A guide to tax on ESOPs

The employee stock option plan (ESOP) is a popular long-term incentive that companies use to attract, retain and reward employees. ESOPs provide the employees with an opportunity to become equity shareholders of the company over a period of time and benefit from the company’s growth. Besides large companies, ESOPs and its variants are very popular among start-ups and are used as an important tool to hire senior or experienced talent.

How ESOPs Work

Under an ESOP, stock options are granted to eligible employees, who may exercise such options to acquire equity shares of the company in the future and at a predetermined exercise price. Such shares may be acquired subject to the conditions being met as per the plan. The broad process of an ESOP and the key terms relevant to employees are as under:

1. Drafting of ESOP scheme or plan: The employer drafts the plan, which comprises of various clauses such as the administration of the plan, role of the compensation committee in identifying eligible employees, the grant of option, the vesting period, manner of determining exercise price  and period, eligible employees, situations for lapse of options due to resignation or termination of employees.
2. Board approvals and secretarial compliances: Employers are required to comply with applicable compliances like passing of the board or shareholder resolution, ensuring compliance with the Securities Exchange Board of India (SEBI) guidelines in case of a listed company.
3. Grant of options: Grant letters are issued to the eligible employees that mentions grant date, vesting details, exercise price and other conditions.. This date is referred to as the “grant date”.
4. Vesting of options: The vesting period is the period from the date of grant of the option to the date the employee becomes eligible to exercise the option. The vesting of options may vary from an employee to employee depending upon various factors like the duration of service, employee’s performance, and other conditions specified under the plan.
5. Exercise of options: Once the vesting period is over, the employee has the right to exercise the option, during the period specified for the exercise of the options. The date on which the employee exercises the options is called the “exercise date”. Upon exercise of the option by the employee, the company allots the shares to the eligible employee in accordance with the ESOP. This is the stage where “options” get converted into “shares” of the company.

How ESOPs are Taxed

Considering the various steps involved in the implementation of an ESOP (i.e. grant, vesting, exercise), it is important to understand the applicable tax provisions to determine taxability for the employees. As per the provisions of Income Tax Act, 1961 (the Act), the tax implications get triggered at two stages — at the time of exercise of options and then at the time of sale of shares.  

(a)   At the time of exercise of ESOPs by employees

Exercise of the options is the first taxable event in the hands of employees when the shares are allotted. The taxable perquisite value is determined under the head of income – “Salary”. The perquisite value of the benefit from exercise of options is computed as under:

Taxable perquisite = Difference between the Fair Market Value (FMV) of the shares as on the date of exercise as reduced by the price actually recovered from the employee (i.e. the exercise price).

As per income tax rules, the FMV for this purpose would be computed as under:

Listed shares

In case where on the date of the exercise of the options, the shares are listed on a recognized stock exchange in India, the FMV shall be the average of the opening price and closing price of the share on that date on the said stock exchange.

In case, on the date of exercise of the options, the shares are listed on more than one recognized stock exchange, the FMV shall be the average of the opening price and closing price of the share on the recognised stock exchange which records the highest volume of trading in the shares.

Unlisted shares

 In a case where on the date of exercise of the options, the shares are not listed on a recognised stock exchange in India, the FMV of such shares shall be determined by a merchant banker on the “specified date”.

“Specified date” means the date of exercise of the options or any date earlier than the date of the exercise of the options. It is pertinent to note that such earlier date should be within 180 days prior to the date of the exercise of option.

Employer’s obligation to withhold tax on ESOP perquisite

As the benefit from exercise of options is taxable as a perquisite i.e. salary income in the hands of employees, the employer is under an obligation to withhold (deduct) tax on such salary. The tax would be withheld by the employer at the time of the allotment of shares to the employees, i.e. the tax would be recovered from the employee through the relevant month’s payroll in which the shares have been allotted. Typically, the allotment of shares takes place on the date of exercise of options.

Recovery of tax upon exercise of option impacts the “net in hand salary” of the employee for that month. To incentivise eligible start-ups and as a relief to their employees, a concession has been provided for the period of withholding of taxes on ESOPs. Accordingly, such “eligible start-ups” can deduct tax on perquisite income on exercise of ESOPs within 14 days of the following events, whichever event occurs earlier:

• After the expiry of 60 months from the end of the relevant financial year;
• From the date of sale of shares; or
• From the date the taxpayer ceases to be an employee of the eligible start-up

Eligible start-ups for this purpose refer to a start-up that is registered with the government and holds a certificate of eligible business from the Inter-Ministerial Board of Certification called the IMB Certificate. 

(b)  At the time of sale of allotted shares

The shares allotted to an employee under an ESOP is considered as a capital asset and any gain on sale of such shares would attract capital gain tax. The capital gains on sale of shares will be computed on the difference between the sale price and purchase cost. The purchase cost for this purpose is FMV of the shares as on the date of exercise of options which was considered for computation of perquisites tax as discussed above.

Capital gains may be classified as long-term capital gains or short-term capital gains based on the period of holding of the shares. The period of holding of the shares will be considered from the date of allotment of shares to the employees till the date of sale.

Long-term vs short-term capital assets

Unlisted shares should be held for more than 24 months (on the date of sale) to qualify as a long-term capital asset. Accordingly, such shares if sold before 24 months would qualify as a short-term capital asset.

In case of listed shares, if the shares are held for more than 12 months (on the date of sale), the same would qualify as long-term capital assets. Else, they would be treated as short term capital assets.

The tax rates as applicable on short term and long-term capital gains arising from sale of shares are summarized below:

Also, the employee would be required to evaluate the advance tax applicable on such capital gain and ensure that taxes are deposited within the prescribed timelines during the course of the financial year.

Reporting /disclosure requirements in tax return for holding shares

The details of shares held in an unlisted company (like company’s name, PAN, number of shares acquired or sold during the year etc.) need to be reported by an employee in their personal income-tax return.

Shares of a foreign company allotted under an ESOP to employees of its group company or to the employees of its subsidiary company in India would also be considered as unlisted shares, as these are not listed on an Indian stock exchange. There are certain additional reporting requirements by an employee whose residential status is that of a resident and ordinary resident (ROR) in India during the financial year, in case they hold shares of a foreign company:

Schedule FA (Foreign Asset Reporting): The shares allotted by foreign company to a resident employee qualify as foreign assets and the details are required to be disclosed in Schedule FA of the income-tax return form. Further, in this case income-tax return form ITR 1 would not be applicable since the same does not have form in Schedule FA. Employees would be required to file form ITR 2 or ITR 3 as may be applicable.

Schedule AL (Asset and Liabilities): Where the employee’s total income exceeds INR 50 lakh during the concerned financial year, they will be required to report details of cost of acquisition of such shares outside India in Schedule AL as well. 

Bottom Line 

Over the years ESOPs have proved to be an efficient form of providing long term incentive to the employees. ESOP millionaires is a reality and many employees of start-ups have benefitted from this wealth creation opportunity. It is therefore important for employees in receipt of ESOPs to understand the tax implications at the time of exercise of  options and upon sale of shares. 

Also, employees should note that non-reporting or incorrect reporting of shares allotted under an ESOP or capital gain arising from sale of shares could result in interest and/ or penalties being levied on the employee.  Therefore, it is important that employees participating in ESOPs or other forms of long-term variable incentives, such as employee stock purchase plan (ESPP) or restricted stock units (RSUs) understand the tax implications arising from such plans.

This article was originally published on Forbes Advisor.