Reward System, Incentives

and Pay Restructuring

UNIT 15: BONUS PROFIT SHARING AND

STOCK OPTIONS
Objectives
After going through this unit, you should be able to:

understand the-concept of bonus, profit sharing and stock options,

be familiar with relevant legal provisions, and
be conversant with the purpose, process/approach and problems in administering
these as part of reward system:

Structure
15.1
15.2
15.3
15.4
15.5
15.6
15.7

Introduction
Bonus
Profit Sharing
Stock Options
Review Questions
Key words
Further Readings

15.1 INTRODUCTION
Bonus, profit sharing and stock options are among the various measures to promote
employees financial participation in the companies they work both in equity (stock
options) and in profits (bonus and profit sharing). Giving say and stake to employees
is part of an ongoing thrust towards democratizing the workplace. In actual
implementation, however, companies enjoy several options and also face several
problems.

15.2 BONUS
The Twentieth century dictionary defines bonus as, la premium beyond the usual
interest for a loan; an extra dividend to shareholders, a policy holders share of profits;
an extra payment to workmen or others.I Neither the Payment of Bonus Act, 1965
nor any other industrial law defines bonus.

30

The concept of bonus payment to workers originated in India during the first world
war in the cotton textile industry in Bombay and Ahmedabad in 1917. When the
practice was discontinued in 1923, there was a general strike and the Government of
Maharashtra appointed a committee headed by Sir Normal Mcleod, the then Chief
Justice of Bombay High Court to consider the nature and basis of payment of bonus
in the cotton textile industry of Bombay. The committee observed that the cotton
mills working in 1923, as compared to the situation in 1917, did not justify any
payment of bonus. Thus a link between profits and bonus was established in early
1920s. During second World War the paymen of bonus resumed and continued till
1945. In 1942, the bonus dispute in General Motors (India) Limited, was referred for
adjudication. In this case Justice Chagla observed that, It is almost universally
accepted principle now that the profits are made possible by the contribution that
both capital and labour make in any particular industry, and I think it is also
conceded that labour has a right to share in increased profits that are made in any
particular period. But the distribution of increased profits among workers is better
achieved by giving of an annual bonus than by a further increase in wages. Wages
must be fixed on the basis of normal conditions .1 The next year in the case of
Standard Vaccume Mill Company the adjudicator held that, 3If large profits were
made as aresult of the abnormal war conditions, it was but fair that a small fraction of
such profits should be given by way of bonus without whose labour and cooperation
the profits could not have been made.

In 1948 the Government of India has appointed a Committee on Profit Sharing. The
Committee observed. that it was not possible to devise a system in which labour share
of profit could be determined on a sliding scale varying with production and favoured
trying out profit sharing bonus industry-cum-locality basis. as (a) an incentive to
production, (b) a method of securing industrial peace, and, (c) a step in the
participation of laobur in management.

Bonus, Profit Sharing and

Stock Options

In 1950 the Labour Appellate Tribunal held, in the case of Mill Owners Association
vs. Rashtriya Mill Mazdoor Sangh, that, Where the goal living wages has been
attained, bonus, like profit sharing, would represent more as the cash incentive for
greater efficiency and production. We cannot, therefore, accept the broad contention
that a claim to bonus is not admissible where wages have (as in the case before us)
been standardised at a figure lower than what is said to be the living wage. Where the
industry has capacity to pay, and has been so stabilised that its capacity to pay may
be counted upon continuously. It thus made a distinction between Eliving wagtail and
eactual wages and held that bonus could be used to bridge the gap between the two.
Five years later, Justice Bltagwati of the Supreme Court of India upheld the tribunal
judgement in the caase of Muir Mills Company vs. Suti Mills Mazdoor Union: lit is,
therefore, that the claim for ebomtat can be made by the employees only if as a result
of the joint contribution of capital and labour the industrial concerned has earned
profits. If m any particular year the working of the industrial concern has resulted in
loss there is no nor justification for a &expand for bonus. Bonus is not a deferred
wage. Because, if it were so., it would neceasarily rank for precedence before
dividends. The dividendi can only be paid out of profits and unless and until profits
are made no occasion, or question ran also arise for distribution of any sum as
ebonises among the employees. If the industrial concern has resulted in a trading
loss, there would. be no profits of the particular year available for distribution of
dividends, much less could the employees claim the distribution of bonus during that
year
Thus, profit was considered as a precondition for bonus. Several companies fi
including, for instance, Tam Iron and Steel Company, Indian Iron 'and Steel
Company, Bharat Tin Plate Company and Buckingham and Carnatic Mills - have
adopted voluntarily profit sharing bonuses. Notwithstanding this, there have been a.
series of disputes and a spate of strikes over bonus issue, with workers and their
unions contending bonus to be a deferred wage. In 1961 the Government of India
constituted Bonus Commission. Based on the report of the Commission in 1964,
Payment of Bonus Act was enacted in 1965 with a view to: (a) enforce statutory
liability upon employers covered by the Act to pay bonus to employees in the
establishments concerned, (b) define the principles for payment of bonus according
to the prescribed formula, (c) provide for payment of a minimum and maximum
bonus and linking payment of bonus with a scheme of eset-of and eset-on, and, (d) to
provide machinery for the enforcement of the liability for payment of bonus. The
salient features of the legislation are shown in Box 1. The legislation did not achieve
the intended objective of minimising conflict on account of bonus. During the
discussions before the Bonus Commission when the employers wanted a ceiling on
bonus, the workers asked for a floor. With the result, the legislation provided for a
minimum of bonus of 4 percent regardless of whether a company earns profit or not.
Subsequently it was raised to 8.33 per cent (section 10 of the Act) which is
equivalent to one months wages. In effect, this meant 13 months wages for 12
months work, and thus bonus has actually become, at the minimum level, a deferred
wage that bore no relationship whatsoever with either productivity or profitability.
The ceiling remained at 20 per cent, but with a provision far bargaining production
linked bonus (Section 31-A of the Act). There are instances in the public sector
where sick industries had agreed to pay more than 8.33 per cent.

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Reward System, Incentives

and Pay Restructuring

THE PAYMENT OF BONUS ACT, 1965

The Payment of Bonus Act, 1965 applies to ever' factory and every establishment in
which twenty or more persons are employed on any day during an accounting year.
The definition of the factory is the same as under the Factories Act, 1948. Under the
Act `establishment' has been defined as the place in which one is permanently fixed
for business, with necessary equipment, and office or place of business. An
establishment covered under the Act shall continue to be governed by this Act
notwithstanding that the number of persons employed below twenty.
Eligibility
Every employee shall be entitled to be paid bonus provided he has worked for at least
30 working days in a year.
Employee means any person employed on a salary or wage not exceeding Rs.1,600
per month. This upper ceiling was first revised to Rs.2,500 and then in 1995, to
Rs.3,500. For computing maximum bonus the limit was raised from Rs.1,600 to
Rs.2,500. During late 1990s the Government proposed to further increase the limit to
Rs.5,000 or even completely abolish the ceiling and cover all employees.
Salary or wage means all remuneration (other than remuneration in respect of overttime work) capable of being expressed in terms of money, including dearness
allowance. This, however, does not include value of any house accommodation,
supply of light, water, medical attendance or any service or any concessional supply
of food-grains, any travelling concession, any bonus such as incentive, production
and attendance bonus, any retrenchment compensation or any gratuity or other
retirement benefit, any other allowance or any commission payable to the employee.
Disqualification for Bonus
Under the Act an employee may be disqualified from receiving bonus if he is
dismissed from service for fraud; riotous or violent behaviour; or theft,
misappropriation or sabotage of property of the establishment.
Payment for Minmum Bonus
Every employer shall be bound to pay every employee in respect of any accounting
year a minimum bonus which shall be 8.33 per cent of the salary or wage earned by
the employee during the accounting year or one hundred rupees, whichever is higher,
whether or not the employer has any allocable surplus in the accounting year. If an
employee is below fifteen years of age, the minimum amount of one hundred rupees
in this case would be sixty rupees.
Payment for Maximum Bonus
Where the allocable surplus exceeds the amount of minimum bonus payable to the
employees, the employer shall be bound to pay every employee in respect of that
accounting year bonus which shall he an amount in proportion to the salary or wage
earned by the employee subject to a maximum of twenty per cent of such salary or
wage.
Proportionate Reduction in Bonus
Where an employee has not worked for all the working days in an accounting year, if
the minimum bonus of one hundred rupees is higher than 8.33% of his salary or wage
for the days he has worked, shall be proportionately reduced.
Computation of Number of Working Days

32

For the purposes of computing proportionate bonus, an employee shall be deemed to

have worked on the days on which he has been laid off under an agreement, standing
orders, or Industrial Disputes Act; on leave with salary or wage absent due to

Bonus, Profit Sharing and

Stock Options

33

Reward System, Incentives

and Pay Restructuring

Maintenance of Registers, Records, etc.

Every employer shall prepare and maintain registers, records and other documents in
the prescribed form and manner for the purpose of this Act.
Penalty
If any person contravenes any of the provisions of this Act or fails to comply with the
direction given or requisition made to him, he is punishable with imprisonment
which may extend to six months or with fine of one thousand rupees or with both.
Bonus Linked with Productivity
Where the employer and the employees enter into an agreement or settlement for
payment of annual bonus linked with production or productivity in lieu of bonus
based on profits, such employees shall be entitled to be paid bonus of not more than
twenty percent and less than 8.33 per cent of the salary or wage earned by them
during the relevant accounting year.
Expenditure from Bonus Payment
The appropriate government, having regard to the financial position of any
establishment or class of establishments, may give exemption for such establishments
from all or any of the provisions of this Act.
Act not to Apply to Certain Classes of Employees
The Act is not applicable to apprentices and it excludes employees in an
establishment and in an industry carried on by or under the authority of an
department of the Central Government, or State Government or local authority.
The Act also does not apply to Seamen, employees registered or listed under any
scheme made under the Dock employees (Regulation of Employment) Act of 1948,
Employees of Life Insurance Corporation and General Insurance Companies, Indian
Red Cross Society, Universities and other educational institutions, inland water
transport establishments operating on routes passing through any other country,
Reserve Bank of India, Unit Trust of India, Industrial and Financial Corporations
established in the public sector, and employees engaged through contractors on
building operations and institutions established not purposes of profit.
The government employees are not covered by the Payment of Bonus Act. Still they
receive annual a certain amount over and above the salary fit loosely called ebonusi
under either of the following two schemes: (a) ex gratia payment, (b) productivity
linked bonus (PLB). Those who are covered under the PLB include those working in
Railways, Posts and Telecommunications and productions units under the Ministry of
Defence. Those who are not covered by PLB are given ex gratia payment fixed by
government annually on ad hoc basis. The concept of PLB to employees in
government services, including organisations mentioned above was not favoured by
Bhoothalingam Committee (1978) on wages, incomes and prices. Still, the PLB
scheme was first introduced in the Railways in 1979-80 and later extended to the
other departments.

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The PLB schemes have by now become a permanent features, and the norms of
productivity subject to negotiation at periodic (usually once every three years)
intervals. The functioning of these schemes was are reviewed by a group of officers
headed by Bazle Karim, Secretary (Coordination), Cabinet Secretie, as the Chairman.
The IV Central Pay Commission observed that the Bazle Karim committee were of
the view that government departments constitute a single infrastructure for the
economy as a whole and that there should be no sense of discrimination resulting in
demoralisation among them as a group when the service conditions are uniform all
along. They suggested the evolution of a productivity linked bonus scheme for
central government employees as a whole. There are, however, problems in
considering productivity of government as a whole. The IV Central Pay Commission
observed that, while there is nothing to prevent government from making such
payment if it so desires, it is in the nature of a concession arising out

of goodwill and cannot be claimed as of right. It cannot, therefore, be said to form

part of a regular scheme of emoluments of employees to whom it is granted. The
reality, however, is that in late 1990s when the Government conceded PLB revision
for Railways, but not to posts and telecom, the latter went on strike and obtained the
revision.

15.3

Bonus, Profit Sharing and

Stock Options

PROFIT SHARING

Profit sharing means paying employees a share of the net profits in addition to their
wage or salary. It is payment of a dividend or a sum based on wage or salary, grade
or seniority. It is supposed to be a stimulous for higher performance.
Profit sharing is different from shareholding which is discussed in the next section
under the head, employee stock options. Employees can become shareholders in a
company by either or both of the following two ways: (a) when they offered and buy
shares in the company where they work; (b) when they offered shares as a reward or
incentive for better performance or seniority/loyalty or both.
Profit sharing is also different from gainsharing. Gainsharing of the kind proposed by
Joe Scanlon called the Scanlon Plan fit provided for a share to the workers of the
savings in input costs. This combines incentive payments with worker participation
in decision making and rewards people not necessary for working hard, but for
working smart.
Profit sharing can take a number of different forms: (a) cash, (b) deferred payments
(distributed on a deferred basis, with the seam being invested in enterprise funds or in
special funds for a specific period), (c) offered as equity.
Profit sharing, like incentives, should be in addition to regular wage, should not he
considered as a substitute for it. However, economists like Weitzman consider that
expected profit-sharing bonuses will substitute for the basic wage, lower wage rates
and wage costs, reduce marginal cost of hiring and increase employment. Profit
sharing is considered as a useful tool in stabilizing wage costs, and yet rewarding
workers when they and the company perform better. In some countries, particularly,
the U.S., profit sharing schemes competed with or became complementary to pension
schemes. Tax policies favoured and exempted differed payments at the time of
retirement. The usual mechanism is the creation of different profit-payment trust
which invested the funds in interest carrying special bonds and released tax free
payments to workers upon retirement.
Profit sharing is supposed to contribute to productivity, worker motivation, worker
participation and wage flexibility. The results may be reflected either in higher output
or better financial performance through savings in input costs. When employees
receive payments based on companys financial performance they become aware and
concerned about factors contributing to business success and the commonality in goal
with reduce mutual antagonism, if any. Thus profit sharing is also considered to
improve the general climate of employment and industrial relations.
To let employees feel and actually realize that they are getting their due share in
profits requires transparency in book-keeping practices. As of now in quite a few
enterprises, both in the public and the private sectors, balance sheets are considered
by their employees as excellent pieces of fiction. In some companies there is a
feeling that their managements tell one thing to their shareholders and the other the
union leaders and the workers. In the absence of trust and transparency, misgivings
persist.
There are also some problems with profit sharing. Profit sharing being a group based
scheme, could result in the problem of free-riders. Some individual employees get
reward without deserving it and a few others may feel that what they are getting as a
share in the profits of the company is not in proportion to the contribution they made.
Even though profit sharing is a gravy, and not a substitute to the wages or salary,
some trade unions also consider that profit sharing being a variable payment shifts
risk to the employees. In the case of employee share-ownership, employees are
putting not only their jobs and incomes at risk, but also their savings.
Companies Act in India provides for payment of upto 11 per cent of profits to the
whole-time directors of the company. Justice Mohan Committee, which was set up to
recommend pay revision for public sector executives, submitted its report in 1998 and

35

Reward System, Incentives

and Pay Restructuring

recommended that perquisites and allowances beyond 50 per cent of pay should be
linked to performance. It observed that, These performance related payments should
be a function of profitability at the level of a particular enterprise and emoluments at
the level of the individual executive. While it is not possible to think of definitive
stipulations or ceilings in these spheres, the Committee believes that some norms
would be desirable. It would be appropriate to suggest that such performance related
payment should not, as a norm, exceed 5 per cent of the distributable profits in an
enterprise. However, there would b e situations where distributable profits are not
large enough for performance related payments that could suitably reward executives
for turning around or significantly improving performance of an enterprise. Similarly,
it would be appropriate to suggest that performance related payments should not, as a
norm exceed 50 per cent of the basic pay of an individual executive. The Board
should, of course, have the flexibility and discretion to go beyond this norm wherever
necessary and appropriate but the justification for the relaxation should be explicitly
recorded.

15.4

STOCK OPTIONS

Stock options are opportunities to buy stock at a set price, immediately or some time
in the future. Employers offer stocks to their employees for several reasons such as
the following:
1).
2).
3).
4).
5).
6).
7).
8).
9).

10).

Attraction
Retention
Motivation
Financial participation by employees in the wealth created through the
joint efforts of management and labour or employers and employees
Commitment
Develop common purpose/ideology between employers and employees.
Performance based reward
Supplement retirement/social security benefits
Incentives for improved performance on a sustained basis. When
employees become owners too they put not only their blood but also
their sweat
Prevent hostile take over. It is expected employee shareholders will
provide the hedge against unfriendly takeovers by other firms

Stock options are becoming familiar in view of the following:

1). The shift from industrial to information revolution. Knowledge workers
expect say and stake.
2). Public policy in many countries favours giving employees a share in
equity and profits. This is pursued in few countries through legislation
and in many others it is encouraged through voluntary persuasion.
3). In the wake of disinvestments and privatisation of public enterprises,
employees are offered shares with' a view to ease their opposition, if
any, and also to give the workers a stake. This is also considered as an
effort at redistribution of wealth.
Stock options can be introduced not only by publicly traded firms, but also by
privately held firms. Stock options by foreign companies to national employees
should be guided by national law and tax policies. If the citizens are prohibited from
holding foreign assets, even if the foreign employer is willing to offer stock options,
national laws and tax policies may impose restrictions and hurdles in the way of
national employees accepting such offers.

36

A survey of experiences of industrialized countries and those in Central and Eastern

Europe by Daniel Vaughan-Whitehead et. al. (1995) revealed that: (a) the latter countries
developed financial participation by workers as a part of the privatisation process with a
view to soften the opposition to economic reforms, achieve redistribution of wealth,

through not only private capital share-ownership but wider share-ownership by

employees and citizen. Consequently, these countries developed share-ownership
systems instead of profit-sharing schemes and as such they do not necessarily constitute
a progressive evolution of their pay system or their work organization process. This does
not mean that there are no similarities between experiences in Central and Eastern
Europe and the industrialised Western Europe. For instance, both U.K. and France have
used wider share ownership concept during the process of privatisation.
In some western industrialised countries, financial participation by employees is
promoted through legislation. In U.K. and U.S.A. it is encouraged mainly through a
variety of tax incentives for deferred profit-sharing schemes and employee stock
option programmes. In Belgium and Italy it evolved through collective bargaining. In
Japan it is highly decentralized and became a part of management policy than public
policy and legislation. In most countries employers want profit sharing and employee
stock options to be voluntary.
In India, during the 1980s a scheme was introduced by Mr, V. P. Singh, when he was
the Finance Minister whereby 5 per cent of the new issues could be reserved for
employees of the company. Over a decade later, the Securities Exchange Board of
India (SEBI) issued the following guidelines, effective from June 1999: (a) all
employees except promoters and part time directors are eligible to participate in
employee stock option schemes (ESOS); (b) ESOS would be recommended n
including terms and conditions and quantum, exercise price and period - by a
compensation committee of Board of directors comprising majority of independent
directors and approved by the by the shareholders through a special resolution; (c)
the shares and convertible securities under the scheme may include American
Depository Receipts and Global Depository Receipts. The guidelines also deal with
valuation, funding and purchase of stocks.
In the past companies offered stock options to a handful of top ranking key
managers. However, with the advent of information, the need to attract, retain and
motivate workforce is making it imperative to give them both say and stake. In India
mainly information technology and software firms introduced employee stock option
plans. In recent years many FMCG (fast moving consumer goods industry) firms
have also begun to offer stock options to their employees.
Which companies in India have employee stock option plans? The prominent examples
in India include Castrol, CRISIL, Global Trust Bank, Godrej-GE, HCL, Infosys
Technologies, Mastek, MIT, Pentafour, Proctor and Gamble, WIPRO, Zee Network, etc.
Several others are planning to introduce employee stock options.
In several public enterprises employees are offered shares on special terms at the
time of disinvestments and/or public offering. Initially trade unions in banks and
several public enterprises resisted the idea of workers owning sharing because of
ideological aversion to worker capitalism. However, trade union opposition to stock
options weakened because many of their own members did not want to let the
opportunity to go. Actually in several cases they asked for more shares than the
government was initially willing to offer to the workers. In a quite a few cases
workers have made a bid for taking over the enterprise through worker ownership.
While it has indeed happened in Jaipur Metal Works, Kamani Tubes and New
Central Jute Mills in others like the Indian Petrochemicals Limited and one of the
units of Philips in Calcutta it did not quite materialize.
Tax Treatment of Stock Options
While bonus and profit sharing earnings of employees are deductible expenses for
companies and taxed in the hands of the employees the tax treatment of stock options is
somewhat different. At present stock options are tax as perquisite when option is granted
at discounted prices. They are also taxed as a capital gain when they are converted into
cash. Stock options offered by foreign parent companies to employees of its Indian
subsidiaries are also taxed under the Income Tax Act. Several companies and chambers
of commerce have been pleading with the government that employee stock options be
taxed as a capital gain only at the time of sale of stock options. The following are key
issues in taxation of stock options:
1 In the U.K. and the U.S.A. and several other industrialized countries there are a
variety of legislative measures which provide tax concessions to corporates and

Bonus, Profit Sharing and

Stock Options

37

Reward System, Incentives

and Pay Restructuring

trusts establishing employee stock options .In India, such tax concessions have
not been introduced yet.
2.

If stock options are given at a concessional rate how should the difference
between such rate (also called acceptance price or exercise price) and the market
value be treated for tax purposes?

Stock options are several cases part of a motivational package. It could be, in
some cases in lieu of a part of salary or incentive for outstanding. performance.
But they are not income in the hands of the employees concerned. Therefore the
question is whether they should be taxed at the time they are granted or vested
or at the time the employees actually convert those stock options into cash by
disposing off their stock/shares. In the budget for 2000-2001 the Finance
Minister of India proposed to tax them at the time they are offered to the
employees because it is difficult to keep track of movement of shares
between/among employees.

4.

In April 2000 one of the' companies appealed to the income tax authorities that
the stock options should not be taxed upon grant because they are vested only
after the lock in period is over. Therefore, there is merit, if at all, in taxing stock
options after they are vested or preferably after they are encashed.

15.5

REVIEW QUESTIONS

1.

What is the purpose and rationale of Payment of Bonus Act? What are the
problems with it?

2.

What are the advantages and disadvantages of profit-sharing schemes?

3.

Discuss whether and why stock options are becoming popular? What are their
advantages and disadvantages?

4.

How stock options are currently treated for tax purposes and how should they be
treated?

5.

Write notes on the following:

a)

Is bonus a differed wage?

b)

What is the difference between gain sharing and profit sharing?

c)

What is the difference between stock options and profit sharing?

d)

What is the difference between employee sharing and performance linked

stock options'?

15.6

KEY WORDS

Factory

: Any premises wherein ten or more workers are working or were.

working on any day of the proceeding twelve months, and in any
part of which a manufacturing process is being carried on with the
aid of power.
or
Wherein twenty or more workers are/were working ____without
the aid of power.

Establishment:

38

:The place in which one is permanently fixed for business, with

necessary equipment, and office or place of business (Section
2(16))

Allocable Surplus :In relation to an employer, being a company which has not made
the arrangements prescribed under the Income Tax Act for the
declaration and payment within India of the dividends payable
out of its profits in accordance with the provisions of Section 194
of that Act; 67% of the available surplus in an accounting year; in

any other case 60% of such available surplus.

Bonus

: Bonus is defined as sharing by the workers in the prosperity of

the concern in which they are employed. (The Bonus
Commission)

Gain-sharing

: It is a pay system which provides rewards through variable pay

for members of a group or organization for improvements in
organizational performance.

Profit sharing

: It is a system where part of the remuneration linked to profits or

other measures of financial performance

Employee
shareholding

: It is a system where part of the remuneration of employees is

: paid in the form of equity under preferential conditions in the
company rather in the form of cash. This is different from letting
employees buy shares from their own amounts or through loans.

15.7

Bonus, Profit Sharing and

Stock Options

FURTHER. A DINGS

Blinder, A. S. 1990. Paying for Productivity. Washington, D.C. Brookings Institute.

ILO. 1982. Wages n Workers Education Manual. Geneva, ILO.
Vaughan-Whitehead, D. et. al. 1995. Workers Financial Participation n East West
Experiences. Geneva, ILO.
Weitzman, M. L. 1984. The share economy. Cambridge, Mass., Harvard University
Press.

39