Tax Guide on ESOPs for Employees and Employers

Summary: Employee Stock Options (ESOPs) are a popular employee benefit, granting employees the right to buy company shares at a discounted price in the future. While the decision to exercise these options is at the employee’s discretion, they must provide services for a period to vest in the ESOPs. The taxation of ESOPs occurs at two stages: when the employee exercises the option and when the shares are sold. At exercise, the difference between the fair market value (FMV) of the shares and the exercise price is taxed as a perquisite under Section 17(2)(vi) of the Income Tax Act, 1961. The FMV is determined based on whether the shares are listed or unlisted, with different rules for each. The employer is responsible for withholding tax on these perquisites, with a deferral option for startups under certain conditions. When the employee sells the shares, any gains are taxed as capital gains, with the sale price minus the FMV at the time of exercise determining the taxable amount. The holding period from the exercise date determines whether the capital gain is long-term or short-term. The rules governing the taxation of ESOPs aim to balance the interests of both employees and employers while ensuring tax compliance.

A guide to tax ESOPS:

Employees are the backbone of every organization, driving its success through their skills, dedication, and innovation. Recognizing their importance, Employee Stock Options (“ESOPs”) are popular employee benefit plan in which employees are given ownership interest in the company, often in the form of stock. Under ESOPs, an entity grants an option to its eligible employee to acquire the shares at a future date but at a predetermined price which is very minimal as compared to the fair market value of the shares.

In general, there is no obligation on the employees to exercise the above options, he/she is at his discretion whether to opt it or not. However, point to be noted that employees are required to render services for some period in the organization to vest in their ESOPs.

While issuing ESOPs is a win-win situation for both the employer and the employees, there are tax implications for both. Here we are discussing the taxation for the employees who are liable to tax at the following stages:

• When employee exercises the option of ESOP
• When employee sells the shares

Let us delve into the discussion in the upcoming paras.

Taxation of ESOPs:

Section 2(37) of Companies Act, 2013 defines “employees stock option” which means, ‘the option given to the directors, officers or employees of the company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a pre-determined price.

At the time of allotment of shares:

As per section 17(2)(vi) of the Income-tax Act, 1961 (“the Act”), the value of any ESOP allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at concessional rate to the employee shall be considered as perquisite in the hands of employees. For this section, the value of ESOP shall be as follows:

• the fair market value of the equity shares, as the case may be, on the date on which the option is exercised by the employee as reduced by the amount actually paid by or recovered from the employee in respect of such security or shares. Please note that exercise of the option is the first taxable event in the hands of employees. In addition, FMV of the ESOP on the date of allotment is not relevant for the valuation of perquisite, instead FMV of the ESOP on the date of exercising the option is relevant.

FMV shall be determined in accordance with the Rule 3 of the Income-tax rules, 1962 (“the rule”), summarized as follows:

Provision for tax deduction at source:

As the benefit arising from the ESOP is taxable under the head salaries, the person responsible for paying salaries to the employees is liable to withhold tax at the time of payment of such salary monthly at the average rate of tax in accordance with section 192 of the Act.

However, to incentivize the eligible startups referred in section 80-IAC and providing relief to the employee, the obligation to withhold tax under section 192 of the Act has been deferred to avoid the cash crunch in the hands of the employees. In the said case, TDS is required to be deducted within 14 days of any of the earliest event:

• After expiry of 48 months from the end of the relevant assessment year or
• from the date of the sale of such ESOP by the employee or
• from the date of the assessee ceasing to be the employee of the person

At the time of sale of ESOPS:

The ESOPs allotted to the employees are considered as capital assets and gain/loss arising from the transfer of said capital asset shall be taxable under the head capital gains. The capital gains on sale of shares will be computed on the difference between the sale price and purchase cost /indexed purchase cost depending on the nature of gain being long term or short term. The purchase cost for this purpose is FMV of the shares as on the date of exercise of options which was considered for computation of perquisites tax as discussed above.

Decision of long term or short term shall depend on the period of holding of the shares, which shall be computed from the date of allotment of the shares to the date of sale of the shares.