Summary: Employee Stock Option Plans (ESOPs) allow companies to grant employees the right, but not the obligation, to purchase company shares at a pre-determined price after a specific vesting period. This mechanism is primarily used to attract, retain, and motivate personnel by providing them with a stake in the company’s growth. If the market value of the shares increases, employees can profit by exercising their option at the lower, fixed price and selling the shares at the higher market rate. ESOPs are commonly adopted by startups and IT firms. In India, they are governed by the Companies Act and SEBI regulations for listed entities. For accounting purposes, the cost of ESOPs is recognized as employee compensation and is expensed over the vesting period in the company’s financial records. From the employee’s perspective, the difference between the Fair Market Value (FMV) on the exercise date and the exercise price is taxable as a perquisite under “salaries” in the year of exercise, with the company responsible for deducting TDS. Subsequent sale of these shares by the employee will trigger capital gains tax, with the FMV on the exercise date serving as the cost of acquisition.
What is ESOP’s
ESOP is a scheme where companies give employees the option to buy company shares at a fixed price after a certain period (called the vesting period). It helps attract, retain, and motivate employees by making them part-owners of the company. If the company’s share value rises, employees can benefit by buying shares (i.e., exercising the option) at a lower price (which is the fixed price initially agreed upon) and selling them at a higher market price. ESOPs are common in startups and IT companies. In India, ESOPs are regulated by the Companies Act and SEBI rules (for listed companies).
Accounting in the company’s books
The cost of ESOPs is usually spread over the vesting period — from the date the options are granted to when they vest. As per SEBI guidelines and ICAI’s guidance, this cost is treated as part of employee compensation and is recorded in the company’s books over the vesting period.
Taxation
In the hands of Employees
What does Act say?
Section 17(2) says that: perquisite includes-
(vi) the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at concessional rate to the assessee.
Explanation.-For the purposes of this sub-clause,-
(a) “specified security” means the securities as defined in clause (h) of section 2 10 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and, where employees’ stock option has been granted under any plan or scheme therefor, includes the securities offered under such plan or scheme;
(b)“sweat equity shares” means equity shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called;
(c) the value of any specified security or sweat equity shares shall be the fair market value of the specified security or sweat equity shares, as the case may be, on the date on which the option is exercised by the assessee as reduced by the amount actually paid by, or recovered from, the assessee in respect of such security or shares;
(d) “fair market value” means the value determined in accordance with the method as may be prescribed;
(e) “option” means a right but not an obligation granted to an employee to apply for the specified security or sweat equity shares at a predetermined price;
In Summary,
- Company has to deduct TDS in the year of exercise of options by the employee
- On the value of specified security which is calculated as FMV as on date of exercise and the exercise price
- It is taxable in the hands of employee in the year of exercise of option as perquisite under the head salary
- In case employee sells the shares acquired under ESOP in future date, then capital gains will arise. Cost of Acquisition will be the FMV taken on the date of exercise of option.
Example
An employee is granted 1,000 ESOPs (i.e., 1000 Shares) at an exercise price of ₹100 per share.
After 3 years, the employee exercises the options when the Fair Market Value (FMV) of the share is ₹300 per share.
Tax at Exercise:
- The difference between FMV and exercise price = ₹300 – ₹100 = ₹200
- Total taxable value as perquisite = ₹200 × 1,000 ESOPs= ₹2,00,000
- This ₹2,00,000 is treated as salary income, and the company must deduct TDS in the year of exercise.
Taxation in the hands of Company
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