An Employee Stock Option Plan (ESOP) is a mechanism allowing employees, directors, or officers of a company or its holding/subsidiary firms to purchase company shares at a pre-determined price in the future, providing ownership incentives and aligning employee interests with company growth. Governed under Section 2(37) of the Companies Act 2013, Section 62(1)(b), and Rule 12 of the Companies (Share Capital and Debenture) Rules, ESOPs require formal documentation including the scheme, board and shareholder resolutions, grant letters, vesting schedules, and registers. Eligibility generally covers permanent employees and directors, while promoters and major shareholders face restrictions. Taxation arises at exercise (perquisite under salary) and sale (capital gains). For startups, perquisite tax can be deferred under Section 80-IAC. Listed companies now follow the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, which merged prior ESOP and sweat equity frameworks, standardizing share-based employee compensation across listed entities, including RSUs and SARs. ESOPs thus serve as strategic tools for talent retention, incentivization, and wealth creation.
Legal framework
Defination of ESOP:- Section 2(37) of the companies act 2013 defines “employees’ stock option” (ESOP) as the option given to the directors, officers or employees of a company, or of its holding or subsidiary company, which gives them a benefit or right to purchase or subscribe to the shares of the company at a future date at a pre‑determined price.
Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 lays down detailed conditions (minimum vesting period, lock‑in, disclosures, etc.) for unlisted companies.
Section 62(1)(b) allows issue of shares to employees under a scheme of ESOP approved by special resolution.
Key elements in ESOP
ESOP documentation includes ESOP scheme, Board resolution, shareholders resolution, grant letter, vesting schedule, register of ESOP.
Eligibility:- ESOPs can generally be granted to permanent employees and directors (other than independent directors), including those of holding/subsidiary companies, with restrictions on promoters and 10%+ shareholders except in specific startup exemptions.
Exercise price: Pre‑decided price per share; can be at discount, par, or premium, subject to applicable pricing norms. It is to be mentioned in Grant letter.
Vesting:- Options vest over pre-determined time or on meeting performance milestones, with a statutory minimum one‑year vesting period (except death/merger etc. as defined by company)
Sale:- Employee sells shares (IPO, secondary sale, promoter/buyer purchase, ESOP trust buyback, etc.), realising capital gains or losses
Taxation of ESOP
Taxation for employees trigger at the time of exercise and at the time of sale of shares.
- At the time of exercise – It is treated as perquisite under the head salary
- Perquisite value = Fair Market Value (FMV) on exercise date minus exercise price.
- Taxed as salary income under section 17(2); employer has to deduct TDS.
- For listed shares, FMV is based on specified stock exchange rules; for unlisted, FMV is determined by a Category I merchant banker valuation.
- At sale – Capital gains arise
- Cost of acquisition = FMV considered at exercise.
- Capital gains = Sale price minus FMV at exercise.
- Holding period from date of allotment of shares determines whether short‑term or long‑term, with different rates and indexation rules depending on listed/unlisted status.
- As per amendment in companies act 2013 There is deferral for start up
- For eligible startups under section 80‑IAC, ESOP perquisite tax can be deferred to the earliest of: expiry of 48 months, sale of shares, or cessation of employment, easing cash‑flow issues for employees.
Now SEBI ESOP Regulations replaced to SBEBSE 2021
Prior to amendment their was separate regulations for ESOPs and sweat equity were merged into the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, creating a single framework for ESOP, RSU, SAR and sweat equity schemes for listed companies.
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