Tax implications on ESOP in India

The concept of ESOPs has evolved with a sense of sharing ownership responsibilities with employees and retaining talent that is necessary to startups.

Nowadays, it is popular amongst startups to create an ESOP pool typically about 10% to 15% of the capital before fundraising as it is tax efficient and helps especially when a company has to attract and retain talent with minimal cash outflow.

Employee Stock Option Plan (ESOP)

An Employee Stock Option Plan (ESOP) is an employee benefit plan by which a company offers its employees ownership interest in the organisation.

In the case of ESOPs, eligible employees who meet specified criteria as per the company’s ESOP scheme will be offered the option on a grant date to buy the company’s stock after vesting period (specified time for which employee has to continue his service in the company). After meeting the vesting conditions, if any, an employee can purchase the company's stock at a predetermined value.

Sometimes in the case of group companies, employees of subsidiary companies will be offered with options of the parent company.

Tax consideration

Tax liability will trigger at 2 stages in the hands of employee as detailed below:

At the time of exercise

Difference between Fair Market Value (FMV) as on the date of exercise and the exercise price (i.e. amount paid by the employee) is taxed as a perquisite or a part of salary income in the hands of the employee at the time of exercise.

At the time of subsequent sale or transfer

When the employee subsequently sells or transfers the shares, the difference between actual sale considerations realized and FMV as considered in the previous step is treated as capital gain. Fair market value can be adjusted for indexation if the holding period of the share is more than 12 months in case of shares of listed companies and more than 24 months in case of shares of unlisted companies as it is considered as long term capital gain.

Example:

Grant date: 1^st April 2018
Maturity date: 1^st April 2021
Number of options exercised: 700
Fair market value as on April 2021: INR 150
Amount collected from employee: INR 50

When the employee subsequently sells or transfers the shares, the difference between actual sale considerations realized and FMV as considered in the previous step is treated as capital gain. Fair market value can be adjusted for indexation if the holding period of the share is more than 12 months in case of shares of listed companies and more than 24 months in case of shares of unlisted companies as it is considered as long term capital gain.

In this case on 1^st April 2021 employee will be taxed on INR 70,000, (i.e., 700 shares * (150-50)) as perquisites under the head of salary income.

Note: There will not be any tax implications on lapsed options.

Subsequently, if in October 2022, the employee sells or transfers the share at INR 200 per share, then the employee has to pay a capital gain tax on INR. 35000 (i.e.,700 shares * (200-150)) 

Note: Since in this case the shares are sold within 24 months of acquisition the taxability will be on short term capital gains

Tax implications in the hands of employer

The amount treated as a perquisite upon exercise of option as detailed above, is considered as salary cost and is an allowable expenditure in the hands of the employer. However, the employer is required to deduct TDS on the same as per the provisions for TDS on salary.

Sometimes it may so happen that the benefit arising from an ESOP discount might be more than the salary of the employee itself, say the perquisite amount might be INR 13 lakhs, whereas cash payout might be INR 9 lakhs. In such situations, the company generally has to ensure proper documentation & put in place a system to deduct the number of exercised options for TDS compliance.

Considering such difficulties faced by the employees, an option is given to defer the tax liability on perquisites till 14 days from earlier of the below events instead of date of exercise of option.

• Expiry of five years from the end of year of allotment of shares under ESOPs
• Date of sale of the such shares by the employee
• Date of termination of employment

However such option is available only for eligible start up holding Inter-ministerial Board Certificate (IMB certificate).

Date of allotment	Date of sale	Date of Termination of employment	Expiry of 5 years	Perquisite tax triggering event	Perquisite tax triggering date
01-Oct-20	01-Jul-23	01-Jan-24	01-Apr-26	Date of sale	01-Jul-23
01-Oct-20	01-Feb-24	01-Jan-24	01-Apr-26	Date of Termination of employment	01-Jan-24
01-Oct-20	01-Oct-27	01-Oct-26	01-Apr-26	Expiry of 5 years	01-Apr-26

Cross border ESOP transactions

In the case of group companies that have global presence, an employee may migrate to work in different countries for deputation. Therefore, a situation may arise where residential status at the time of grant of ESOP might change at the time of exercise of option after vesting which leads to double tax of the same income.

Generally, global income will be taxed in the hands of residents after giving the credit for taxes paid in foreign countries.

In such cases, ESOP perquisites are taxable in a country on the basis of the number of days of services rendered in the country. Below example may be considered for the clarity of the situation (this example is only taken for understanding of the concept, however legal provisions of both countries have to be looked in real situations)

Example:

If the resident employee of an Indian parent company, say P. Ltd., is granted 500 ESOPs at INR 30 each in May 2021 which will vest after 4 years in April 2025. He migrated to Dubai on deputation basis to a subsidiary there in April 2023 and continues to be resident in Dubai till May 2024.

If the fair market value at the time of exercise of option is INR 150, then total perquisite of INR  60,000 (INR 120 * 500 shares) will be taxed both in India and Dubai proportionately based on period of service in each country. In this case an employee has worked 3 years in India & 1 year in Dubai. Accordingly INR 45000 will be taxed in India and INR 15000 will be taxed in Dubai.

Issues for consideration

• In India, it will be challenging for the parent company to comply with TDS requirements as there may not be any other source of income of the employee at the time of exercise
• At the time of subsequent sale of shares in the foreign country, it may not accept FMV on the date of acquisition as cost of acquisition. This may lead to double tax for the employee

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^Disclaimer:

^{The content of this article is for information purpose only and does not constitute advice or a legal opinion and are personal views of the author. It is based upon relevant law and/or facts available at that point of time and prepared with due accuracy & reliability. Readers are requested to check and refer to relevant provisions of statute, latest judicial pronouncements, circulars, clarifications etc before acting on the basis of the above write up. The possibility of other views on the subject matter cannot be ruled out. By the use of the said information, you agree that the Author / Treelife Consulting is not responsible or liable in any manner for the authenticity, accuracy, completeness, errors or any kind of omissions in this piece of information for any action taken thereof.}