What’s in a Name? On the Regulation of “Phantom Stocks” under Tax law and FEMA
Introduction
Over the past few years, companies have begun to adopt capital instruments which compensate employees/ investors in ways other than a monetary payment, without further diluting equity. One such instrument is a form of stock appreciation rights, known as “phantom stocks”. The use of phantom stocks has generated some confusion over how they ought to be treated under different legal regimes. This piece is concerned with their treatment under Indian Tax Law, and the Foreign Exchange Management Act, 1999 (“FEMA”). With regards to the FEMA, commentators have frequently opined that the application of the FEMA Rules on “investments” to phantom stocks is unclear. Similarly, with regards to Indian Tax Law, commentators have identified a lack of clarity in existing caselaw on how phantom stocks should be classified. (see here, and here). This is not just an academic problem, as a persistent lack of clarity in this respect can lead to regulatory arbitrage. This piece will argue that (a.) the view taken in some cases – that phantom stock arrangements are a “perquisite” – is not correct, and (b.) commentators have incorrectly presumed that the FEMA Rules on “investment” will apply to phantom stock arrangements in the first place. Instead, phantom stocks should simply be treated as a capital accounts transaction, to which an entirely different set of regulations apply. In this way, clear responses to the treatment of phantom stocks under the existing regulatory framework are identified – which may assist in reducing concerns towards regulatory arbitrage.
To this extent, Section (II) introduces the concept of a “phantom stock”. Section (III) makes the descriptive claim that “phantom stocks” essentially constitute “contingent contracts” under the Contract Act, 1872. This central descriptive insight is used in Section (IV) and Section (V) to propose a principled response to the regulatory framework for “phantom stocks” under tax law, and the FEMA, respectively. Section (VI) concludes.
The regulation of phantom stocks under the Companies Act, 2013 is not addressed by this piece, as any ambiguity in this regard has been clarified by the amendment to section 2(qq) of the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021. The remaining concerns with such regulation have arisen from differing positions taken by stakeholders as a matter of legislative policy – not ambiguity. Such concerns are not the subject of this piece, and in any event, the nature of phantom stock arrangements as a contingent contract is of no relevance to them. Further, what the amendment to section 2(qq) leaves ambiguous is the status of “Restricted Stock Units”. But since these pertain to an actual transfer of shares, and are not phantom stocks – they are also not the subject of this piece.
What is a “Phantom Stock”?
A “Stock Appreciation Right” (“SAR”) can be of two kinds. Both pertain to an agreement between an individual and a Company, where the company ‘allocates’ shares to the individuals (without vesting them), and commits to remunerate the individual if the value of those shares “appreciates” over time to a certain amount. One type effectuates this remuneration by vesting the individual with ownership over the shares themselves. For this reason, such SARs are known as ‘equity-settled’ SARs.
The second type substitutes the SAR as a “right to equity”, to a “right to appreciation value”. Where in an “equity-settled” SAR, the holder of the SAR would be entitled to receive the shares themselves upon an appreciation in their value; in this form, the holder of the SAR is entitled to receive the monetary value of the appreciation in share value – subject to certain conditions, which may differ from company to company. Thus, the holder of the SAR would receive a financial payment amounting to the increase in the value of the share. This is known as a “cash-settled” SAR. Companies interested in conserving equity, yet facing a capital resource crunch (for instance, early stage startups, which lack large amounts of capital, but are also interested in conserving equity to protect their ability to raise funds over time), are now exploring the second form of SARs – because they do not need to give up equity.
The second type of SAR is enabled by an underexplored part of the SEBI’s definition of Stock Appreciation Rights, which defines it as, “a right given to a SAR grantee entitling him to receive appreciation for a specified number of shares of the company where the settlement of such appreciation may be made by way of cash payment or shares of the company.”
Since, in doing so, the SAR holder is receiving returns on the performance of the share without actually owning the share, ‘cash-settled’ SARs are popularly termed as “phantom stocks”.
“Phantom Stocks” as “Contingent Contracts” under the Contract Act, 1872
A contingent contract is defined by section 31 of the Contract Act, 1872, as a “a contract to do or not to do something, if some event, collateral to such contract, does or does not happen.” If the text of the section is itself not clear, it becomes intuitively apparent why phantom stocks are essentially “contingent contracts” from the Illustration to section 31, which states that, “A contracts to pay B Rs. 10,000 if B’s house is burnt. This is a contingent contract.” A phantom stock agreement may be re-written within the language of this illustration as, “A contracts to pay B Rs. X if the value of Z shares of Company Y increases by X.”
Still, I will be careful in classifying phantom stocks as “contingent contracts” by paying close attention to the doctrinal understanding of the phrase “to do or not to do something, if some event, collateral to such contract” in section 31. Courts have relied on this phrasing for two propositions.
First, relying on the first part of the phrasing – they have held that it is the doing of something which must be contingent on some event; and not the existence of the contract itself.[1] Thus, while a contract for fire insurance is an example of a contingent contract, an announcement of providing a reward for the recovery of lost items is not,[2] because a contract has not formed in the latter instance.
Secondly, relying on the second part of the phrasing – they have held that as a “collateral” to the contract, the event must be distinct from the contract. It cannot be a reference to a component of the contract itself, or the promises made by any of the parties thereof.[3] This proposition is slightly tricky, and is best understood through an example. It has been held that a contract where a person agrees to stand surety for a judgement-debtor to be produced in Court is not a contingent contract, even though the liability of the surety is ‘contingent’ on an event.[4] The reason for this is that in a surety contract, the surety has a ‘primary’ obligation to ensure that the judgement-debtor will appear. The obligation to pay is only a means of enforcing that obligation. Thus, the ‘event’ in question – which the obligation to pay is “contingent” on, is a part of the obligations undertaken in the contract itself, it is not just a “collateral” to the contract. One may distinguish this from the example of an insurance contract discussed earlier on the basis that in the insurance contract, the insurance company has no obligation to make the event in question happen. Thus, the events envisioned there, properly constitute a “collateral” to the contract.
On this reasoning, a “phantom stock” agreement is a contingent contract because the grantor of the SAR becomes liable to pay (i.e., “to do something”) upon the appreciation in share value, but neither party undertakes any obligations towards affecting the likelihood of the shares to appreciate in value, itself (for instance, see here). This is so, even though the obligation to pay is co-terminus with the appreciation in share value, and the amount to be paid is usually equal to the appreciation in share price, for two reasons.
First, a contract is a contingent contract because an obligation arises from the occurrence of an event. For this reason, in every contingent contract, an obligation will arise ‘co-terminus’ to an event. Consequently, the fact that an obligation to pay arises co-terminus to the appreciation in share value should not create confusion. It is precisely what characterises a phantom stock agreement as a ‘contingent contract’.
Secondly, in this context it is important to distinguish between a contract which obliges a party to cause an appreciation in share value (and then make a payment), and a “phantom stocks” agreement – which uses the appreciation as a measure of the obligation to pay (See for instance, Sumit Bhattacharya, para 25). In both cases, the appreciation in share value is relevant to determine the consideration. However, the way in which it does so is different. It is this distinction which makes the second case a contingent contract, and precludes the first case from being one. At the heart of ‘consideration’ is the idea of a ‘promise’ – i.e., a ‘proposal’ which has been accepted. A ‘proposal’ is a signification to another of the “willingness to do or abstain from doing something”. In the first case, there is a promise towards appreciation – i.e., the ‘proposal’ is to ensure the appreciation in share value – consequently, the appreciation in share value would form a part of the consideration of the contract itself.[5] This would preclude the contract from being a contingent contract, because the ‘event’ giving rise to an obligation was no longer “collateral” to the contract. In the second case, the ‘proposal’ is to make a payment. Even though the scope of the payment is determined by the appreciation in share value – there is no obligation towards causing the appreciation in share value itself. Consequently, it is submitted that the appreciation in share value remains ‘collateral’ to the contract.
This view is supported by the views adopted by the Income Tax Appellate Tribunal (“ITAT”) in Sumit Bhattacharya v. Assistant Commissioner of Income Tax. Here, (prior to the inclusion of sub-section (vi) in s. 17(2)(c) of the IT Act – see ahead), the Court reasoned that
“… if we are to proceed on the basis that grant of a stock appreciation right gives some benefit to the assessee, it is beyond dispute that such a benefit is contingent upon the market behaviour for value of shares in question…”
For this reason, it held that cash-settled SARs were not taxable because no benefit could be said to have crystallised before appreciation in the value of the shares.
Consequently, it is submitted that “phantom stock” agreements essentially constitute contingent contracts.
Regulating “Phantom Stocks” under Tax Law – ‘Perquisite’ or Not?
The Income Tax Act, 1961 (“IT Act”) develops a general taxation framework applicable to income obtained generally, and a special set of regulations applicable only to income obtained through employment. Generally, the IT Act does not tax individuals for potential future income. It only does so in the context of employees through the concept of a “perquisite”. Accordingly, this section concerns itself with the limited issues arising from the classification of phantom stocks as a “perquisite”.
“Perquisite” is defined by section 17(2) of the IT Act. Simply put, section 17(2) of the IT Act makes access to certain forms of prospective economic benefits which an employee may receive as itself taxable, even at the stage where the economic benefits may not have materialized. This is an exceptional classification, and it has been the consistent view of the Supreme Court that even though the definition of “perquisite” uses the term “includes”, the list of perquisites mentioned in section 17(2) is an exhaustive list. Thus, for something to be taxed as a perquisite, it has to be exhaustively listed in section 17(2). Sub-section (vi) of Section 17(2)(c) is the relevant part here.
Before the inclusion of sub-section (vi), it was the settled view of the ITAT that SARs generally were not taxable until the employee actually received the monetary benefit through the financial transaction. The SAR itself was not taxable per se. Sub-section (vi) extends the definition of “perquisite” to “the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at concessional rate to the assessee.” Importantly, “security” itself is defined further as, “the securities as defined in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and, where employees’ stock option has been granted under any plan or scheme therefore, includes the securities offered under such plan or scheme;”. (On the point that “phantom stocks” do not fall under the definition of “security”, see here).
Thus, the inclusion of sub-section (vi) makes the securities granted to an employee under an ESOPs scheme as being taxable at the time of entering into the ESOPs, even if the stock option provided has itself not been exercised.
After the inclusion of sub-section (vi), the ITAT has expressed the view that even SARs per se are taxable on the reasoning that the use of the term “value” makes s. 17(2)(vi) broad enough to include SARs themselves. Thus, under this view, phantom stock agreements will be taxable as “perquisites”. It is submitted, with respect, that the view expressed by the ITAT is incorrect because it is irreconcilable with the phrasing of sub-section (vi).
First, one way of reading sub-section (vi) is to emphasize the first part of its phrasing and reason that what is being covered as ‘perquisite’ is the value of a security which has been “allotted” to a person; not the security itself. Taken at its highest, the reasoning here would be that even though a security does not vest in a person; the value of a phantom stock still depends on an “allotment” of a security, and that is what is being taxed. At the very least, even under this reasoning, it must be assumed that the person has access to that value at the time at which she is being taxed (otherwise the term “value” would be meaningless). This flows from the general principle that the interest which is being made taxable as a perquisite must be a vested interest. But because a phantom stock agreement is a contingent contract, the interest will only vest upon the occurrence of the contingency. Consequently, the “value” cannot be accessed until the occurrence of the contingency. For this reason, this reading of sub-section (vi) cannot account for the inclusion of phantom stocks. Indeed, the view of the ITAT has the absurd effect of taxing the beneficiaries of a phantom stock agreement for a fictional value of the underlying shares, even though the actual value of the shares themselves may subsequently collapse!
Secondly, the only other way of reading sub-section (vi) is to emphasize the second part of its phrasing and reason that the ‘perquisite’ lies in having been “allotted” a security whose value is what is being taxed. Yet, surely this does not accommodate phantom stocks because they do not constitute a “security” under the definition given under sub-section (vi) – since, no equity has passed.
Consequently, it is submitted that phantom stocks should not, in principle, constitute “perquisites”, and the view of the ITAT, with respect, merits a reconsideration.
Regulating “Phantom Stocks” under the Foreign Exchange Management Act, 1999
As regards the Foreign Exchange Management Act, 1999 (“FEMA”) commentators have opined that except for certain parts of the Foreign Exchange (Non-Debt Instruments) Rules, 2019 (“NDI Rules”); and the Foreign Exchange (Overseas Investments) Rules, 2022 (“OI Rules”) – which regulate ESOPs schemes – the regulatory framework is “silent” on the point of “phantom stocks”,[6] and therefore, the existing regulatory framework is “unclear” (see here, and here).
In truth, it is submitted that “phantom stocks” do not constitute a form of “investment” as defined by either of these Rules at all. Consequently, neither of these Rules would or should apply. “Investment” is defined by the NDI Rules, and the OI Rules as follows. Rule 2(ac) of the NDI Rules defines an “investment” as “to subscribe, acquire, hold or transfer any security or unit issued by a person resident in India;”. While, the OI Rules do not contain a definition of investment, it is submitted that the definition provided in the NDI Rules continues to apply through the operation of Rule 2(2), which states that, “(2) The words and expressions used but not defined in these rules shall have the meanings respectively assigned to them in the Act or the rules or regulations made thereunder.”
What is evident from the definition under the NDI Rules is that “investment” necessarily requires a person to acquire a right to some form of security.[7] (). “Security” itself is defined by section 2 of the FEMA as, “shares, stocks, bonds and debentures…”. But phantom stocks agreements, by definition, do not provide the recipient with access to any form of shares at all (see Section II.). Consequently, they are not an “investment”. Thus, one cannot find the answer to how the regulatory framework would respond to a phantom stocks agreement in either the NDI Rules, or the OI Rules. But this does not make the regulatory framework unclear.
The fact that a phantom stock agreement is essentially a form of a monetary transaction devoid of dealing in any securities indicates that the FEMA would either regulate them as a “current accounts transaction”, or as a “capital accounts transaction” (these are the only two provisions regulating monetary transactions simpliciter). It is submitted that the central descriptive insight, that phantom stock agreements are “contingent contracts” helpfully indicates that they would be the latter.
This is because capital accounts transactions are defined by the FEMA as, “a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India of persons resident outside India.” Here, “contingent liabilities” refers to a liability which may arise on the occurrence of a future uncertain event. In this case, the nature of phantom stock agreements as contingent contracts establishes that the liability of the company giving the phantom stock only arises upon the occurrence of a future event. Thus, it is submitted that the phantom stock agreements simply constitute a “capital account transaction”.
The regulatory response to such transactions is exclusively found in section 6 of the FEMA, and the accompanying FEMA (Permissible Capital Accounts Transactions) Regulations, 2000 (“PCAT Regulations”). [8] Section 6 confers a general permission on all persons to deal in foreign exchange with Authorised Dealers for the purposes of capital account transactions – but this is further regulated by the PCAT Regulations. On account of the Regulations, a capital account transaction is prohibited, unless expressly authorized. Authorized transactions are those which adopt the mechanisms provided in Schedules I (for outward transactions), and II (for inward transactions) of the PCAT Regulations.[9] By generally permitting “remittances” – both Schedules in-fact permit a phantom stocks transaction, subject to an overall limit of drawing USD 250,000 of foreign exchange; which applies to every capital accounts transaction.[10]
Conclusion
Over the course of this piece, I have attempted to show that there are simple regulatory answers to much of the confusions that have arisen through the increased popularity of a new form of capital instrument – “phantom stocks”. It is argued that (a.) phantom stocks constitute “contingent contracts”, and as a result (b.) they do not constitute “perquisites” under section 17(2)(vi) of the IT Act, but (c.) they do constitute “capital account transactions” under the FEMA. To that extent, concerns towards regulatory arbitrage in the existing system might be overstated, and arising from a mis-classification of such instruments to begin with.
[1] See Chitra Narayan & Vinod Kumar (eds), Pollock & Mulla: The Indian Contract and Specific Relief Acts (17th edn, LexisNexis) section [31.4] – “Nature of Events” for more detail
[2] ibid
[3] ibid; Maung Kywe v Maung San Tin, AIR 1923 Rang 26
[4] ibid
[5] See Chitra Narayan & Vinod Kumar (eds), Pollock & Mulla: The Indian Contract and Specific Relief Acts (17th edn, LexisNexis) section [2.9.2] for more detail – in particular, the distinction between the ‘consideration’ and the ‘performance’ of consideration.
[6] There is one important exception to this. Under the OI Rules, the term “ESOPs” is defined in a manner which extends to “phantom stock schemes”. This however, does not clarify the nature of such schemes in principle, and in any case, it does not clarify the regulatory response to phantom stocks issued by an Indian company to an overseas, non-employee.
[7] See further Foreign Exchange Management (Non-debt Instruments) (Second Amendment) Rules, 2024, r 2(aq). The term “unit” refers to the beneficial interest of an investor in an “investment vehicle”, i.e., an investment fund. This term is not relevant here because it pertains to an acquisition of shares in an investment fund.
[8] This is evident from a check on Manupatra. These rules are not listed on Manupatra anymore. In any case, that does not change the way that phantom stock agreements would be regulated. It would only clarify the modalities that a phantom stock agreement would be subject to.
[9] Foreign Exchange Management Act (Permitted Capital Accounts Transactions) Regulations 2000, sch I and II.
[10] Foreign Exchange Management Act (Permitted Capital Accounts Transactions) Regulations 2000, s 4.
About the Author
Bhasvar Adlakha is a fourth-year student at National Law University, Delhi.