What is a Phantom Stock?

Introduction

'Phantom Stocks Options' or 'Shadow Stocks Options' ("Phantom Stock or Phantom Stock Options") is a performance/condition based incentive plan, linked to the valuation of a company, which entitles an employee / non-employee, the benefits of stock ownership without actually giving them any stock. Phantom Stock Options do not confer ownership rights, or dilute the share ownership of a company, although they do create liabilities to the company. It entitles an individual to receive appreciation, for a specific number of shares of a company where the settlement of such appreciation may be made by way of cash payment or issue of shares. Thus, the options granted to such individual may be settled in either of the following 2 ways:

• Issue of shares of the company
• Cash payment

For instance, the employees are generally incentivised by providing ESOPs, which in turn means that the employees have a right to hold a place on the cap-table of the company. However, phantom stock options may or may not lead to a place on the cap-table of a company. This mechanism can be mainly used in the following instances:

• Incentivising the employees based on valuation of the company but without giving a right of stock ownership
• Providing incentives linked to valuation of the company, to people other than employees

Types of Phantom Stock Options

• Appreciation only – Under this plan, the recipient is compensated for the increase in valuation from the date of grant of options. For instance, if the price of shares is INR 1000 on the date of grant of options and increases to INR 1400 on the proposed date of payment / event of occurrence, the amount that would be paid is INR 400 (INR 1400 less INR 1000).
• Fully paid – Under this plan, the recipient is compensated for the full share price. Accordingly, in the above example, the compensation under this plan would be full INR 1400.

Framework

While the Companies Act, 2013 has prescribed rules for issuance of shares to employees under stock plans, it is silent on the grant and exercise of Phantom Stock Options by the unlisted companies. Such companies are free to formulate their own schemes/structures for Phantom Stock Options, subject to the valuation being justifiable.

For the purpose of granting such options, the Company is required to enter into an agreement with the employees/non-employee and a board resolution is required to be passed for authorising any of the director to enter into such agreement on behalf of the Company. These options will further be governed in accordance with the terms laid down in the agreement.

Under this agreement, a certain number of units of Phantom Stocks are granted to the selected individual for a specified period of time. It also includes the starting value of the shares as well as the other conditions like the vesting schedule, the payment events, etc.

Upon fulfilment of the conditions laid down in the agreement, the employees become eligible to exchange their units of Phantom Stock for cash payment / actual shares. However, cash settlement is more prevalent for this instrument. The amount of the cash settlement is dependent on:

• the number of vested units they hold,
• the value of the units at the time of payment, and
• whether the plan was for the full value of their units or strictly the appreciation in the value from the date of grant.

Accounting

For accounting purposes, phantom stock is treated in the same way as deferred cash compensation. As the amount of the liability changes each year, an entry is made for the amount accrued. A decline in value would reduce the liability. These entries are not contingent on vesting.

The company should make provision for the cash required for the entitlement based on fair market value at the end of each financial year until the exercise of the Phantom Stock Options.

Taxability

The income received by an employee, in the form of cash entitlement at the time of the exercise of Phantom Stock Options, should be chargeable to tax under the head ‘Salaries’ in the hands of the employee. For people, other than employees who receive cash at the time of exercise of Phantom Stock Options, the amount received should be chargeable to tax under the head ‘Income from Other Sources’. However, this may vary if contractually some other nature of payment is agreed.

No incidence of tax arises in hands of the company at the time of making payment of the cash entitlement to the employee. However, the company should factor the withholding tax implications, if applicable, on the payment made.

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