Taxation of Employee Stock Option Plan (ESOP)

Employee Stock Option Plans (ESOPs) allow employers to offer shares to employees either free of cost or at a concessional rate, and the taxability arises at two distinct stages—first as a perquisite at the time of exercising the option, and later as capital gains when the shares are sold. Under Section 17(2)(vi), the taxable perquisite equals the difference between the Fair Market Value (FMV) of the shares on the date of exercise and the amount actually paid by the employee. The FMV must be determined as per Rule 3, which prescribes different valuation rules for quoted shares, thinly traded shares, and unlisted shares, including reliance on stock exchange prices or valuation by a merchant banker. The FMV on the date of allotment is irrelevant for computing the perquisite. Once the employee later transfers the shares, capital gains taxation applies. The cost of acquisition for capital gains is the FMV on the exercise date, while the holding period begins from the date of allotment until the date of transfer. This distinction affects the classification of gains as short-term or long-term.

The tax treatment differs significantly for employees of eligible start-ups notified under Section 80-IAC. Recognizing the cash-flow burden arising from immediate taxation of ESOP perquisites despite no monetary benefit at the time of allotment, the Income-tax Act allows deferment of tax deduction and payment for such employees. Under the amended framework, TDS on ESOP perquisites for eligible start-up employees is deferred until the earliest of: expiry of 48 months from the end of the relevant assessment year, cessation of employment, or sale of the shares. The employee must still disclose the perquisite value in the year of allotment, but the corresponding tax liability is deferred. During this period, only tax on the salary portion excluding the ESOP perquisite is payable, which is computed proportionately. Once the deferment period ends or a triggering event occurs, tax must be deducted within 14 days based on the rates applicable in the year the securities were allotted.

The article also illustrates these rules through numerical examples, demonstrating the computation of perquisite value based on FMV, calculation of tax liability attributable to salary excluding perquisites, and the impact of deferment for start-up employees. Finally, a set of multiple-choice questions reinforces the conceptual understanding of ESOP taxation, covering core topics such as valuation date, perquisite computation, capital gains treatment, determination of the holding period, and conditions for deferred taxation. These principles collectively highlight the dual-stage taxation framework of ESOPs, the valuation mechanism, and the specific relief available to employees of eligible start-ups.

Taxation of Employee Stock Option Plan (ESOP)

Introduction

When an employer offers securities to an employee under an Employee Stock Option Plan (ESOP) scheme, free of cost or at a concessional rate, it is taxable as a perquisite in the year in which the securities have been allotted to the employee.

However, the liability of payment or deduction of tax on such perquisite is allowed to be deferred in case of an employee of an eligible start-up. The value of the perquisite shall be its market value as on the date of exercising the ESOP, as reduced by the amount recovered from the employee. When securities allotted under ESOPs are subsequently transferred by the employee, the gains arising therefrom shall be taxable under the head ‘Capital Gains’. [Section 17(2)(vi)]

Why are ESOPs given?

Generally, ESOPs are offered by employers as an award to employees in order to retain top talent. It acts as a motivational tool for employees, making them feel responsible for the performance of the company after owning a stake in it.

ESOPs are particularly popular among start-ups that cannot afford to pay high salaries to employees in the initial phase. ESOPs allow start-ups to employ highly talented employees at a relatively low salary amount with the balance being made up via ESOPs.

Tax implications of ESOPs

At the time of allotment of shares

Any company responsible for paying salaries to employees shall deduct tax at the time of payment of such salary at the average rate of tax. The definition of salary also includes perquisites provided by the employer to employees. The value of any securities allotted to employees either free of cost or at a concessional rate would be treated as perquisite.

The first tax instance shall arise at the time of allotment of securities.

When an employee exercises the option, the difference between the Fair Market Value (FMV) of the securities on the date of exercising of option and the amount paid by the employee for such securities, is taxable as perquisite. The fair market value of ESOPs shall be determined in accordance with the manner prescribed under Rule 3.

The FMV of the securities on the date of allotment is not relevant for the calculation of perquisite value. Instead, the FMV of securities at the time of exercising of option is considered.

The fair market value of the following securities allotted under the ESOP scheme shall be computed as per Rule 3:

a. Quoted shares; and

b. Unquoted equity shares.

For example, ABC India Private Limited issued ESOP to Mr. B during the financial year 2024-25. Calculate the value of the perquisite based on the following data:

At the time of transfer of shares by the employee

When securities allotted under ESOPs are subsequently transferred by the employee, the gains arising therefrom shall be taxable under the head ‘Capital Gains’. The taxability of capital gains shall depend on the type of security and the period of holding thereof.

The period of holding of securities shall be the period commencing from the date of allotment of securities, and not from the date of exercising of option, ending on the date when employees transfer the securities.

Further, the fair market value of securities on the date of exercising the option shall be taken as the cost of acquisition of such securities to compute the capital gain.

For example, Mr. John exercised the ESOP on 01-04-2022, and the shares are allotted to him on 01-05-2022. He sold such shares on 01-04-2024. The period of holding of such shares shall be counted from 01-05-2022 (and not from 01-04-2022) till 31-03-2024. However, for computing the cost of acquisition, the fair market value of shares as on 01-04-2022, being the date of exercising of ESOP, shall be considered.

Tax treatment of ESOPs where the employer is an eligible start-up

The taxability of ESOPs arises in the hands of the employee at two stages. Firstly, when securities are allotted to the employee and, secondly, when the same is sold.

At the time of allotment of securities, the difference between the fair market value of shares on the date of exercising the option and the amount actually paid by the employee for such securities is taxable as perquisite and chargeable to tax under the head salary. Consequently, the employer is required to include the amount of perquisite in the salary of the employee and deduct tax thereon under section 192 in the year in which securities are allotted.

As employees do not get any immediate benefit from securities allotted under the ESOPs, the deduction of tax thereon in the year of allotment itself was very burdensome for them as it reduces the cash flow in their hands. To reduce the burden of taxes, various provisions of the Income-tax Act, inter-alia, Section 192 (TDS on salary), Section 140A (self-assessment tax), Section 191 (direct payment of tax by the employee), and Section 156 (notice of demand) amended to defer the deduction and payment of tax on income in the nature of perquisites arising from ESOPs.

Only an eligible start-up as referred to in Section 80-IAC and its employees would get the benefit of deferment of TDS and tax payment on perquisite arising from ESOPs.

Section 192, which provides for the deduction of tax by the employer from the salary of the employee, provides that an eligible start-up shall deduct tax from income arising in the nature of perquisites from ESOPs within 14 days from the happening of any of the following events (whichever is earlier):

a. On the expiry of 48 months from the end of the assessment year in which securities are allotted under ESOPs;

b. From the date the assessee ceases to be an employee of the organization; or

c. From the date of sale of securities allotted under ESOP.

For this purpose, the tax shall be deducted on the basis of rates in force for the financial year in which securities are allotted or transferred under ESOPs.

Thus, an employee is required to disclose the value of perquisite from ESOPs in his return of income for the year in which securities are allotted. However, due to the deferment of payment of tax, the employee shall not be required to pay tax on perquisites arising from ESOPs in such year.

The tax to be payable on the salary income, excluding the perquisite value of ESOPs, should be computed as per the following formula.

For example, Mr. A, working in an eligible start-up company, has been allotted 100,000 shares at the rate of Rs. 10 per share under the ESOP scheme in the Financial Year 2024-25. The fair market value of shares at the time of exercising of option by Mr. A is Rs. 100. The perquisite value of ESOPs taxable in the hands of Mr. A shall be Rs. 90 Lakhs [100,000 shares* (Rs. 100 – Rs. 10)]. The annual salary of Mr. A (excluding perquisite value of ESOPs) in that year is Rs. 40 Lakhs. He continues with the company even after the expiry of 48 months from the end of the assessment year in which shares are allotted and he does not sell the shares even after the expiry of said period. What shall be the mechanism for deferment of TDS and tax on the perquisite value of ESOPs in such a case?

a) Assessment Year 2025-26

Mr. A would be required to disclose the perquisite value of ESOPs, i.e., Rs. 90 lakhs in his return of income but he shall not be liable to pay any tax thereon in the year of allotment of shares. The tax to be payable on the salary income, excluding the perquisite value of ESOPs, shall be computed in the following manner:

MCQs on Employee Stock Option Plan

Q1. Under an Employee Stock Option Plan (ESOP) scheme, an employer offers securities to an employee at , it is taxable under the Income Tax Act as .

a. Free of cost or Concessional rate, Perquisites

b. Free of cost or Concessional rate, Capital Gains

c. Market Price, Perquisites

d. Market Price, Capital Gains

Correct answer: (a)

Justification for correct answer: When an employer offers securities to an employee under an Employee Stock Option Plan (ESOP) scheme, free of cost or at a concessional rate, it is taxable as a perquisite in the year of exercising such option.

Q2. If securities allotted under ESOPs are subsequently transferred by the employee, the gains arising therefrom shall be .

a. taxable under the head Salaries

b. taxable under the head Capital Gains

c. taxable under the head Other Sources

d. Not Taxable

Correct Answer: (b)

Justification for correct answer: When securities allotted under ESOPs are subsequently transferred by the employee, the gains arising therefrom shall be taxable under the head ‘Capital Gains’.

Q3. When an employee exercises the option, the difference between the of the securities and is taxable as perquisite.

a. Fair Market Value of securities, the price paid by the employee

b. Price paid by the employee, Face Value of securities

c. Either (a) or (b)

d. Both (a) or (b)

Correct Answer: (a)

Justification for correct answer: When an employee exercises the option, the difference between the Fair Market Value (FMV) of the securities on the date of exercising of option and the amount paid by the employee for such securities, is taxable as perquisite.

Q4. While computing the income chargeable as perquisites, Fair Market Value shall be considered as on the date of .

a. Allotment of shares

b. Granting the option

c. Exercising option

d. Vesting the option

Correct Answer: (c)

Justification for correct answer: When an employee exercises the option, the difference between the Fair Market Value (FMV) of the securities on the date of exercising of option and the amount paid by the employee for such securities, is taxable as perquisite.

Q5. The period of holding in case of securities derived through ESOPs shall commence from the date of .

a. Grant of options

b. Exercising the option

c. Allotment of securities

d. Payment of tax on such perquisite

Correct Answer: (c)

Justification for correct answer: The period of holding of securities shall be the period commencing from the date of allotment of securities, and not from the date of exercising of option, ending on the date when employees transfer the securities.

Q6. In case of subsequent transfer of the securities by the employee, the cost of acquisition of those securities will be .

a. Amount paid by the employee at the time of exercising the option

b. Fair Market Value of the securities as on the date of exercising the option

c. Fair Market value of the securities at the time of allotment of securities

d. Either (a) or (b)

Correct Answer: (b)

Justification for correct answer: The fair market value of securities on the date of exercising the option shall be taken as the cost of acquisition of such securities to compute the capital gain.

Q7. In the case of an employee of an eligible start-up, tax shall be deducted from the perquisites within 14 days:

a. On the expiry of 48 months from the end of the assessment year in which securities are allotted under ESOPs

b. From the date the assessee ceases to be an employee of the organization

c. From the date of sale of securities allotted under ESOP

d. Earlier of (a), (b), or (c)

Correct Answer: (d)

Justification for correct answer: Section 192, which provides for the deduction of tax by the employer from the salary of the employee, provides that an eligible start-up shall deduct tax from income arising in the nature of perquisites from ESOPs within 14 days from the happening of any of the following events (whichever is earlier):

a. On the expiry of 48 months from the end of the assessment year in which securities are allotted under ESOPs;

b. From the date the assessee ceases to be an employee of the organization; or

c. From the date of sale of securities allotted under ESOP.

Q8. For the purpose of deduction of tax under section 192 in case of an employee of an eligible start-up, the rate of tax shall be the rates in force of the financial year in which:

a. Employee exercised the option

b. Securities were allotted

c. tax is required to be deducted i.e. current year

d. Either (b) or (c)

Correct Answer: (b)

Justification for correct answer: The tax shall be deducted on the basis of rates in force for the financial year in which securities were allotted or transferred under ESOPs.

(Republished with amendments)