of India stated the meaning of sweat equity shares as equity shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called;

References-

1. Future Agrovet Ltd vs. CIT, I.T.A. No. 2654/Mum/2012
2. Commissioner of Income Tax, Bangalore vs Infosys Technologies Ltd Appeal (civil) 3725 of 2007
3. Companies act 2013
4. Dr. Avtar Singh, “Company Law”, 7 th Edition (2016), Eastern Book Company Publications.
5.  N. D. Kapoor, “Elements of Company Law”, 30 th Edition (2016), Sultan Chand & Sons. Publications.
6.  C.R. Dutta, “Company Law”,7 th edition (2016), Lexis Nexis Publications.

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