Phantom Stock and Stock Appreciation Rights in India: Legal, Tax and Regulatory Framework for Cash-Settled Employee Incentives

Introduction

Equity-linked compensation has become an important tool for Indian startups and established businesses seeking to attract, retain and incentivise employees. Traditional Employee Stock Option Plans (“ESOPs”) can, however, involve dilution of existing shareholders, creation of an employee option pool, shareholder approvals and other corporate and securities-law compliances. As an alternative, companies may consider phantom stock or cash-settled stock appreciation rights (“SARs”). These arrangements seek to provide employees with an economic benefit linked to the value or appreciation of a company’s shares without transferring actual shares to the employee.

The distinction is important. A conventional ESOP can ultimately result in the employee becoming a shareholder. A purely cash-settled phantom stock or SAR arrangement, by contrast, generally creates a contractual entitlement to a cash payment and does not itself result in the issuance or transfer of shares.

Indian law does not presently contain a standalone statutory regime specifically governing private-company phantom stock plans. However, the legal position cannot be reduced simply to saying that such arrangements are “unregulated”. Their treatment depends on their structure and may involve contract law, company law, securities regulations, tax law, foreign exchange regulations and accounting standards.

What Is Phantom Stock?

Phantom stock, also referred to as phantom equity or phantom stock options in some arrangements, is a contractual employee incentive under which an employee receives a notional number of units linked to the value of the company’s shares.The employee does not receive actual shares. Instead, the plan specifies a future event such as completion of a vesting period, an exit, a liquidity event or another settlement date, upon which the employee becomes entitled to a cash payment calculated by reference to the notional shares. A phantom stock plan may broadly be structured in two ways:

• Full-value phantom stock: the employee receives a cash amount linked to the full value of the notional shares at settlement; or
• Appreciation-based phantom stock: the employee receives only the increase in the value of the notional shares over a specified base value.

The precise economic formula is a matter of contract and should be clearly documented in the plan. Unlike actual equity, phantom stock does not ordinarily give the employee voting rights, shareholder rights or an interest in the company’s issued share capital.

What Are Stock Appreciation Rights?

A Stock Appreciation Right (SAR) generally gives an employee an economic benefit linked to the appreciation in the value of a specified number of shares between a base or grant price and the settlement price. For example, if the base value is ₹100 per share and the relevant value at settlement is ₹175, the employee’s economic benefit may be calculated by reference to the ₹75 appreciation, multiplied by the number of SARs. The important distinction is between:

1. Equity-settled SARs, where the settlement ultimately involves shares; and
2. Cash-settled arrangements, where the employee receives only a monetary payment.

The distinction has particular significance under the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (“SEBI SBEB & SE Regulations”).

Are Phantom Stock and Cash-Settled SARs Regulated by SEBI?

This is one of the most important areas requiring careful analysis. SEBI’s FAQ on the SEBI SBEB & SE Regulations states that phantom stock options involving cash settlement and no actual purchase or sale of equity shares of a listed company are not covered by those Regulations.

The position also needs to be read with the amendments made to the SEBI SBEB & SE Regulations in December 2025. The current Regulations define “SAR” in a manner that refers to equity-settled SARs and expressly state that the term does not include a scheme which does not, directly or indirectly, involve dealing in, subscribing to or purchasing securities of the company.

Accordingly, a purely cash-settled phantom stock arrangement that does not involve an actual or indirect dealing in securities would generally fall outside the specific regulatory framework governing share-based employee benefits under the SEBI SBEB & SE Regulations.

This does not mean, however, that every cash-settled incentive linked to a listed company’s share price is automatically free from securities-law considerations. The structure, participants, settlement mechanism and other activities associated with the arrangement must be examined separately.

Companies Act, 2013: Does Section 62 Apply to Phantom Stock?

Section 62(1)(b) of the Companies Act, 2013 deals with further issue of shares to employees under an employee stock option scheme, subject to the applicable statutory requirements. The Companies (Share Capital and Debentures) Rules, 2014 prescribe additional requirements for employee stock option schemes, including requirements concerning eligibility, vesting, approvals and disclosures. A purely cash-settled phantom stock plan is structurally different from an ESOP because it does not confer an option to acquire or subscribe to shares and does not culminate in an allotment of shares.

Consequently, Section 62(1)(b) and the ESOP-specific requirements under the Companies Act would generally not govern a plan that is genuinely and exclusively cash-settled. That said, companies should avoid assuming that describing an arrangement as “phantom stock” is sufficient to determine its legal treatment. If the arrangement contains any mechanism that may result in the acquisition, transfer or settlement of securities, the analysis can change. For private companies, the plan should therefore be structured carefully so that its contractual character and cash-settlement mechanism are unambiguous.

Contractual Framework: The Importance of the Plan Document

In the absence of a dedicated statutory framework for purely cash-settled phantom equity, the plan document becomes particularly important. A well-drafted phantom stock or cash-settled SAR plan should address, among other matters:

• eligibility and grant terms;
• number of phantom units or SARs granted;
• grant or base value;
• vesting conditions;
• performance conditions, if any;
• settlement events;
• treatment upon resignation, termination or retirement;
• treatment of misconduct or termination for cause;
• treatment upon death or permanent incapacity;
• treatment upon a merger, acquisition, IPO or other change-of-control event;
• valuation methodology;
• treatment of dividends or distributions, if applicable;
• adjustment mechanisms for corporate actions;
• withholding and tax obligations;
• dispute resolution;
• payment timelines; and
• circumstances in which awards may lapse, be cancelled or be forfeited.

These provisions are particularly important for unlisted companies because there may be no readily observable market price against which the employee’s entitlement can be calculated.

Valuation of Phantom Stock in Unlisted Companies

Valuation is one of the principal practical challenges associated with phantom stock in privately held companies. For a listed company, a plan may be able to refer to an observable market price, subject to the terms of the relevant plan and applicable law. For an unlisted company, however, the plan should establish a clear and objective methodology for determining the value of the underlying shares. Possible approaches may include reference to:

• the price in a recent arm’s-length financing round;
• an independent valuation;
• a valuation based on an agreed financial metric;
• a formula based on revenue or EBITDA; or
• another objectively ascertainable methodology agreed between the parties.

The plan should also specify who determines the valuation, what valuation date applies, whether minority or other discounts are relevant, and how valuation disputes are resolved. Leaving these matters to be determined only when the award becomes payable can create significant disputes between the company and the employee.

Taxation of Phantom Stock and Cash-Settled SARs in India

The tax treatment is an important distinction between phantom equity and actual equity-based compensation. As of 1 April 2026, the Income-tax Act, 2025 has replaced the Income-tax Act, 1961. The 1961 Act continues to govern relevant earlier tax years and proceedings under the transitional framework, but current arrangements should be analysed under the new Act.

Where a phantom stock or cash-settled SAR payment is made to an employee as employment-linked compensation, the payment would generally be examined as salary/employment income rather than as consideration for the transfer of a capital asset, because no shares are actually allotted or transferred to the employee. Indian tax jurisprudence has previously considered the taxability of SAR receipts. In Sumit Bhattacharya v. ACIT, the Income Tax Appellate Tribunal’s Special Bench treated the redemption of employment-linked SARs as an employment-related monetary benefit, and the subsequent litigation examined the applicable salary/perquisite provisions.

The distinction from an ESOP is significant. In a conventional ESOP, the employee may have:

1. a salary/perquisite tax event when shares are acquired pursuant to the option; and
2. a separate capital-gains tax event when those shares are subsequently sold.

The Income Tax Department’s guidance on ESOP taxation reflects this two-stage framework for actual securities allotted under an ESOP. A purely cash-settled phantom stock arrangement does not ordinarily create that subsequent share-sale event because no shares are acquired by the employee. The precise tax treatment should nevertheless be determined from the terms of the plan, the employer-employee relationship, the nature of the entitlement and the applicable provisions of the Income-tax Act, 2025.

Tax Deduction and Employer Compliance

Where a payment constitutes taxable salary or an employment-related perquisite, the employer must consider its applicable tax deduction and reporting obligations. The timing of taxation and withholding should be aligned with the actual structure of the award and the applicable provisions of the Income-tax Act, 2025 and the Income-tax Rules, 2026. Accordingly, companies should not simply assume that tax is payable at grant or vesting. A properly structured cash-settled plan should clearly identify the relevant settlement event and provide for applicable tax withholding.

Foreign Parent Companies and Cross-Border Phantom Stock

Cross-border arrangements require additional caution. A common structure involves an Indian subsidiary whose employees receive phantom stock or SAR benefits linked to the shares of an overseas parent company. Such an arrangement may raise questions under:

• the Foreign Exchange Management Act, 1999 (“FEMA”);
• RBI regulations and directions;
• income-tax withholding provisions;
• transfer pricing rules;
• accounting standards; and
• the contractual allocation of the payment obligation between the foreign parent and Indian subsidiary.

The FEMA analysis should be undertaken based on the actual flow of funds and contractual obligations. It should not automatically be assumed that the Liberalised Remittance Scheme (“LRS”) is the appropriate route merely because an employee receives a payment from, or linked to, a foreign company. This is particularly important where the foreign parent funds the benefit, the Indian subsidiary bears or reimburses the cost, or the employee receives the payment directly from the overseas entity.

The RBI framework separately contains provisions governing certain employee stock options and share-based benefits involving persons resident outside India. However, those provisions should not be mechanically applied to a cash-only phantom arrangement without examining its precise structure.

Transfer Pricing Considerations

A foreign-parent phantom stock plan can also have transfer pricing implications where the Indian subsidiary and foreign parent are associated enterprises and the arrangement involves a recharge, reimbursement, allocation or other inter-company transaction.

For example, if the foreign parent grants phantom awards to employees of the Indian subsidiary and subsequently seeks reimbursement from the Indian entity, the parties should examine whether the reimbursement constitutes an international transaction and whether the amount and basis of recharge satisfy the arm’s-length requirements. Conversely, where the Indian subsidiary bears the employee compensation cost without any inter-company reimbursement, the tax and transfer pricing consequences may differ.

The analysis therefore depends on the contractual and accounting architecture of the plan rather than simply on the fact that the underlying shares belong to a foreign parent.

Accounting Treatment: An Important Practical Consideration

A further issue often overlooked in discussions on phantom stock is accounting treatment. Cash-settled share-based payment arrangements can create a liability for the company, with the liability potentially requiring remeasurement until settlement depending on the applicable accounting framework. For companies preparing financial statements under Ind AS, the treatment of share-based payment arrangements should therefore be considered under the applicable provisions of Ind AS 102, Share-based Payment.

This is particularly relevant for startups and other privately held companies because a phantom stock plan may avoid equity dilution while still creating a potentially significant financial liability. Accordingly, the decision between an ESOP and a cash-settled phantom plan should not be evaluated solely by reference to dilution.

Phantom Stock vs ESOP: Key Differences

What Companies Should Consider Before Implementing a Phantom Stock Plan

For companies considering phantom equity or cash-settled SARs, the absence of a dedicated statutory framework should not be treated as a reason for minimal documentation. It makes careful drafting more important. Before implementation, companies should consider:

1. Define the economic entitlement clearly: The formula for calculating the employee’s payout should be objectively ascertainable.
2. Establish a robust valuation mechanism: This is particularly important for private and venture-backed companies.
3. Distinguish vesting from settlement: The plan should specify when an award becomes vested and when the employee becomes entitled to payment.
4. Address termination scenarios: Good-leaver, bad-leaver, resignation, termination without cause and termination for cause can have substantially different consequences.
5. Plan for liquidity events: Acquisitions, mergers, IPOs and secondary transactions should be expressly addressed.
6. Consider tax withholding: The documentation should specify whether and how taxes will be withheld from the cash payout.
7. Review cross-border structures separately: Foreign-parent arrangements require a FEMA, tax and transfer-pricing review rather than reliance on a generic ESOP structure.
8. Consider accounting consequences: Avoiding equity dilution does not necessarily mean avoiding a financial liability.

Conclusion

Phantom stock and cash-settled stock appreciation rights can provide companies with a flexible way to link employee compensation to business growth without issuing actual shares. Their principal attraction is structural: the employee can participate economically in the value created by the business without necessarily becoming a shareholder and without the dilution associated with an equity-settled award.

However, the absence of a dedicated statutory framework for cash-settled phantom equity should not be confused with an absence of legal considerations. The enforceability and operation of the plan will depend heavily on its contractual terms, while tax, accounting, FEMA, transfer pricing and, where relevant, securities-law considerations must be evaluated according to the specific structure.

For Indian startups, private companies and multinational groups, the central question is therefore not simply whether phantom stock is “legal” in India. It is how the arrangement is structured, documented, valued, funded and settled. A carefully drafted phantom stock or cash-settled SAR plan can offer a meaningful alternative to conventional ESOPs—but its apparent simplicity should not replace a proper legal, tax, foreign exchange and accounting review before implementation.

Frequently Asked Questions

Last Updated on 27 August, 2026