ESOPs: Untangling Tax Complexities
In this blog, we aim to demystify the tax complexities surrounding Employee Stock Ownership Plans (ESOPs) both at the time of exercise and sale. Understanding these intricacies is crucial for employees and employers alike to navigate effectively through financial planning and compliance challenges.
Employee Stock Option Plans (ESOPs) are a popular form of employee benefit in India, allowing employees to own shares in the company they work for. The taxation of Employee Stock Option Plans (ESOPs) in India involves two main stages: the time of exercise and the time of sale.
For those seeking to understand the basics and terminology of ESOPs, we recommend referring to our previous article here as a primer.
Primarily two sections of the Income Tax Act of 1961 govern these transactions-
- Section 17(2)(vi) for the perquisite taxation at exercise and
- Section 45 for the capital gains taxation at the sale
Taxation at the Time of Exercise:
When an employee exercises their option to purchase shares under an ESOP, the difference between the fair market value (FMV) of the shares on the date of exercise and the exercise price (the price at which the employee buys the shares) is treated as a perquisite under Section 17(2)(vi) of the Income Tax Act.
Perquisite Calculation:
Perquisite Value = (Fair Market Value on the date of exercise − Exercise Price) × Number of shares
Perquisite Value = (Fair Market Value on the date of exercise − Exercise Price) × Number of shares
This perquisite is added to the employee’s income and taxed according to the applicable income tax slab rates.
Example:
If an employee exercises an option to buy 1,000 shares at an exercise price of INR 100 per share when the FMV is INR 150 per share:
Perquisite Value = (150 − 100) × 1,000 = 𝐼𝑁𝑅 50,000
This INR 50,000 will be treated as part of the employee’s salary income and taxed according to the individual’s income tax slab.
Taxation at the Time of Sale:
When the employee eventually sells the shares, capital gains tax is applicable on the difference between the sale price and the fair market value on the date of exercise. This is governed by Section 45 of the Income Tax Act.
Capital Gain Calculation:
Capital Gain = (Sale Price − Fair Market Value on the date of exercise) × Number of shares
Capital Gain = (Sale Price − Fair Market Value on the date of exercise) × Number of shares
The type of capital gain depends on the holding period of the shares:
Short-Term Capital Gains (STCG): If the shares are sold within 24 months from the date of exercise, the gains are considered short-term. STCG on listed shares is taxed at 15% under section 111A, while for unlisted shares, it is taxed according to the individual’s applicable income tax slab rates.
Long-Term Capital Gains (LTCG): If the shares are sold after 24 months from the date of exercise, the gains are considered long-term. LTCG on listed shares exceeding INR 1 lakh is taxed at 10% without the benefit of indexation under section 112A. For unlisted shares, LTCG is taxed at 20% with indexation benefits under section 112.
Example:
Suppose an employee is granted an ESOP with the following details: Number of shares: 1,000
Exercise price: INR 100 per share
FMV on the date of exercise: INR 150 per share
Sale price after 2 years: INR 200 per share
At the time of exercise:
Perquisite Value = (150 − 100) × 1,000 = 𝐼𝑁𝑅 50,000
Perquisite Value = (150 − 100) × 1,000 = INR50,000
This INR 50,000 is added to the employee’s salary and taxed according to the applicable income tax slab.
At the time of sale:
Capital Gain = (200 − 150) × 1,000 = 𝐼𝑁𝑅 50,000
Capital Gain = (200 − 150) × 1,000 = INR50,000
Since the shares are held for more than 24 months, the gain is long-term. For listed shares, the first INR 1 lakh of LTCG is exempt, and the remaining is taxed at 10%.
Special Provisions for Startup
Recognized startups in India have a provision under which the tax on the perquisite value of ESOPs can be deferred. According to the amendment in the Finance Act 2020, the tax payment can be deferred for up to five years from the date of exercise or until the employee leaves the company or sells the shares, whichever is earlier.
Deferral of TDS deduction on ESOP Prerequisite–
As per the amendments under budget 2020, from FY 2020-21 onwards, when an employee receives ESOPs from an eligible startup, they need not pay tax in the year they exercise the option.
Section 192(1C) of the Income-tax Act allows eligible start-ups, as defined under Section 80-IAC, to defer the deduction of TDS on ESOP prerequisites for their employees. The employer can postpone this deduction of TDS up to any of the following events, which occurs first: –
- Expiry of 5 years from the year of allotment of ESOP
- Date of sale of ESOP by the employee
- Date of termination of the employment
Understanding these tax complexities is essential for employees and employers alike, enabling informed decision-making and effective financial planning.
Employee Stock Option Plans (ESOPs) provide a valuable opportunity for employees to share in the success of their organisation through ownership. However, navigating the tax implications requires careful consideration of provisions under the Income Tax Act, such as Section 17(2)(vi) for perquisite taxation and Section 45 for capital gains.
As ESOPs continue to evolve as a critical component of employee compensation packages, staying informed about tax regulations and planning strategies is crucial. We hope this blog has equipped you with the knowledge needed to navigate ESOP taxation effectively, ensuring compliance and maximising financial benefits.
For further details on specific scenarios or additional insights, feel free to reach out to us.
Happy Reading!
Team Businezexcellence
