ESOP taxation under the Income-tax Act, 2025 continues to impose a structural hardship through a dual-stage tax model that taxes employees before real cash is realised. At the exercise stage, employees are liable to perquisite tax on the difference between the fair market value and exercise price, often at the highest slab rates, despite receiving no liquidity. When shares are eventually sold, capital gains tax applies again on appreciation from the exercise-date FMV. Limited relief exists under Section 192(1C), which allows employees of eligible DPIIT-recognised startups to defer perquisite tax, but this benefit is unavailable to most employees in established companies, creating unequal outcomes. The 2026 framework further tightens valuation norms for unlisted shares, reducing flexibility to soften the perquisite impact, while rationalised capital gains rates offer only marginal relief. Without broader deferment of perquisite taxation, ESOPs remain a tax burden driven by timing rather than real income.
The Dual Tax Trap: A Structural Hardship
To understand why ESOPs are a “hardship,” we must look at the two-stage taxation model that remains the backbone of the Income-tax Act, 2025 (which replaced the 1961 Act effective April 1, 2026).
1. The Perquisite Stage (The “Paper Wealth” Tax)
The moment an employee exercises their option, they are hit with a “Perquisite Tax.” This is calculated as:
Perquisite Value = (Fair Market Value (FMV) on Exercise Date) – (Exercise Price)
The “hardship” here is visceral. The employee is paying tax (often at the 30% or 39% slab) on a benefit they haven’t yet converted to cash.
2. The Capital Gains Stage
When the employee finally sells the shares, they pay tax again on the appreciation:
Capital Gain = (Sale Price) – (FMV on Exercise Date)
Relief for Some: The Startup Oasis
The government did introduce a significant relief mechanism under Section 192(1C), but it is a gated community. Employees of “Eligible Startups” (DPIIT-recognized and meeting specific criteria) can defer their perquisite tax payment until:
- 48 months from the end of the relevant assessment year; or
- The date the employee sells the shares; or
- The date the employee leaves the company.
The Reality Check: While this is a massive relief for startup talent, it creates a “tax apartheid.” A software engineer at a mature tech giant or a mid-cap manufacturing firm still has to pay tax upfront at the time of exercise, while their peer at a certified startup enjoys a 4-year holiday.
The 2026 Landscape: New Rules, Old Problems
As we navigate the Finance Act, 2025 and the Draft Income-tax Rules, 2026, a few things have sharpened:
- Stricter Valuation: The new rules mandate tighter FMV formulas, especially for unlisted shares. Relying on a Merchant Banker’s report is now under higher scrutiny, leaving less room for “aggressive” (lower) valuations that previously helped minimize the perquisite hit.
- Capital Gains Rationalization: With the holding period for “Long Term” status now standardized (12 months for listed, 24 months for unlisted), the tax rate of 12.5% (above the ₹1.25 lakh exemption) is a slight relief compared to earlier years, but it doesn’t solve the initial liquidity crisis at exercise.
- Cross-Border Complexity: For “Global Indians” or expats, the lack of clear apportionment rules for ESOPs earned across multiple jurisdictions remains a major source of litigation and “tax traps.”
The Verdict: Relief or Hardship?
Despite the “Startup Relief,” for the vast majority of India’s workforce, ESOP taxation remains a continued hardship. The fundamental issue is the timing of the tax. Taxing a non-cash benefit at the point of “exercise” is philosophically grounded in “accrual,” but practically results in “distress.” Until the deferment of perquisite tax is extended to all employees—not just those in a handful of certified startups—the ESOP will remain a “golden handcuff” that feels a bit too heavy on the wallet.
My Advice to Employees: Before you hit that “Exercise” button, ensure you have a “Sell-to-Cover” strategy or enough liquid cash to satisfy the taxman. Never assume the stock price will only go up; the tax is certain, but the gain is not.
*****
For any other query, you can contact me on lavishaofc.ca@gmail.com
CA Lavisha Agarwal
Partner
Author Bio
