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I. Taxation of ESOPs in India has witnessed continuous changes. Until the financial year-ending March 1999, there were no specific guidelines for taxing the benefits arising from ESOPs. The ESOPs were usually taxed as a perquisite in the hands of the employees on the difference between the FMV of the stock on the date of vesting of the options and the exercise price. Subsequently, there was a concessional tax treatment for ESOPs, which were designed in accordance with the prescribed ESOPs Guidelines. The taxation is initiated only at the time of sale of the shares for such qualified ESOPs.
ESOPs falling in unqualified category were taxable as a perquisite on the difference between the Fair Market Value (FMV) on the date of vesting/exercise and the exercise price.
During the period of April 2007 to March 2009, employer was required to pay a Fringe Benefit Tax (FBT) on benefit derived by employee from ESOPs. The employer was free to recover such FBT from the employees.
Currently, ESOPs benefits are taxable as perquisite and are included in the salary of the employees as a part of it. The employer is required to withhold tax at source in respect of such perquisite. The value of the perquisite is computed as the difference between the FMV of the share on the date of exercise and the exercise price. The employer is also required to deduct the TDS in respect of such perquisite.
Let’s understand the provisions for taxation of ESOPs for Employee and Employer.
II. Taxation of ESOPs for Employee:
Employees who exercise the option and become the shareholder of the company are taxed under the Income Tax Act, 1961. There are no cash outflows or taxation implications when the options are granted as and when the options are vested in the employee. The tax liability can arise at two stages for shares allotted under ESOP.
Stage 1: At the time of exercise of the option:
When the employees exercise their right to convert options into equity shares after the end of the vesting period, the tax is charged on the perquisite value under the head ‘Income from salary’. The employer (i.e., company) computes the perquisite value of ESOP in the hands of the employee and deduct tax thereon. The employer is required to show this value and the tax deducted thereon, in Form 16 issued to the employee. The perquisite value and the tax deducted thereon by the company would be reflected in Form 16 and Form 12BA of the employee and treated as income from salary in the tax return.
The computation of taxable value is as follows:
Fair Market Value of Shares (on the date of exercise of the option)
Less: Amount recovered from employees for such shares (exercise price)
Taxable Value of Perquisite
Fair Market Value is computed based on methods prescribed for the same.
Stage 2: At the time of sale of shares:
When the employees sell the shares allotted to them by the company under ESOP, at higher prices, a capital gain arises. Tax is charged on this capital gain under the head ‘Capital Gains’. The gain is either long term capital gain or short-term capital gain. Rate of tax will depend on the type of capital gain as mentioned below.
a) If the company is listed on an Indian stock exchange and shares are held for more than 12 months, it will be considered as long-term capital gain and as per Finance Act 2018, it will be taxed u/s 112A at 10% exceeding Rs. 1 lakh of Capital Gain. If shares are held for less than 12 months, it will be considered as short-term capital gain and profit will be taxed at 15% u/s 111A.
b) Today, employees in start-ups and unlisted companies are also allotted ESOPs. These shares will be considered short-term assets if held for less than 24 months from the exercise date and taxed according to the respective tax slab. If the shares are held for more than 24 months, and sold after this period, these are considered as long-term gains and taxed at 20% after indexation of cost.
The computation of capital gain is as follows:
Sale Price of Shares
Less: Fair Market Value of Shares (on the date of exercise of the option)
Capital Gain
III. Taxation of ESOPs for Company:
a) The Issuing Company can claim ESOP cost as deduction.
Income Tax Appellate Tribunal in an order by (Dy. Commissioner of Income-tax (LTU), Bangalore Vs M/s. Biocon Limited) held that “discounts under the ESOP are an employee cost and should be allowed as a deduction over the vesting period, in the hands of the issuing company.” In an ESOP, the shares are issued to the employees at a future date (after vesting period) at price lower than fair market value (FMV) of the share.
Hence, ESOP discount, is nothing but the reward for services, is a taxable perquisite to the employee at the time of exercise of option, and its valuation is to be done by considering the fair market value of the shares on the date on which the option is exercised.
The discounts under the ESOP is an employee cost and should be allowed as a deduction over the vesting period, in the hands of the issuing company.
b) In case of Buy-Back of ESOP-shares by the Company:
When it comes to a buyback of shares of an unlisted company, then provisions under sections 10(34A) and 115QA of the Income Tax Act shall intervene. As per section 10(34A), any income arising to a shareholder (including ESOP-shares) on account of buy back of unlisted shares by the company shall be exempt in the hands of such shareholder. Further, as per section 115QA, the tax @ 20% shall be paid by the unlisted company on the buyback of its shares.
Therefore, in the hands of the employees, the gain from the buyback of shares by an unlisted company shall be exempt and the company shall be liable to pay buyback distribution tax.
Conclusion: To conclude, ESOP is a great way to build the foundation of financial freedom and retirement. Since many companies have now made ESOPs as part of the compensation for key employees, it is very important for an employee to be aware of its taxability. ESOPs are beneficial to both employees as well as Startups if implemented effectively.
Article by: Ms Bhavya Sharma, a Practising Company Secretary from Delhi.
You can contact us at: Legal@bhavyasharmaandassociates.com or for more details you can visit: www.bhavyasharmaandassociates.com
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