A founder I worked with recently was putting together an ESOP buyback for the first time. About 15 employees were set to receive liquidity — ₹5 to ₹40 lakh each, depending on their tenure and option count. He assumed the tax story was straightforward: employees had already paid perquisite tax when they exercised their options. The buyback was just collecting cash. Wrong.
Here is the reality. ESOP taxation in unlisted companies happens at two distinct points, governed by two separate provisions, and they interact in a way that catches employees off guard every time. Section 17(2)(vi) of the Income Tax Act hits them at exercise. The capital gains provisions — now restored to their pre-2024 form by the Finance Act 2026, effective April 1, 2026 — hit them again when the company buys back those shares.
Understanding both is not optional. It is the difference between an employee receiving a pleasant surprise and a tax demand notice three months after the buyback.
The First Tax: Perquisite at Exercise under Section 17(2)(vi)
When an employee exercises stock options in an unlisted company, the difference between the Fair Market Value (FMV) on the date of exercise and the exercise price is treated as a perquisite — salary income — and taxed at the applicable slab rate.
Formula: Perquisite = (FMV on Exercise Date − Exercise Price) × Number of Options
The FMV for unlisted shares must be certified by a Category I SEBI-registered Merchant Banker. Rule 3(9)(ii) of the Income Tax Rules is clear on this — the certificate must not be older than 180 days from the date of exercise. The employer deducts TDS on this perquisite under Section 192 of the Income Tax Act, 1961 (or Section 392 of the IIncome Tax Act 2025, applicable from April 1, 2026).
The 180-day window is frequently mishandled in practice. In several mandates I’ve worked on, the company obtained one merchant banker certificate and used it for multiple exercise tranches over 8–10 months. If any tranche falls outside 180 days from the certificate date, the FMV is technically undocumented — and the employer faces TDS default under Section 201, with interest and penalty.
Get a fresh certificate before each exercise event. It is a small cost relative to the exposure.
The Second Tax: Capital Gains When the Company Buys Back
After exercise, the employee holds actual shares in the company. When the company buys those shares back, the employee receives sale consideration. That triggers capital gains tax.
The cost of acquisition for capital gains purposes is the FMV on the date of exercise — not the original exercise price. This is correct: the employee already paid perquisite tax on the FMV at exercise, so the tax basis “steps up” to that value. Capital gains is computed only on the appreciation beyond that FMV.
Holding period classification (unlisted shares): Shares held for more than 24 months from the date of allotment/exercise qualify as long-term capital assets. LTCG is taxed at 12.5% without indexation. STCG (held ≤24 months) is taxed at slab rates.
A Worked Example (in ₹)
Let us say Anjali is a senior engineer who exercised 10,000 options in January 2024. Her exercise price was ₹10 per share. The merchant banker certificate issued in December 2023 (within 180 days) put FMV at ₹150 per share.
Step 1 — Perquisite at exercise (January 2024):
Perquisite = (₹150 − ₹10) × 10,000 = ₹14,00,000
This ₹14 lakh is added to her salary income for FY 2023–24. Employer deducts TDS under Section 192. She pays tax at her slab — let us say 30% plus cess, so roughly ₹4.33 lakh in tax.
Step 2 — Company announces buyback in June 2026 at ₹250 per share:
Anjali has held the shares from January 2024 to June 2026 — just over 28 months. That crosses the 24-month threshold. Long-term capital asset.
Capital Gain = (₹250 − ₹150) × 10,000 = ₹10,00,000
LTCG Tax = 12.5% of ₹10,00,000 = ₹1,25,000
Total tax across both events: ₹4,33,000 + ₹1,25,000 = ₹5,58,000 on a buyback receipt of ₹25,00,000.
Had Anjali sold one month earlier — at 23 months — the same ₹10 lakh gain would have attracted tax at slab (30% + cess = ₹3.12 lakh instead of ₹1.25 lakh). The timing difference costs ₹1.87 lakh in tax. For employees with larger option pools, this number scales significantly.
What Valuation Does the Company Need for the Buyback?
This is where I see most companies cut corners. There are actually three separate valuation requirements that can apply in an ESOP buyback, and they are governed by different laws.
First, the Income Tax valuation for the perquisite — Rule 3(9)(ii) merchant banker certificate, as discussed above. This is for employees who are still exercising options at or near the buyback date.
Second, the Companies Act 2013 valuation for the buyback price. Section 68 of the Companies Act and Rule 17 of the Companies (Share Capital and Debentures) Rules require that the buyback price be fair and reasonable. An IBBI Registered Valuer report provides the most defensible basis for this determination. If the Board approves a buyback price without an independent valuation, the directors face the risk of shareholder challenges and potential NCLT scrutiny.
Third — and this one surprises companies — if the company has any foreign shareholders who are also selling in the buyback, FEMA Regulation 4 and FEMA 20R apply. The pricing guidelines under FDI require that foreign shareholders receive a price not exceeding the FMV determined by a SEBI Registered Merchant Banker or IBBI Registered Valuer using an internationally accepted pricing methodology. A rupee-denominated buyback to foreign holders without this certificate is a FEMA violation.
One certificate does not cover all three. The company needs to understand which compliance layers apply before pricing the buyback.
The Grey Area: What Happens When the Merchant Banker Cert Is Stale at Buyback Time?
Here is a genuine ambiguity that comes up in practice. Say the company did a merchant banker valuation in October 2025 at ₹200 per share. The buyback is being structured in June 2026 — more than 180 days later. The October valuation cannot be used for perquisite purposes under Rule 3(9)(ii) for any options exercised after April 2026. But the company wants to use that same FMV to defend the buyback price under the Companies Act.
Strictly speaking, the Companies Act does not impose a 180-day window. But there is a practical problem: if the company obtains a fresh valuation in June 2026 (as required for Income Tax compliance) and that fresh valuation comes in materially higher than October 2025, the buyback price starts to look like it undervalues the shares. This creates a gap that regulators or minority shareholders can exploit.
The clean answer is to time the buyback so the board approval, fresh merchant banker certificate, and exercise date all fall within a 60–90-day window. That aligns all three valuations and removes ambiguity.
What Employees and Finance Teams Should Do
For employees: check your exercise date. If you exercised options more than 24 months ago, you are in long-term capital gains territory on the appreciation above FMV. The Finance Act 2026 capital gains treatment is actually more favourable than the dividend regime that applied briefly for listed company buybacks under Finance Act 2024. Time the sale to your advantage. If you are a few weeks short of 24 months, wait.
For finance teams and CFOs: do not run a buyback without a fresh independent valuation. The three-layer compliance check (Income Tax, Companies Act, FEMA) is non-negotiable. Get clarity on which layers apply before the board approves the pricing. And plan the timeline so the valuation certificate, the exercise window, and the buyback record date fall within the same 90 days.
The tax math on an ESOP buyback is not complicated once you break it into its two parts. The problem is that most employees — and some HR teams — only see part one.
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About the Author: Prateek Mittal is Director at FinVal Research & Consultancy, an IBBI Registered Valuer firm based in New Delhi. The firm advises Indian companies on business valuation, ESOP structuring, and M&A transactions. finvalresearch.in
Disclaimer: The views expressed are for educational purposes only and do not constitute legal or tax advice. Readers should consult their advisors for specific situations.
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