The Executive Remuneration Review: India

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I INTRODUCTION

The terms of employment and remuneration of a large section of the Indian workforce are governed by statutory employment laws. However, in most cases, senior executives are exempt from the applicability of such employment laws and their terms of employment and remuneration are ordinarily contractually driven. That said, based on the position in which the senior executive is engaged, certain corporate and securities laws considerations are triggered.

India revamped its law regulating companies in 2013 and the terms with respect to executive remuneration were also closely reviewed as part of this exercise. The objectives of ensuring transparency and parity in executive remuneration, however, have always been discussed while keeping in mind the need to pay senior executives as per market standards to attract the right talent. In this regard, Dr Jamshed J Irani’s Report on Company Law dated 31 May 2005 highlighted the need for companies to adopt remuneration policies to attract, retain and motivate executives to enhance the performance of the company and that the decision on how to remunerate executives should be left up to the company. This report further stated that this decision should be transparent and based on principles that ensure fairness, reasonableness and accountability.

Executive remuneration (i.e., the remuneration of managing directors, key managerial persons, and managers) is governed by the Companies Act, 2013, and the Security and Exchange Board of India. The remuneration of senior executives is typically a combination of fixed salary, incentives linked to individual and organisational performance, and stock linked incentives. Recent instances of financial and other impropriety by senior executives have resulted in significantly impacting companies, their reputation, and valuation. Organisations have now started evaluating compensation structures and reviewing terms of executive employment more closely. Consequently, more robust covenants are being included in employment documents to detail responsibilities, build in the required checks and balances, and highlight consequences of breach, such as including clauses to claw back bonuses and other discretionary payments.

This article seeks to highlight certain key issues that companies should keep in mind when structuring executive compensation.

II TAXATION

i Income tax for employees

Income tax in India is levied by the Income Tax Act, 1961 (ITA), which follows a scheduler approach to taxation of income. Residents are taxed on global income while non-residents are taxed on Indian-source income. Residency is based on a day count test. An intermediate category of Resident but not Ordinarily Resident (RNoR) is available for transitory persons, who are taxable only on Indian source income in spite of satisfying the residency test in a given year. Further, a globally resident Indian citizen may be deemed to be resident in India and taxable on Indian source income if such person is not liable to be taxed in any other country. Citizenship, with some exceptions, is generally not relevant to the determination of tax liability.

Whether income is considered to be of Indian source would depend on the nature of income and whether it satisfies the relevant source ruling under the ITA. For example, capital gains is considered to have its source in India if it derives from the transfer of a capital asset situated in India whereas employment income is taxable if the employment is rendered in India, although this requirement maybe subject to minimum periods of stay in India under a relevant tax treaty. The rule for the business income of consultants and contractors would depend on whether they are considered to be providing technical services. If not, business income would only be considered to have an Indian source if there exists a business connection in India (under the provisions of the ITA), or a permanent establishment or fixed base in India (under a relevant tax treaty).

The maximum marginal tax rate applicable to the ‘total income’ (including salary income) of individuals is 30 per cent. Individuals may be subject to a surcharge ranging from 10 per cent–37 per cent, which would result in an effective maximum rate of 42.74 per cent in the highest band. All taxpayers including individuals are subject to a ‘cess’ (tax or levy) of 4 per cent over tax and surcharge. Capital gains are not subject to ordinary or progressive slab rates of income tax. Capital gains tax is levied at a flat rate which may vary from zero per cent to 40 per cent, depending on the residence and type of the tax payer, type of capital asset, mode of transfer and the holding period of the asset.

Compensatory payments maybe taxable either as employment income, if in consideration for a relationship of employment, or profits and gains of business and profession, if in consideration of a consultancy or contractorship. A third possibility is capital gains income, if the payment is structured as being due on redemption of a security held by an individual. Typically, one of the objectives of equity incentive structuring will be to try to accomplish capital gains treatment to the extent possible, as the rates are frequently lower. Salary income is taxable at the earlier of receipt or accrual whereas profits and gains from business are taxable on an accrual or cash basis, depending on the nature of taxpayer and system of accounting adopted. Capital gains, on the other hand, are taxable in the year of transfer of shares, irrespective of when the consideration is received. This may create characterisation difficulties in relation to deferred income such as earnout payments which are paid over a period of time.

Equity incentives are frequently used in the Indian context, primarily comprising of employee stock options (ESOPs) or sweat equity. ESOPs are not taxable upon grant or vesting. They are taxable upon exercise, at ordinary income tax rates, on the spread between exercise price and the fair market value of the share issued upon exercise. Employees receive a step up in basis (cost of acquisition) of the share and are required to pay a capital gains tax on disposition of the share, on the difference between the stepped up cost of acquisition and the sale price of the share. The tax consequences on delivery of shares would be similar to those described above, notwithstanding that they maybe subject to forfeiture at some point in the future, say upon termination of employment. This means that, if a share is issued to an employee at lower than fair market value, he would be taxable on the difference between price paid and the fair market value of the share, at ordinary rates applicable to salary income. When the share is subsequently forfeited, presumably for nil value or a very low value, the employee may claim a capital loss on the difference between fair market value (on the date of issuance) and price received.

ii Social security benefits

The Employees’ Provident Funds and Miscellaneous Provisions Act, 1952 (EPF Act) is the primary social security legislation in India. This statute is applicable to employers having 20 or more employees and requires the employer and employee to make contributions to a statutory retirement fund at the rate of 12 per cent of the basic wages, dearness allowance and retaining allowance, capped at 15,000 rupees. Only employees who are earning less than 15,000 rupees per month or who are already existing members of the statutory fund are mandatorily to be covered under the fund.

In this regard, courts have held that the term ‘basic wages’ would include all components of wages that are universally paid, across the board to all employees. Therefore, any ad hoc payments that may be specifically paid to certain employees would be exempt for the purposes of contributions to the provident fund.

Additionally, the EPF Act was amended in 2008 to bring within its purview ‘international workers’. An international worker, for the purpose of the statute, means (1) an Indian employee having worked or going to work in a foreign country with which India has entered into a social security agreement and being eligible to avail the benefits under a social security programme of that country, by virtue of the eligibility gained or going to gain under the said agreement; or (2) an employee other than an Indian employee, holding other than an Indian passport, working for an establishment in India to which the EPF Act applies. Note that the wage ceiling of 15,000 rupees mentioned above for computing contributions under the EPF Act is not applicable to international workers.

In addition to the EPF Act, various states in India have enacted state specific labour welfare fund statutes that require employers and employees to make periodic contributions to a state labour welfare fund. Further, India also provides for a statutory end of service entitlement under the Payment of Gratuity Act, 1972 (the Gratuity Act). This statute prescribes compulsory gratuity payable by establishments where 10 or more persons are employed or were employed on any day of the preceding 12 months. The Gratuity Act entitles every employee who has completed five years of continuous service (taken as four years and 240 days for those having a six day work week and four years and 190 days for those having a five day working week), upon termination of employment, to gratuity calculated at the rate of 15 days’ wages, based on the rate of wages last drawn, for each year of completed service or part thereof in excess of six months, currently subject to a maximum of 2 million rupees).

iii Tax deductibility for employers

Remuneration paid to employees is generally deductible. This includes bonuses and commissions, approved payments (within certain limits) towards gratuity, pensions, a recognised provident fund or superannuation fund. Some exceptions where deductions are not allowed are: if a salary is paid by an Indian employer to a non-resident outside India, without tax being deducted, or if a non-monetary perquisite is provided by the employer, in which case the employer is liable to pay the tax, with the said perquisite being exempt in the hands of the employee. Employers can claim the deduction on an accrual basis if they follow the mercantile system of accounting (which companies are required to do) or on payment basis if they follow the cash system of accounting, which is an option available to certain employers such as sole proprietorships. However, even employers who follow the mercantile system may be required to claim certain deductions on an actual payment basis, with examples being contribution to a provident fund or super annuation fund or sums payable in lieu of leave not taken by the employee. These deductions are subject to the employer complying with their withholding tax obligations on payments to employees.

iv Other special rules

There are no specific rules applicable to employees in connection with a change in control. However, where employees hold shares in an entity which undergoes a merger or demerger, and receive shares in a new entity in exchange for such shareholding, it should not result in tax consequences for the employees, provided that the restructuring is a tax qualifying merger or demerger under the ITA and relevant conditions are satisfied.

Payments towards enhanced health, life insurance or similar benefits are deductible when made by employees, and maybe deductible (in some circumstances) in the hands of the employer, when made by the employer.

III TAX PLANNING AND OTHER CONSIDERATIONS

Structuring options such as personal service corporations are not common in the Indian context, primarily because India follows the classical system of corporate taxation. This means that the tax rate applicable to individuals (at a maximum rate of 42.7 per cent under current law) would be more favourable than the tax rate applicable to distributions made by a corporation (with the corporation paying tax at 25 per cent plus surcharge and cess and the shareholder paying tax at applicable personal tax rates on any dividends received). Other forms of intermediate holding entity may also result in tax inefficiencies. Personal holding companies are setup in some situations, for example by fund managers who are expected to receive a carried interest from an offshore fund, although these structures are becoming less common with the recent introduction of the Indian general anti-avoidance rule.

Trusts are commonly used in the Indian planning context, to provide an economic right to the employee without a title to the underlying equity. This is particularly the case where large numbers of employees are sought to be compensated. These trusts are generally set up as determinate irrevocable trusts, which are considered tax transparent in India. Having said this, it is important to be mindful of tax consequences while setting up a trust structure for equity incentives, as tax can be levied at various stages, such as upon the trust if it is settled for the benefit of non-relatives and receives shares at lower than fair market value.

Globally resident employees do also frequently consider secondment arrangements when they take up employment in India as it enables them to receive their salary payment outside India, subject to the payment of tax dues in India. In comparison, under Indian exchange control provisions, Indian resident employees are required to repatriate to India any foreign exchange dues that maybe payable to them, with certain exceptions.

It is relevant to examine the provisions of the applicable tax treaty while evaluating tax consequences for a globally resident employee, as these will frequently provide for minimum thresholds of physical stay in India prior to the salary income being taxable in India. Provisions pertaining to taxation of dependent personal services in several treaties require a minimum period of stay of 183 days in India, in order for salary income to be taxable in India, as well as separate provisions relating to allocation of taxing rights over pensions and annuity. India has a large network of treaties, which tend to be broadly based on the OECD model treaty.

IV EMPLOYMENT LAW

The terms of employment with senior executives are largely governed by contract and therefore it is very important that the employment agreements be detailed with robust confidentiality, intellectual property assignment, termination rights and other relevant restrictive covenants. We have highlighted key areas in this regard below:

i Non-compete covenants

Section 27 of the Indian Contract Act, 1872 (Contract Act) provides that any agreement that restrains a person from exercising a lawful profession, trade or business is void to the extent of such restriction.2 The only exception under Section 27 of the Contract Act is with respect to restrictions on carrying on business of which goodwill is sold. This exception is however subject to the restriction being reasonable with respect to (1) the nature of business that the individual is restrained from engaging in; (2) territorial restrictions; and (3) period of restriction. Since contracts in restraint of trade are prima facie void, the onus is on the party supporting the contract to show that the restraint falls within the exception and is reasonable.

Post employment non-competition covenants have consistently been held to be unenforceable in India. While courts have held non-competition covenants during the term of employment to be enforceable, those applicable post-employment are consistently considered void.3 However, post employment non-competition covenants are commonly included to deter employees from engaging with competition.

Given that post employment non-competition obligations are unenforceable, employers rely on confidentiality obligations to protect their intellectual property and proprietary information. In this regard, of the restrictive covenants that are imposed on employees, courts in India are typically most inclined to uphold and enforce restrictive covenants in relation to non-disclosure of confidential information. There is no fixed standard of what information constitutes ‘confidential information’ and the same could vary based on factors including the industry of the employer.

ii Garden leave

As post-employment, non-competition covenants have been held to be unenforceable in India, employers typically resort to including the right to require employees to proceed on garden leave while they are serving out their notice period; typically, the notice period included the employment agreements for executives are longer than the notice periods contained in regular employee agreements. Garden leave is a process by which employees are indirectly restrained from joining competitors by paying money to the employees for the garden leave period.

iii Non-solicitation covenants:

In an employer-employee relationship, non-solicitation agreements are generally understood to refer to contracts whereby an employee is restricted from soliciting the employer’s clients, customers, vendors or employees for a pre-determined duration after termination of the employment. While it is an established position of law in India that restrictive covenants seeking to operate post termination of employment are void, courts in India have, on a case to case basis, upheld the validity of non-solicitation agreements even after conclusion of the employment.

The position under Indian law in relation to the enforceability of non-solicitation restrictions is that courts typically would not grant a specific injunction to enforce a non-solicitation covenant and would be more inclined to grant damages. That said, practically allegations of breach of non-solicit clauses are difficult to establish in a court of law.

iv Termination of employment

To carry out termination of employment, an employer would need to adhere to the specific requirements in relation to termination of employment under the Industrial Disputes Act, 1947 (ID Act), State specific legislations applicable to commercial establishments (S&E Acts), and the terms of employment contained in the employment documentation and company policies.

Requirements under ID Act

The ID Act is only applicable to employees categorised as ‘workmen’ – that is, a person employed in any industry to do any manual, unskilled, skilled, technical, operational, clerical or supervisory work for hire or reward. This definition excludes persons employed mainly in a managerial or administrative capacity and those persons who are employed in a supervisory capacity drawing monthly wages in excess of 10,000 rupees. Senior executives would ordinarily not fall within the purview of the ID Act. With respect to employees who are not ‘workmen’ (which would include executives), termination of their employment will need to be as per the S&E Act (if applicable) and the contractual terms of employment.

Requirements under S&E Acts

S&E Acts typically require that employment of employees who have been in employment for a certain period are terminated for ‘reasonable cause’ and with prior notice of one month or pay in lieu. However, these requirements could vary based on the state in which the establishment is located.

Requirements per the terms of employment

The employer would also be required to adhere to the terms of employment as contained in employment contracts and the organisation’s policies. In the event that the terms of employment are more beneficial to employees (such as a longer notice periods, higher severance, etc.) than those offered under statute, the more beneficial terms would need to be provided.

Having said the above, given that executives are largely exempt from statutory employment law protections for wrongful termination, it is essential to clearly document the terms of employment, minimum commitment in terms of duration of employment, termination of employment (for cause and otherwise) and consequences of termination.

There are no specific limits on severance remuneration that is payable to executives from an employment law perspective. Additionally, executives will also be eligible to payment of gratuity and leave encashment, in addition to other contractual severance payments.

v Change of control

The implications of change in control do not apply to executives, unless contractually determined. In this regard, rules in relation to the termination of employment in connection with a change in control depends on the category of employee and the manner in which the change in control has occurred. In this regard, please note the following:

a. Transfer of ‘workment’ pursuant to transfer of an ‘undertaking’: The ID Act prescribes the process of transfer of workmen in case of the transfer of ownership/management of an ‘undertaking’. Where there is a transfer of ownership or management of an undertaking from one employer to a new employer, every ‘workman’ who has been in continuous service for not less than one year (240 days) is deemed to be retrenched (terminated), unless the following conditions are fulfilled:

> the workmen are being transferred under terms and conditions that are not less favourable than the terms and conditions of service immediately before the transfer;
> the employment is not being interrupted by the transfer;
> the transferee, under the terms of transfer or otherwise, is legally liable to pay the workmen, in the event of termination of his or her service, compensation on the basis that their service had been continuous and not affected by the transfer; and
> the workmen consent to their transfer.

If all of the conditions in (a) mentioned are not met, then the workmen who have been in continuous service for one year (240 days) or more shall be deemed to have been retrenched and be entitled to the following from the transferor entity: (1) one month’s notice or wages in lieu thereof; and (2) retrenchment compensation calculated at the rate of 15 days’ ‘average pay’ for every year of continuous service or part thereof in excess of six months.

b. Transfer of non-workmen or for transfers not pursuant to a transfer of undertaking: For non-workmen or where the transfer is not pursuant to a transfer of undertaking, the mode of transfer of employment is via contractual agreement between the transferor entity, employee and transferee entity. The transfer documentation should capture (1) cessation of employment with the transferor and settlement of dues; (2) commencement of employment with the transferee entity and terms of employment; and (3) consent of the employees to transfer to the transferee entity. Typically, such transfers are on terms that are not less favourable applicable immediately before the transfer and employees are generally provided with continuity in service. In the event that their employment is to be terminated, the employer would be required to adhere to the process prescribed under their employment agreement and the S&E Acts (if applicable).

vi Reason for termination and constructive dismissal

Employment law statutes largely permit for termination of non workmen with notice or payment in lieu of notice in cases of termination simpliciter. Employers can terminate employment without notice or payment in lieu of notice in case the termination is on grounds of misconduct. However, it is required that the employers adhere to the principles of natural justice when determining whether there has been misconduct. The law regarding constructive termination is yet to develop in India and currently this concept is not applicable under Indian law.

vii Unions and collective bargaining agreements

All categories of employees (including executives) are permitted to unionise in India. That said, executives generally tend not to unionise or to collectively bargain.

V SECURITIES LAW

i Stock-based employee benefits

Stock-based employee benefits in India are often structured in the form of stock options, restricted stock units, stock appreciation rights, or a hybrid of such forms. Issuance of such stock-based benefits is governed by the Companies Act, 2013 (Companies Act) and the regulations promulgated by the Securities and Exchange Board of India (SEBI), as applicable.

For companies other than listed companies, issuance of employees’ stock options (ESOPs) is governed by the Companies Act and the Companies (Share Capital and Debentures) Rules, 2014 (SCD Rules). The Companies Act defines an ESOP to mean an option given to the directors, officers or employees of a company or of its holding company or subsidiary company or companies, if any, giving such persons the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a predetermined price.

Unlisted companies: With respect to unlisted companies, the Companies Act and the SCD Rules prescribe, inter alia, the following conditionalities in respect of the issuance of ESOPs:

Eligibility
The following persons are eligible for the receipt of ESOPs:

a permanent employee of the company who has been working in India or outside India;
a director of the company, whether a whole time director or not but excluding an independent director; or
an employee as under clauses (a) or (b) above of a subsidiary, in India or outside India, or of a holding company of the company.

Companies are not permitted to grant stock options to an employee who is a promoter or a person belonging to the promoter group; or a director who either him or herself or through his or her relative or through any body corporate, directly or indirectly, holds more than 10 per cent of the outstanding equity shares of the company.

These restrictions are not applicable in respect of a ‘start-up company’, for a period of 10 years from the date of its incorporation or registration.

Minimum vesting period
There must be a minimum period of one year between the grant of the ESOPs and the vesting of such ESOPs.

Approvals
Issuance of ESOPs is subject to receipt of shareholders’ approval by a special resolution – that is, the votes cast in favour of the resolution are not to be less than three times the number of votes cast against the resolution. Further, while a company may undertake to vary the terms of any ESOPs not yet exercised by a special resolution, such variation must not prejudicial to the interests of the option holders.

Miscellaneous
Employees do not have right to receive any dividend or to vote or in any manner enjoy the benefits of a shareholder in respect of ESOPs granted to them, till such time that shares are issued on exercise of the ESOPs. A company has the freedom to specify any lock-in period for the shares issued pursuant to exercise of the ESOPs, and is to determine the exercise price in conformity with applicable accounting policies, if any.

Listed companies
For listed companies, the Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014 (SBEB Regulations) govern employee stock option schemes, employee stock purchase schemes, stock appreciation rights schemes, general employee benefits schemes, and retirement benefit schemes. The SBEB Regulations prescribe, inter alia, the following conditionalities in respect of the issuance of ESOPs:

Eligibility
The eligibility critiera and exclusions with respect to stock linked incentives under the SBEB Regulations are the same as under the SCD Rules. The SBEB Regulations additionally state that an employee will be eligible to participate in the company as determined by the compensation committee of the company.

Minimum vesting period
A minimum vesting period of one year is prescribed in respect of options granted under an employee stock option scheme or a stock appreciation right scheme.

Approvals
As with a private company, no scheme may be offered to employees in the absence of approval accorded by the shareholders by way of special resolution. Further, a company may not vary the terms of any scheme (including of a scheme offered but not yet exercised) in any manner which may be detrimental to the interests of the employees.

Miscellaneous
In case of a new issuance of shares under any scheme, such newly issued shares are to be listed immediately in any recognised stock exchange where the existing shares are listed, subject to:

> compliance with the other stipulations of the SBEB Regulations;
> filing of a statement with SEBI in such regard, and receipt of an in-principle approval from the stock exchanges; and
> notification to the stock exchanges as per the statement specified by SEBI as and when an exercise is made.

ii Sweat equity

For companies other than listed companies, the SCD Rules govern the grant of sweat equity by the company to its executives. Sweat equity means equity shares issued by a company to its directors or employees at a discount or for consideration other than cash, for providing their know-how or making available rights in the nature of intellectual property rights or value additions. The SCD Rules, inter alia, prescribe the following conditionalities for issuance of sweat equity shares:

Eligibility
Permanent employees and directors (whether whole time or not) of a company, its subsidiary in India or outside India, its holding company are eligible to be issued sweat equity in a company.

Approvals
Issuance of sweat equity is subject to receipt of shareholders’ approval in a general meeting by way of passage of a special resolution.

Miscellaneous
Subject to exemption afforded to start-ups, a company may not issue sweat equity shares for more than 15 per cent of its existing paid-up equity share capital in a year or shares of the issue value of 50 million rupees, whichever is higher;

> The issuance of sweat equity shares in a company may not exceed 25 per cent of the paid-up equity capital of the company at any time;
> The sweat equity issued to directors or employees is locked-in/non-transferable for a period of three years from the date of allotment; and
> The sweat equity shares are to be issued at a price determined by a registered valuer and justified under a valuation report addressed to the board of directors, with the gist and critical elements of the valuation report required to be shared with the shareholders at the general meeting convened for obtaining their approval.

For a listed company, the SEBI (Issue of Sweat Equity) Regulations, 2002 (the Sweat Equity Regulations) govern grant of sweat equity to employees, directors and promoters.

An issuance of sweat equity under the Sweat Equity Regulations requires approval of the shareholders by way of special resolution. Further, the pricing of the sweat equity shares must adhere to the floor price and valuation norms as specified under the Sweat Equity Regulations.

The company is also required to submit a statement to the stock exchanges within the prescribed time period, providing requisite details of the issuance including the number of sweat equity shares, pricing, total amount invested, details of the persons participating in the issuance, and consequent changes in the capital structure after and before the issuance of sweat equity.

iii Sale of company stock and short-swing trading

The sale of a company’s stock by its executives must adhere to the trading norms under the concerned SEBI regulations, as applicable. These trading norms may be further supplemented by a company via its articles of association to include further stipulations in relation to the sale of company stock by executives.

For listed or proposed-to-be listed entities, the Securities And Exchange Board Of India (Prohibition Of Insider Trading) Regulations, 2015 (Inside Trading Regulations) place various restrictions on ‘insiders’, such as a prohibition on communication of any unpublished price sensitive information and trading in securities that are listed or proposed to be listed on a stock exchange when in possession of unpublished price sensitive information. An ‘insider’ in the context of the Insider Trading Regulations is any ‘connected person’ and any person in possession or having access to unpublished price sensitive information. A connected person includes any person who is or has during the six months prior to the concerned act been associated with a company, directly or indirectly, in any capacity (including as a director, officer or an employee of the company or holding any position including a professional or business relationship with the company) that allows or can reasonably be expected to allow such person, directly or indirectly, access to unpublished price sensitive information.

While short-swing trading rules are not formally crystallised under the Insider Trading Regulations, an insider is permitted to formulate a trading plan and present it to the compliance officer for approval and public disclosure, pursuant to which trades may be carried out on his behalf in accordance with such plan. Such trading plan may establish the mechanics of permitted trades, a violation of which would be addressed as a violation of the Insider Trading Regulations and is punishable as such. Trading under the trading plan cannot commence on behalf of the insider earlier than six months from the public disclosure of the plan, and further, such trading plan must:

> not entail trading for the period between the twentieth trading day prior to the last day of any financial period for which results are required to be announced by the issuer of the securities and the second trading day after the disclosure of such financial results;entail trading for a period of not less than 12 months;
> not entail overlap of any period for which another trading plan is already in existence;
> set out either the value of trades to be effected or the number of securities to be traded along with the nature of the trade and the intervals at, or dates on which, such trades shall be effected; and
> not entail trading in securities for market abuse.

iv Anti-hedging rules

The Reserve Bank of India has issued the Guidelines on Compensation of Whole Time Directors/Chief Executive Officers/Material Risk Takers and Control (RBI Guidelines), applicable to private sector banks including local area banks, small finance banks and payments banks.

Per the RBI Regulations, banks are not to permit employees to insure or hedge their compensation structure to offset the risk alignment effects embedded in their compensation arrangement. The RBI Guidelines call upon the banks to enforce the same by establishing appropriate compliance arrangements.

VI DISCLOSURE

i Disclosure of remuneration information

The Companies Act requires every company is required to file an annual return with the Registrar of Companies, disclosing details of the remuneration of its directors and key managerial personnel, including gross salary, commission, and stock option/sweat equity.

Additionally, every listed company is to disclose particulars of remuneration of its directors in the report of its board of directors, detailing the following:

> the ratio of the remuneration of each director to the median remuneration of > the employees of the company for the financial year;
> the percentage increase in remuneration of each director, chief financial officer, chief executive officer, company secretary or manager, if any, in the financial year;
> the percentage increase in the median remuneration of employees in the financial year;
> the number of permanent employees on the rolls of company; and
affirmation that the remuneration is as per the remuneration policy of the company.

ii Perquisites

Perquisites are defined to include the following under the Companies Act as read with the Income-tax Act, 1961 (the Income Tax Act) subject to prescribed thresholds (materiality or otherwise), qualifications, and exceptions:

> the value of rent-free accommodation provided by an employer and the value of any concession in the matter of rent respecting any accommodation provided by an employer;
> the value of any benefit or amenity granted or provided free of cost or at concessional rate in specified cases including by a company to an employee who is a director thereof, and by a company to an employee being a person who has substantial interest in the company;
> any sum paid by an employer in respect of any obligation which, but for such payment, would have been payable by the concerned person;
> any sum payable by an employer to effect an assurance on the life of the assessee or to effect a contract for an annuity;
> the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or a former employer, free of cost or at concessional rate;
> the amount of any contribution and accretions to specified superannuation fund or provident fun by the employer in respect of the assessee; and
> the value of any other fringe benefit or amenity as may be prescribed.

The Income Tax Act and allied rules prescribes valuation norms for various classes of perquisites, with perquisites accordingly required to be valued in monetary terms and taxed as part of the employee’s salary income.

iii Disclosures for related party agreements

A related party is defined under the Companies Act to include a director or his or her relative, in addition to a key managerial personnel or his or her relative. Every contract or arrangement with a related party is required to be referred to in the report of the board of directors to its shareholders, along with the justification for entering into such contract or arrangement.

A related party’s appointment to any office or place of profit in a company, subsidiary company, or associate company is required to be undertaken only with the consent of the board of directors, or by way of passage of a resolution by the company’s shareholders where the appointment to such office or place of profit entails a monthly remuneration exceeding 250,000 rupees.

In this context, an ‘office or place of profit’ includes:

when held by a director, any office or place, by virtue of which the director receives from the company anything by way of remuneration over and above the remuneration to which he or she is entitled as director, by way of salary, fee, commission, perquisites, any rent-free accommodation, or otherwise; and
when held by an individual other than a director, any office or place, by virtue of which such individual receives from the company anything by way of remuneration, salary, fee, commission, perquisites, any rent-free accommodation, or otherwise.

VII CORPORATE GOVERNANCE

The Companies Act 2013 defines ‘remuneration’ as any money or its equivalent given or passed to any person for services rendered by him and includes perquisites. All companies (whether private, public, or listed) are subject to corporate governance norms applicable to executive remuneration as explored below.

i Nomination and remuneration committee

Every listed public company, and every company fulfilling the following-listed criteria, is required to constitute a Nomination and Remuneration Committee (NRC):

> public companies having paid up share capital of 100 million rupees;
> public companies having turnover of 1 billion rupees; and
> public companies which have, in aggregate, outstanding loans, debentures and deposits, exceeding 500 million rupees.

The NRC must consist of three or more non-executive directors out of which not less than one-half are to be independent directors. Further, the chairperson of the company (whether executive or non-executive) may be appointed as a member of the NRC but may not chair the NRC.

The NRC is to recommend to the board of directors a policy relating to the remuneration of the directors, key managerial personnel, and other employees. The NRC is further tasked with certain obligations including ensuring that:

> the level and composition of remuneration is reasonable and sufficient to attract, retain and motivate directors of the quality required to run the company successfully;
> the relationship of remuneration to performance is clear and meets appropriate performance benchmarks; and
> the remuneration to directors, key managerial personnel and senior management involves a balance between fixed and incentive pay reflecting short and long-term performance objectives appropriate to the working of the company and its goals.

ii Ceiling on remuneration

The Companies Act prescribes limits on the remuneration payable by a public company to its directors, prescribing that the total managerial remuneration payable by a public company to its directors, including its managing director and whole time director, and its manager in any financial year shall not exceed 11 per cent of the net profits of that company.

Additionally, in respect of a managing director, whole time director, manager, the total remuneration payable to any one such person is to not exceed 5 per cent of the net profits of the company, and if there is more than one such person, the remuneration to all such persons is to not exceed 10 per cent of the net profits.

In respect of directors that are neither a managing director nor a whole time director, the remuneration to all such directors must not exceed 1 per cent of the net profits of the company if there is a managing director or whole time director or manager, and should not exceed 3 per cent in any other case.

Further, in any financial year, in the event that the concerned company has no profits or if its profits are inadequate, the Companies Act prescribes limits to the yearly remuneration that are pegged to the effective capital of a company.

The Companies Act further provides that in respect of cases where a company has inadequate or no profits, the company may fix the remuneration within the limits specified under the Companies Act, at such amount or percentage of profits of the company, as it may deem fit and while fixing the remuneration, the company is to have regard to criteria including:

> financial position of the company (including its financial and operating performance over the three preceding financial years);
> the remuneration or commission drawn by the individual concerned in any other capacity or from any other company;
> securities held by the director, including options and details of the shares pledged as at the end of the preceding financial year;
> performance of the director and proportionality of remuneration; and
> professional qualifications and experience of the individual concerned.

The above-stated limits are exclusive of sitting fees paid to the directors that are separately capped at 100,000 rupees per meeting of the board of directors or committee thereof.

Further, subject to the prescribed procedure under the Companies Act, a public company may elect to increase the above-stated thresholds for remuneration by way of passage of a special resolution in its general meeting.

In addition, as per the SEBI (Listing Obligations and Disclosure Requirements), 2015 (the LODR Regulations) applicable to listed companies, approval of shareholders by special resolution shall be obtained every year, in which the annual remuneration payable to a single non-executive director exceeds 50 per cent of the total annual remuneration payable to all non-executive directors, giving details of the remuneration thereof.

The LODR Regulations also provide that fees or compensation payable to executive directors who are promoters or members of the promoter group shall be subject to the approval of the shareholders by special resolution if the annual remuneration payable to such executive director exceeds 50 million rupees or 2.5 per cent of the net profits of the listed entity, whichever is higher; or where there is more than one such director, the aggregate annual remuneration to such directors exceeds 5 per cent of the net profits of the listed entity.

iii Corporate governance for foreign companies

Where not less than 50 per cent of the paid-up share capital of a foreign company is held by one or more citizens of India or by one or more companies or bodies corporate incorporated in India, whether singly or in the aggregate, such company is to comply with the provisions of the Companies Act made applicable to it in India as if it were a company incorporated in India.

Every foreign company (i.e., a company or body corporate incorporated outside India which has a place of business in India whether by itself or through an agent, physically or through electronic mode, and conducts any business activity in India in any other manner), is required to submit a profit and loss account and balance sheet containing the prescribed particulars to the Registrar of Companies. To the extent that these relate and are pertinent to the executives of a company (such as related party transactions involving the executives of the company including advances due by directors or other officers of the company or any of them either severally or jointly with any other persons, or amounts due by firms or private companies respectively in which any director is a partner or a director or a member), the relevant disclosures are required to be made in the prescribed form to the Registrar of Companies.

iv Clawback/recoupment of remuneration

The Companies Act contemplates the recovery of remuneration from certain specified executive personnel in the event of fraud or non-compliance.

In the event that a company is required to restate its financial statements because of fraud or non-compliance, such company is to recover from any past or present managing director or whole-time director or manager or chief executive officer (by whatever name called) who, during the period for which the financial statements are required to be restated, received remuneration (including any stock options) in excess of what would have been payable to him as per restatement of financial statements.

The Companies Act also contemplates the procurement of insurance coverage by a company on behalf of its managing director, whole-time director, manager, chief executive officer, chief financial officer or company secretary towards indemnifying them against any liability in relation to the company. The premium paid in relation to such insurance is not treated as part of the remuneration payable to any such personnel. However, in the event that the concerned executive is proved to be guilty, premium paid toward such insurances is treated as part of the remuneration.

Further, under the labour laws pertaining to payment of gratuity, in the event that employees eligible for receipt of gratuity are terminated from employment on account of any acts, wilful omission or negligence that causes substantial damages to the company, such employees can be required to forfeit their gratuity entitlement to recoup the losses of the company.

v Shareholders approvals and executive remuneration

In respect of the limits on executive remuneration prescribed under the Companies Act for a public company (as detailed above), the shareholders of a company may elect to increase such limits by way of passage of a special resolution.

In respect of stock-based executive remuneration, the issuance of any sweat equity shares or other form of stock-based benefit by a company requires the approval of the company’s shareholders by way of passage of a special resolution. Shareholders further enjoy information rights in relation to such proposed issuances.

Further, the articles of association of a company may provide additional rights to a company’s shareholders in respect of oversight or control over managerial and executive remuneration.

vii Government approval of executive remuneration

While the earlier regulatory regime required approval of the central government for payment of managerial remuneration beyond the limits specified under the Companies Act, such approval is no longer required and a company may undertake to pay its executives beyond the specified thresholds upon receipt of the prescribed shareholders’ approvals.

viii Proxy advisory firms

Proxy firms supplement statutory corporate governance norms in India, and advise on a range of issues including appointment and remuneration of key executives.

Proxy firms are regulated by the Securities and Exchange Board of India, which prescribes disclosure standards and other norms to ensure transparency and prevent any conflict of interest in relation to the activities undertaken by proxy firms.

IX EXECUTIVE REMUNERATION IN BANKS

Executive remuneration in banks is regulated by a special regime as prescribed by the RBI under the Banking Regulation Act 1949. In this context, the RBI has, in November 2019, issued Guidelines on Compensation of Whole Time Directors/Chief Executive Officers/Other Risk Takers and Control Function Staff keeping in mind international best practices, with a view to providing sound compensation practices. The Guidelines have been made applicable with effect from 1 April 2020. They rely on the principles issued by the Financial Stability Board in 2009 with the objective of ensuring effective governance of compensation, alignment of compensation with prudent risk-taking and effective supervisory oversight and stakeholder engagement in compensation. As per the Guidelines, private banks are, inter alia, required to:

> formulate and adopt a comprehensive compensation policy covering all their employees and conduct an annual review of the same. The policy should cover all aspects of the compensation structure such as fixed pay, perquisites, performance bonus, guaranteed bonus (joining/sign-on bonus), severance package, share-linked benefits;
> constitute a Nomination and Remuneration Committee of the board to oversee the framing, review and implementation of compensation policy of the bank on behalf of the board. This committee should work in close coordination with Risk Management Committee of the bank, to achieve effective alignment between compensation and risks;
> ensure that for the whole time directors (WTDs)/chief executive officers (CEOs)/material risk takers (MRTs):compensation is adjusted for all types of risks;
> compensation outcomes are symmetric with risk outcomes,
> compensation payouts are sensitive to the time horizon of the risks, and
the mix of cash, equity and other forms of compensation are consistent with risk alignment;
> ensure that the fixed portion of compensation is reasonable, taking into account all relevant factors including adherence to statutory requirements and industry practice;
> ensure a proper balance between the cash and share-linked components in the variable pay and ensure that the limits on variable pay as prescribed under the guidelines are adhered to;
> have deferred compensation subject to malus/claw-back arrangements in the event of subdued or negative financial performance;
> not permit employees to insure or hedge their compensation structure to offset the risk alignment effects embedded in their compensation arrangement;
> members of staff engaged in financial and risk control, including internal audit, should be compensated in a manner that is independent of the business areas they oversee; and
> make disclosure on remuneration of WTDs/CEOs/MRTs on an annual basis at the minimum, in their annual financial statements.

X DEVELOPMENTS AND CONCLUSIONS

The current economic climate has brought the topic of corporate governance to the forefront with shareholders wanting to ensure that their companies are effectively managed. Consequently, corporate governance is becoming more critical not only from a compliance perspective but also from a value and reputation perspective.

Additionally, the Code on Wages, 2019 received Presidential Assent on 8 August 2019 and has been published in the gazette but the same has not yet been brought into effect. The Wage Code seeks to consolidate and replace the Payment of Wages Act, 1936; the Minimum Wages Act, 1948; the Payment of Bonus Act, 1965; and the Equal Remuneration Act, 1976.

Authors:

Nohid Nooreyezdan, Senior Partner
Shreya Rao, Partner
Veena Gopalakrishnan, Partner
Nishanth Ravindran, Senior Associate
Pranjal Singh, Associate

Footnotes:

1. Nohid Nooreyezdan is a senior employment partner, Shreya Rao is a tax partner, Veena Gopalakrishnan is an employment partner, Pranjal Singh is an associate and Nishanth Ravindran is a senior associate at AZB & Partners.
2. Section 27 of the Contract Act – Every agreement, by which any one is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void. Exception 1 – saving of agreement not to carry on business of which goodwill is sold – one who sells the good-will of a business may agree with the buyer to refrain from carrying on a similar business, within specified local limits; so long as the buyer, or any person deriving title to the good-will from him, carries on a like business therein, provided that such limits appear to the court reasonable, regard being had to the nature of the business.
3. Niranjan Shankar Golikari v. The Century Spinning and Mfg. Co. Ltd. (AIR 1967 SC 1098).

Published In:The Law Reviews
Date: January 30, 2021