Employee Stock Option Plans (ESOPs) have emerged as a pivotal tool for aligning employee incentives with long-term business objectives. They not only help in attracting and retaining talent but also drive ownership thinking by offering employees the right to acquire shares at a predetermined price. However, recent regulatory enforcement, most notably in the Paytm case, has brought the spotlight back on the need for robust ESOP governance, fair disclosures, and strict promoter eligibility compliance.  

This article unpacks the ESOP compliance framework under Indian law, highlights recent judicial interpretations, and uses the Paytm case as a lens to understand the practical risks of non-compliance. 

Legal Framework under the Companies Act, 2013 

The Companies Act, 2013 (“Act”) provides the statutory foundation for issuing ESOPs in India. Under Section 62(1)(b) of the Act, a company may offer shares to its employees under a duly approved ESOP scheme, provided a special resolution is passed by shareholders. 

The Companies (Share Capital and Debentures) Rules, 2014 further operationalize this provision, especially through Rule 12, which defines the eligibility criteria, procedural requirements, and necessary disclosures. 

Key Features: 

• Eligible Employees include permanent employees in India or abroad, full-time directors (including non-executive directors), and employees/directors of holding and subsidiary companies. 

• Exclusions: Independent directors and Individuals holding more than 10% of the company’s equity capital, either directly or indirectly, are barred from participating. 

• Vesting: Minimum vesting period must be one year. 

• No Shareholder Rights Prior to Exercise: Employees do not receive voting rights, dividend entitlements, or other shareholder privileges until options are exercised. 

Loan Prohibition: 

To avoid misuse, the Act prohibits companies from directly or indirectly financing employee share purchases under an ESOP. 

Disclosure Obligations: 

The explanatory statement to the general meeting notice must include: 

• Number of options, 

• Pricing methodology, 

• Vesting and lock-in conditions, 

• Lapse conditions, and 

• Valuation approach. 

Detailed records of grants, vesting, exercises, and lapses must be maintained for transparency. 

SEBI Regulations for Listed Companies 

For listed entities, ESOPs must comply with: 

1. SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021; and 

2. SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015. 

These frameworks mandate: 

• Scheme adoption via shareholder resolution, 

• Appointment of trustees (if applicable), 

• Detailed disclosures regarding grant, vesting, and exercise, 

• Compliance with voting rights and promoter participation restrictions. 

Judicial Precedents and Taxation Insights 

Key Case Laws: 

1. Ravi Kumar Sinha v. Commissioner of Income Tax

The Delhi High Court held that shares issued under an ESOP subject to a lock-in period do not constitute taxable notional income under Section 17(2)(iiia). 

2. Nishithkumar Mukeshkumar Mehta v. DCIT

The Madras High Court ruled that discretionary compensation for loss in ESOP value constitutes a taxable perquisite, not a capital receipt. 

3. The Pr Commissioner Of Income Tax  v. SAP India Pvt. Ltd

The Karnataka High Court upheld the deductibility of ESOP discounts as legitimate business expenditure under Section 37(1) of the IT Act. 

4. Sanjay Baweja v. DCIT

The Delhi High Court held that compensation for unexercised ESOPs does not amount to taxable income if the employee did not exercise the vested options. 

5. Dcit, New Delhi vs M/S. Info Edge India Ltd

ITAT Delhi stressed the need for fair valuation and proper ESOP documentation for tax deductibility.  

Step-by-Step Process for ESOP Implementation 

1. Board Approval – Draft policy and obtain Board approval. 

2. Shareholder Approval – Special resolution in general meeting. 

3. Drafting the Scheme – Compliance with Rule 12, detailing eligibility, vesting, and valuation. 

4. Valuation – Unlisted companies require a valuation report from a Registered Valuer. 

5. Grant of Options – Grant letters specifying terms. 

6. Vesting – Over minimum one-year period. 

7. Exercise – Payment of exercise price and option conversion. 

8. Allotment & Filing – Allot shares and file Form PAS-3 with RoC. 

9. Disclosures – Include in Board report and financials; listed companies follow SEBI norms. 

10. Tax Deduction & Reporting – TDS deduction and Form 16 issuance at exercise. 

Recent Regulatory Enforcement: SEBI Action in Paytm ESOP Case 

In 2024-2025, SEBI initiated enforcement proceedings against Paytm’s founder Vijay Shekhar Sharma and certain board members for alleged misclassifications and disclosure lapses concerning ESOP allocations in the lead-up to its IPO. SEBI contended that Mr. Sharma, though having transferred shares to a family trust to bring his stake below 10%, continued to exercise effective promoter control, thereby making him ineligible for ESOPs under SEBI’s regulations. 

Following its investigation, SEBI passed a settlement order in May 2025, which included: 

• Cancellation of over 21 million ESOPs granted to Vijay Shekhar Sharma; 

• A three-year ESOP ban on Mr. Sharma; 

• Monetary penalties on Paytm, its founder, and his brother Ajay Sharma; and 

• Mandatory disgorgement of ESOP gains improperly received. 

This case underscores SEBI’s stance on substance over form in assessing promoter status and reinforces the need for strict ESOP governance, transparent disclosures, and independent board oversight, particularly during public listing processes. 

Conclusion 

The legal and regulatory framework governing ESOPs in India is both comprehensive and increasingly scrutinized. The Companies Act, 2013, coupled with SEBI’s Share-Based Employee Benefits Regulations and a growing body of judicial precedents, establishes clear expectations for transparency, fairness, and compliance in ESOP implementation. 

The recent SEBI enforcement action in the Paytm case serves as a powerful reminder that technical compliance is not enough, regulators will assess the substance of corporate conduct, especially concerning promoter control, board independence, and ESOP eligibility. The consequences of non-compliance, as seen, can include cancellation of stock options, monetary penalties, reputational damage, and long-term regulatory restrictions. 

To avoid such risks and unlock the true potential of ESOPs as a strategic tool for employee engagement and retention, companies must: 

• Engage experienced legal advisors and registered valuers, 

• Ensure accurate disclosures and obtain timely shareholder approvals, 

• Conduct regular audits of ESOP grants and board processes, and 

• Foster a culture of transparency and compliance at every level. 

When thoughtfully structured and lawfully executed, ESOPs not only drive wealth creation and talent retention but also signal strong governance and stakeholder trust, a hallmark of truly future-ready organizations.