Employee Stock Option Plans (ESOPs) are a popular way for Companies to attract, retain and incentivize employees by offering them ownership in the company. This involves granting employees of a Company, rights to purchase a certain number of shares of the Company at a discounted price. Such options to purchase shares at a discounted price can be exercised by the employees after a certain period of time, called the vesting period.

While ESOPs can be a lucrative part of an employee’s remuneration, understanding the tax implications is crucial for maximizing their benefits. In this article, we will explore how ESOPs are taxed in India, covering various stages from grant to sale.

Stages of ESOP Taxation

Taxation of ESOPs in India occurs at two main stages:

1. At the time of exercise and;
2. At the time of sale.

At the Time of Exercise:

The employee can exercise his options to buy shares once the vesting period elapses. The difference between the fair market value (FMV) of the shares on the date of exercise and the exercise price paid by the employee (determined as per Rule 3(8) of the Income Tax Rules, 1962) is considered as a perquisite and taxed u/s 17(2) of the Income-tax Act, 1961, in the hands of the employee. The value of this perquisite is added to the salary income of the employee and taxed according to the applicable income tax slab rates.

Example:

• Grant Date: January 1, 2020
• Vesting Date: January 1, 2023
• Exercise Date: January 1, 2023
• Exercise Price: ₹100 per share
• FMV on Exercise Date: ₹300 per share (computed under Rule 3 of the Income tax Rules)
• Number of Shares: 1,000

In this case, the perquisite value would be (₹300 – ₹100) * 1,000 = ₹200,000.

As per Rule 3 of the Income tax rules, the FMV for ESOPs is determined as explained below:

Listed Shares:

• If shares are listed on a recognized stock exchange in India on the exercise date, the FMV is the average of the opening and closing prices on that date.
• If shares are listed on multiple exchanges, the FMV is the average of the opening and closing prices on the exchange with the highest trading volume in the said share.

Unlisted Shares:

• If shares are not listed on a recognized stock exchange in India on the exercise date, the FMV is determined by a merchant banker on the “specified date.”
• The “specified date” can be the exercise date or any date within 180 days prior to the exercise date.

At the Time of Sale:

When an employee sells shares acquired through an ESOP, the gains are taxed as capital gains. The nature of these gains (short-term or long-term) and the applicable tax rate depend on the holding period of the shares:

Listed Companies:

• Long-Term Capital Gains (LTCG): If shares are held for more than 12 months before sale, gains are treated as LTCG. Gains exceeding ₹1 lakh are taxed as per Section 112A of the Income Tax Act, at the rate of 10% without indexation.
• Short-Term Capital Gains (STCG): If shares are held for 12 months or less, gains are treated as STCG and taxed as per Section 111A of the Income Tax Act, at 15%.

Unlisted Companies:

• Long-Term Capital Gains (LTCG): If shares are held for more than 24 months, gains are treated as LTCG and taxed as per Section 112 of the Income Tax Act, at 20% with the benefit of indexation.
• Short-Term Capital Gains (STCG): If shares are held for 24 months or less, gains are treated as STCG and added to the employee’s total income, taxed at the applicable slab rate.

Taxability from Employer’s perspective:

The benefit from exercising ESOPs is taxable as a perquisite and treated as salary income for employees. Consequently, the employer must withhold tax (TDS) on the perquisite value at the time of exercise. This TDS is deducted when the shares are allotted. The tax is recovered from the employee through the payroll of the relevant month.

Employers can claim a tax deduction under section 37(1) of the Income Tax Act in computing the income in profit and loss of business or profession, for the cost of shares issued to employees under the ESOP scheme. This is allowed in the year the employee exercises the option and acquires the shares. Various rulings, such as CIT Vs Lemon Tree Hotels Limited (2015) and M/s Biocon Limited Vs Deputy Commissioner of Income Tax (2020), have favoured employers, stating that ESOP-related expenses are allowable deductions. The courts have recognized these expenses as employee costs, incurred to compensate employees for their continued service.

Taxation of ESOPs from eligible start-ups:

The Finance Act, 2020 introduced a significant change for employees of eligible start-ups. For these employees, the tax on the perquisite arising from ESOPs can be deferred. The tax payment can be deferred to a date within 14 days from the earliest of the following events:

• Expiry of 48 months from the end of the relevant assessment year
• The date of the employee leaving the company
• The date of the sale of shares

Reporting and Disclosure Requirements:

Employees must report ESOP shares in their income tax returns under the ‘Schedule Salary’ for perquisites and ‘Schedule CG’ for capital gains. Employees must report details of shares held in an unlisted company, including the company’s name, PAN, and the number of shares acquired or sold during the year, in their personal income tax return.

Shares of a foreign company allotted under an ESOP to employees of its group or subsidiary company in India are considered unlisted shares since they are not listed on any Indian stock exchange.

Double Taxation Avoidance Agreement (DTAA)

For employees who receive ESOPs from foreign companies, the tax implications can involve both the country of the employer and India. In such cases, the Double Taxation Avoidance Agreement (DTAA) between India and the country of the employer can provide relief. Employees can claim credit for taxes paid in the foreign country against their tax liability in India. To do this, Form 67 must be submitted before filing the ITR.

Tax Planning:

• Understand Vesting and Exercise Dates: Plan the exercise and sale of shares to optimize the tax liability. For instance, selling shares of listed companies after 12 months can qualify for LTCG, which has a lower tax rate.
• Utilize Exemptions and Deductions: Keep track of the available deductions to avail them.
• Consider Deferring Taxes: If you work for an eligible start-up, explore the option to defer tax payments.
• Seeking professional advice: This is essential for navigating the complexities of ESOP taxation and leveraging the benefits of the Double Taxation Avoidance Agreement (DTAA).

An expert team, such as BCL India, can provide valuable guidance in this area. BCL India specializes in international taxation and their expertise ensures that employees maximize the financial benefits of their ESOPs while remaining fully compliant with both Indian and international tax regulations.

ESOPs can be a valuable component of an employee’s compensation, offering the potential for significant financial gain. However, understanding the tax implications at various stages is essential for maximizing their benefits. By staying informed about the latest tax laws and planning strategically, employees can optimize their tax liabilities and fully leverage the advantages of ESOPs.