Understanding ESOPs in India: Process, Tax Implications, Exercise Price, Benefits

Introduction

In the contemporary competitive job market, companies are constantly seeking innovative ways to attract and retain top talent. Employee Stock Option Plans (hereinafter ESOPs) have emerged as a popular tool, offering employees a stake in the company’s success and fostering a sense of ownership. ESOPs have become a game-changer, offering employees a chance to foster a sense of ownership in the company and to partake in its success.  But ESOPs are more than just a fancy perk in a landscape where talent reigns supreme; understanding how the process flow works, the tax implications involved in India, and the factors that influence the exercise price – the price employees pay for the stock – is crucial for both employers and employees.  

What are ESOPs?

Simply put, ESOPs are financial instruments that grant employees the right to purchase company shares at a predetermined price (also known as the exercise price) within a specified period (also known as the vesting period). These are typically structured as a performance-based equity incentive program, where employees are granted stock options as part of their compensation package.

ESOPs serve as a means to align the interests of employees with those of the company’s shareholders and can play a significant role in driving employee engagement, productivity, and long-term company performance. Additionally, ESOPs can be used as a tool for attracting and retaining top talent, as well as incentivizing employees to contribute to the company’s growth and success.

Benefits of ESOPs

ESOPs serve as a means to align the interests of employees with those of the company’s shareholders and can play a significant role in driving employee engagement, productivity, and long-term company performance. Additionally, ESOPs can be used as a tool for attracting and retaining top talent, as well as incentivizing employees to contribute to the company’s growth and success.

How do ESOPs Work?

The ESOPs work in following manner, primarily Finalizing Terms, ESOP Policy Adoption, Grant of ESOPs, Vesting of ESOPs, Exercise of ESOPs, Payment and Allotment of Shares.

1. Finalizing Terms: The company agrees on terms of ESOP policy such as grant, vesting, exercise, etc. 

2. Adoption of ESOP policy: The company through board and shareholder resolutions, adopts the ESOP policy.

3. Grant of ESOPs: The eligible employees (as determined by the ESOP policy and/or the board of the company) will be granted options through issue of grant letters. 

4. Vesting of ESOPs: In accordance with the vesting schedule set out in the ESOP policy/grant letter issued by the company, and upon completion of the milestones thereunder, the employees will be eligible to purchase the ESOPs.

5. Exercise of ESOPs: In accordance with the procedure set out in the ESOP policy and the grant letter, the employee will exercise the ESOP options.

6. Payment of Exercise Price: In accordance with the conditions set forth in the grant letter and the ESOP policy, the employee will pay the exercise price to purchase the vested ESOP options.

7. Allotment of Shares: Upon receipt of the exercise price, the company will allot the relevant shares to the name of the employee. It is important to note here that the shares given to the employees will be within the ESOP pool. Any proposed ESOPs that exceed the available pool will require that the pool first be increased. 

Please see the image below describing the process flow of ESOPs:

We have provided a brief description of the important terms used in the ESOP process flow below:

Term	Brief description
Grant date	Date on which agreement is entered into between the company and employee for grant of ESOPs by issuing the grant letter
Vesting period	The period between the grant date and the date on which all the specified conditions of ESOP should be satisfied
Vesting date	Date on which conditions of granting ESOPs are met
Exercise	The process of exercising the right to subscribe to the options granted to the employee
Exercise price	Price payable by the employee for exercising the right on the options granted
Exercise period	The period after the vesting date provided to an employee to pay the exercise price and avail the options granted under the plan

What is the eligibility criteria for the grant of ESOPs?

The grant of ESOPs by a publicly listed company is governed by the Securities and Exchange Board of India, which prescribes strict conditions within which such public companies can reward their employees with stock option grants. 

However, private companies are governed within the limited purview of the Companies Act, 2013 and the corresponding Companies (Share Capital and Debenture) Rules, 2014. Under this, the ESOPs can be granted to:

• a permanent employee of the company who has been working in India or outside India; or
• the director of the company including a whole-time director but not an independent director; or
• a permanent employee or a director of a subsidiary company in India or outside India or of a holding company.

However, the legal definition of an employee excludes the following categories of “employees”:

• an employee who is a promoter or a person belonging to the promoter group; or
• a director who either himself or through his relative or through any body corporate holds more than 10% of the outstanding equity shares of the company, whether directly or indirectly.

Note: These exceptions are not applicable to start-ups for a period of 10 years from the date of their incorporation/registration.

Tax Implication of ESOPs – Explained through an Example

The example below demonstrates on a broad level how ESOPs are typically taxed in India:

Employee Mr. A is granted ESOP of Company X (not assumed to be an eligible startup as per Section 80-IAC of Income Tax Act, 1961), which entitles him to get 1 equity share per option:

No. of Options = 100

Exercise Price = INR 10

Fair market value (FMV) of the share on exercise date = INR 500

FMV of share on the date of sale = INR 600

Assuming that all options have vested to Mr. A and are exercised in the same year, the tax liability would be as below:

On Exercise of ESOPs	On Sale of ESOPs
Number of shares = 100	Number of shares = 100
FMV = INR 500 per share	FMV = INR 600 per share
Exercise price paid by employee = INR 10 per share	FMV on date of exercise of option = INR 500 per share
Gain to employee = INR 490 per share	Gain to employee = INR 100 per share
Taxable income = INR 4,90,000 (taxable as salary income)	Taxable income = INR 1,00,000 (taxable as capital gains)

Deferred Tax Liability for Startups

In order to ease the burden of payment of taxes, employees of “eligible startups” (i.e., startups fulfilling eligibility criteria as specified under Section 80-IAC of the Income Tax Act, 1961 and obtaining an Inter-Ministerial Board Certificate) can defer the payment of tax or employers can defer the deduction of TDS for employees arising at the time of exercise of ESOPs. In other words, there is no taxable event for eligible startups on the date on which the employee exercises the options.

The tax liability will arise within 14 days from the earliest of any of the following events :
(a) after completion of 48 months from the end of relevant accounting year; or
(b) date of sale of shares by the employee; or
(c) date from when the assessee ceases to be an employee of the ESOP-allotment company.

Determining the exercise price of a stock option

The exercise price is a crucial element of a stock option and denotes the predetermined rate at which an employee can procure the company’s shares as per the ESOP agreement. This price is established at the time of granting the option and remains fixed over the tenure of the option. 

Factors Influencing Exercise Price

• Fair Market Value (FMV): This is a key benchmark. Ideally, the exercise price should be set close to the FMV of the stock on the grant date. However, there can be variations depending on the company’s life stage, liquidity, and overall ESOP strategy. The exercise price is often tethered to the prevailing market value of the company’s shares. If the existing market value exceeds the exercise price, the option is considered “in the money,” rendering it more lucrative for the employee. Conversely, if the market value falls below the exercise price, the option is “out of the money,” potentially reducing its attractiveness.

• Company Objectives: The ESOP policy outlines the rationale behind granting stock options and the intended benefits for employees. A lower exercise price can incentivize employees and align their interests with the company’s growth.

• Dilution Impact: Granting options increases the company’s outstanding shares. The exercise price should consider the dilution impact on existing shareholders. The inherent volatility in Indian stock markets significantly impacts the exercise price. Heightened volatility tends to inflate option premiums, including the exercise price, owing to the increased likelihood of significant price fluctuations in the underlying shares.

• Accounting and Legal Considerations: Indian Accounting Standards (Ind AS) and tax implications need to be factored in to ensure proper financial reporting and tax treatment. Tax consequences can vary based on the timing of the exercise and the type of ESOP. 

Conclusion

In a nutshell, ESOPs have emerged as a significant instrument in India’s corporate landscape, fostering a sense of ownership and alignment between employees and companies. Understanding the key features including the process flow, tax implications and exercise price determination associated with ESOPs is paramount for companies to highlight maximized potential benefits to employees. 

Frequently Asked Questions (FAQs) about ESOPs in India

Q. How is Exercise Price determined?
A. Exercise Price can be whatever price the Company chooses at the time of issuing the grant letter. Some firms use a minimal exercise price (for example, INR 10) while others choose an exercise price depending on the company’s latest round value. The greater the difference between FMV and exercise price at the time of ESOP sale, the more money you create.

Q. How is a Vesting Schedule fixed?
A. The most typical vesting plan is uniform yearly vesting over four years, which means that after the first year of mandatory ‘cliff’ vesting, you will get 25% of the total ESOPs guaranteed to you every year for the next four years.

Q. What happens to the ESOPs when an employee leaves the Company?
A. This is typically governed by the ESOP Policy adopted by the Company. In short, unvested ESOPs are returned to the ESOP pool when an employee leaves and the employee may exercise the vested options in accordance with the ESOP Policy.

Q. Can ESOPs be subject to transfer restrictions?
A. This would again be subject to the ESOP Policy but yes, a Company can subject these shares to restrictions such as Right of First Refusal or Right of First Offer, in order to create visibility on any transfers for the Company.

Q. How is ESOP liquidity made available to employees?
A. This is again, subject to the ESOP Policy. It is important to note that employees can only profit from the ESOPs if a liquidity event (such as secondary transaction, repurchase or IPO) occurs.

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. However, the company 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: (i) expiry of five years from the end of year of allotment of shares under ESOPs; (ii) date of sale of the such shares by the employee; or (iii) date of termination of employment.

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.