Introduction
ESOP stands for Employee Stock Option Plan (or Scheme). It is an employee benefit plan where a company grants its employees the right (but not the obligation) to purchase the company’s shares at a future date for a pre-determined price.
Further, Companies introduce ESOPs with specific strategic goals that benefit both the organization and the workforce. The primary objectives are:
A. For the Employer (Company)
i. Talent Retention: ESOPs typically come with a “vesting period” (a waiting period). To earn the shares, an employee must stay with the company for a number of years. This acts as “golden handcuffs,” reducing attrition of key talent.
ii. Performance Alignment: When employees hold shares, their personal financial growth is directly tied to the company’s success. This aligns individual goals with the organization’s goals, encouraging employees to think and act like business owners.
iii. Cash Conservation: For startups and growing companies, cash flow is critical. ESOPs allow companies to compensate employees competitively without an immediate outflow of cash, as the “payment” is in the form of future equity.
B. For the Employee
i. Wealth Creation: ESOPs offer employees a chance to create significant wealth beyond their regular salary. If the company grows and the share price skyrockets, the value of the ESOPs can far exceed standard bonuses.
ii. Sense of Ownership: Owning a piece of the company fosters a sense of belonging and pride. Employees are not just working for a salary; they are working to increase the value of their own assets.
Various schemes covered under ESOP
1. ESOS (Employee Stock Option Scheme) – Under ESOS model, the company grants an option to employees to buy share in the future after a set period (Vesting Period) at a pre-set price (Exercise Price) which is required to be paid by the employee to the company.
Under this model, the primary purpose of the company is to attract, retain, and motivate top talent by aligning the employees’ financial interests with the long-term growth and success of the company, fostering a sense of ownership.
2. RSU (Restricted Stock Units) – Under RSU model, the company grants actual shares to the employees at a future date after a set period (Vesting Period) or performance goals without paying NIL or very nominal amount by the employee.
3. ESPP (Employee Stock Purchase Plan) – Under ESPP model, employee is given an option to purchase the shares of the company at a discount and the amount agreed to buy the shares is deducted from the salary of the employee at equal intervals.
4. SAR (Stock Appreciation Rights) – Under SAR model, employees are given the right to receive benefit with respect to appreciation in price of shares and the benefit is in the form of cash or shares for the difference in price of shares.
5. Phantom Stocks – Under phantom stocks, ownership of shares is granted to employees hypothetically without actual transfer of shares for a mutual agreed number of shares. Under this arrangement, employees are given actual shares either upon exit from the company, sale of the company or achievement of specific milestones as mutually agreed between the company and employees.
Regulatory Framework governing ESOP schemes
1. At the time of Allotment – Under the Income-tax Act, value of any security allotted or transferred to employees is considered as perquisite in the hands of employee and taxable as income under the head Salary.
Further, the value shall be the fair market value of the security allotted on the date on which option is exercised as reduced by the amount actually paid by the employee in respect of such security.
Further, the company shall deduct TDS on amount of perquisite at the applicable slab rates applicable to the employee.
Under the Companies Act, in case of ESOP schemes where actual shares were allotted, as per the provisions contained in Companies Act, it enable the companies to issue shares to employees under a scheme of stock options subject to special resolution passed by the company and other prescribed conditions satisfied.
2. At the time of Sale of Shares – At the time of sale of shares of the company, Capital Gains arises on such sale and employee is required to pay Capital Gains Tax basis the period of holding of such shares. If the shares qualify as Long-Term Capital Asset, then Long-Term Capital Gains Tax Rate is applicable and if shares qualify as Short-Term Capital Asset, then Short-Term Capital Gains Tax Rate is applicable on employees.
Further, the cost of acquisition shall be the fair market value of such shares which has been considered for computing perquisite under the head salary.
Additionally, in case of cash settled SAR or Phantom Stocks, since no actual shares are allotted, the cash bonus received is taxable as profit in lieu of salary under the head Salary under the Income-tax Act and the company is required to deduct TDS on such amount.
3. Computation of Fair Market Value – Fair Market Value (FMV) as on the date of exercise shall be determined as per the provisions contained in Income-tax Rules.
In case of shares are listed on recognised stock exchange, FMV shall be determined basis the share price and the prescribed rules provided.
In case of shares are not listed on recognised stock exchange, FMV shall be such value of shares as determined by the Merchant Banker on the specified date.
Timeline from Grant of Stock Options to Sale of Shares
Stage 1 : Grant of Stock Options – Under the stage one, stock options are granted by the company to employees as per the Stock Option Plan prepared by the Company and in accordance with regulatory provisions contained in Income-tax Act read with Companies Act.
Stage 2 : Vesting of Stock Options – Under the stage two, stock options are vested to employees once the prescribed conditions based on performance milestones or tenure of employee in the company or combination of both are satisfied.
Stage 3: Exercise of Stock Options – Under the stage three, once the stock options are vested, employees are given the right to exercise the stock options and it is an act of purchasing the shares of the company at the agreed exercise price paid to the company NIL exercise price as agreed with the company. Once the stock options are exercised, employees are become the actual owners of the company after allotment of shares.
Stage 4: Sale of Shares – Under the stage four, once the shares are allotted after exercise of stock options, employees can sell shares either in the recognised stock exchange (if listed) or offer to sale in the next round of investment or offer to sale in the Initial Public Offering (IPO) or Further Public Offering (FPO) by the company.
Reporting in Foreign Asset (FA) Schedule of Income Tax Return Form
In case of Stock Options are granted or shares are allotted of foreign entity and the employee’s residential status for the particular financial year is Resident and Ordinarily Resident (ROR) of India, then he is mandatory required to disclose the details of such stock options or shares in the FA Schedule of the Income-tax return form.
Applicable of Tax Collected At Source (TCS) on amount paid to Foreign Entity
1. In case of shares or stock options of foreign entity allotted or granted to employees qualifying as Person Resident in India under the Foreign Exchange Management Act, 1999, then provisions of TCS are applicable on any amount paid by the employee by way of exercise price and such amount will be considered as amount remitted outside India under the Liberalised Remittance Scheme (LRS) introduced by Reserve Bank of India.
2. Credit of such TCS can be claimed as refund at the time of filing of the Income-tax return or can be set off with the tax liability of the employee.
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Disclaimer: This article serves an educational purpose and should not be considered as professional advice. Consultation with a qualified professional is recommended before making any decisions based on the content provided. The author bears no responsibility for any actions taken based on this article.
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