In this simple explainer on Share Warrants, Sandeep Koonaparaju breaks down what is a share warrant, how share warrants are priced and taxed, and how share warrants differ from ESOPs. Sandeep is a practicing Chartered Accountant based out of Bangalore.
Share warrants are instruments that give their holder the right to buy the stock of the issuing company at a predetermined price within a stipulated time frame. They are similar to options, the holder of a warrant has the right (but not the obligation) to purchase the shares of a company at a specified price in the future.
The erstwhile Companies Act 1956 had two sections (sec .114 and 115) that specifically dealt with share warrants. These sections defined the rules and procedures to be followed by companies while issuing share warrants. Interestingly, these two sections didn’t find a place in the new Companies Act enacted in 2013 which replaced the 1956 Act.
The new Act does not directly discuss warrants in any meaningful way. So we are left on our own to figure out the rules and procedures for issuing warrants by interpreting a few relevant sections from the Act. Listed companies are governed by SEBI regulations.
Why do companies issue warrants?
Warrants provide a way for the company to reward employees and allow them to participate in the growth of the firm. They are also a way to attract more investors. Since the price of a warrant is considerably less than the share price, investors can purchase warrants when they lack enough capital to buy an equivalent number of shares. Warrants also provide a potential source of future capital to the company. Warrant holders are not entitled to voting rights.
As an investor, if you believe in the company’s growth story you can stay invested in the company by paying a small price without any obligation to invest further if things go south.
How are warrants priced?
Share warrants, in essence, are just like options. An option pricing model like Black Scholes can be used for pricing warrants as well. SEBI regulations mandate a listed company to obtain a minimum of 25% of the total consideration upfront. In case the warrant holder decides not to exercise the warrant in future, the amount paid will be forfeited to the company. The condition of 25% upfront payment is applicable only to listed companies, for other companies it is left to the discretion of the Board of Directors.
How are share warrants taxed?
Tax implication of share warrants can be discussed under three events:
On subscription of warrants:
When a person subscribes to warrants they pay the subscription premium upfront there is no tax implication for either the company or the subscriber at this stage.
On forfeiture of subscription premium:
If the subscriber to the warrants chooses not to convert the warrants into shares by the stipulated date the company may forfeit the premium paid (forfeiture is mandatory for listed companies). In such cases the subscriber can claim the subscription amount as capital loss (short term or long term depending on the period of holding the warrants). There is no tax implication from the company’s perspective, the premium collected upfront is considered capital receipt (like proceeds from issue of shares), hence it’s not taxable.
On conversion of warrants into shares:
When the warrants are converted into shares, the difference between fair market value of the share on date of conversion and the strike price is considered as income of the subscriber and the subscriber has to pay taxes even though they do not have to sell the shares.
On sale of shares:
Once the shares are sold, after conversion, the gain/loss is taxed as capital gain/loss (long term or short term, depending on the period of holding of the shares). Cost of shares for the purpose of computing capital gains would be the fair value of shares on the date of conversion of warrants into shares.
What happens if the share price subsequently falls to zero? I’ve already paid income tax and now I just have a capital loss?
Warrants Vs ESOPs
- Both warrants and ESOPs provide options to purchase shares of the company at a pre-agreed price by a specific date.
- Unlike ESOPs, which can be issued only to employees of the company, warrants can be issued to a much wider range of people (including employees, directors etc).
- ESOPs come with certain restrictions such as:
- ESOPs cannot be issued to an employee who is either a promoter or part of the promoter group.
- They cannot be issued to a director of a company who, either directly or indirectly holds more than 10% of equity in the company.
There are no such restrictions on issuing share warrants, though listed companies are governed by SEBI regulations.
- An important distinction is that ESOPs do not require an upfront payment from employees, on the contrary SEBI regulations mandate all listed companies to pay 25% of the total consideration upfront, for warrants.
- In terms of duration, the minimum vesting period for ESOPs is 1 year. For warrants the maximum duration is 18 months (again, mandated by SEBI and applicable only to listed companies).
Other Popular Taxation Articles
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A brief guide to ESOP taxation in India
How taxation works for AIF and PMS Investors
The Basics of Capital Gains Taxes
How to set-off and carry forward losses
If you’re a Capitalmind Premium member you can continue the conversation and ask more specific questions on the #taxation channel in Slack. You can reach Sandeep on email sandeep.vvc98 [at] gmail.com
