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

FAQs about ESOPs

Q. How does ESOP work in India?

A. An Employee Stock Option Plan (ESOP) is an employee benefit plan that enables eligible employees to buy equity shares in their company at a predetermined price after completing a specified vesting period. After vesting, the employee can exercise the option to buy the shares at the predetermined price, which is usually lower than the market price.

Q. What are ESOPs in India?

A. ESOPs (Employee Stock Option Plans) are a popular employee benefit plan which grants eligible employees the right to buy shares in their company at a predetermined price in the future.

Q. What are the tax benefits of ESOP for the employer?

A. ESOPs amount treated as a perquisite upon exercise of the option is considered a salary cost and is an allowable expenditure in the company’s hands.

Q. Is ESOP expense taxable?

A. ESOP expenses are considered a salary cost and are an allowable expenditure in the hands of the employer. However, the employer must deduct TDS on the same as per the provisions for TDS on salary.

Q. Are ESOPs part of CTC?

A. Yes, ESOPs may be included in the Cost to Company (CTC) of an employee.

Q: What is the tax treatment for ESOPs in the hands of the employee at the time of exercise?

A: The difference between the Fair Market Value (FMV) of the shares on the date of exercise and the exercise price (amount paid by the employee) is taxed as a perquisite or a part of the employee’s salary income at the time of exercise.

Q: What is the tax treatment when the employee sells or transfers the shares later on?

A: When the employee subsequently sells or transfers the shares, the difference between the actual sale considerations realized and the FMV considered at the time of exercise is treated as capital gain.

Q: Can the Fair Market Value be adjusted for indexation during subsequent sale or transfer?

A: Yes, the Fair Market Value can be adjusted for indexation if the holding period of the shares is more than 12 months for shares of listed companies and more than 24 months for shares of unlisted companies.

Q. How do I defer tax on ESOP?

A. One way to defer tax liability on perquisites related to ESOPs is to opt for an Inter-ministerial Board Certificate and 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

Q. How is tax calculated on ESOP?

A. Tax on ESOP is calculated based on the difference between the fair market value of the shares at the time of exercise and the exercise price.

Q. How are ESOPs taxed in India?

A. ESOPs in India are taxed as perquisites at the time of exercise and as capital gains at the time of sale or transfer of the shares.

Q. Is TDS applicable on ESOP?

A. Yes, the employer must deduct TDS as per the provisions for TDS on salary on the perquisite amount at the time of exercise of the option.

Q. How is perquisite tax calculated on ESOPs?

A. Perquisite tax on ESOPs is calculated as the difference between the Fair Market Value (FMV) of the shares at the time of exercise and the exercise price.

Q. What is the taxability of dividend on ESOP shares?

A. The dividend earned on ESOP shares is taxable as per the applicable tax rates, which can vary depending on the individual’s income tax bracket.