What Are ESOPs And How Are They Taxed?

ESOPs help an employee own the stocks of a company they are working in. However, the
taxation of Esops is a bit complicated. Read on to understand how it works.

Recently, a lot of companies, including startups, have issued empoyee stock option plans
(ESOPs) to their employees. Esops are becoming increasingly popular in India, with
several local and international companies doling out Esops to their employees.

What are Esops?

Esops are employee benefit plans that offer employees ownership interest in the
organisation. In other words, Esops are the right/option given to eligible employees to
buy equity shares of the company at a predetermined rate (mostly face value) within a
stipulated time (exercise period).

There are some key terms that you should know to understand the concept. Exercise date
is the one when the employee exercises the option of buying shares. Vesting period is the
time period between the grant date and vesting date. Vesting date refers to the date the
employee is entitled to buy shares, after conditions agreed upon earlier are fulfilled. Grant
date is the date of agreement between the employer and employee to give an option to
the employees to own shares (at a later date).

“In a way, Esop is like a profit-sharing plan. Under these plans, the company or the
employer offers its stocks, typically, at low or negligible prices. These stocks remain in an
ESOP Trust Fund until the vesting period and (employees usually) exercise these options
when they retire/leave the company,” says Archit Gupta, founder and CEO, Cleartax, a tax
portal.

Taxation of Esops
Tax is levied at two points in Esops. First, at the time of exercise of the Esop. Second, at
the time of selling the shares.

Exercise of Esop is taxed under the head salary (perquisite) where the difference between
fair market value of the shares and exercise price of shares is taxed as per the normal tax
slab of the employee.
“Sale of shares are further subject to tax under the head capital gains where the difference
between sales price and exercise price is taxed at capital gain (short- or long-term) rates,”
says B.M. Singh, ESOP expert and managing partner, BMSA, a consultancy firm that
specialises in tax planning and financial management for startups.

Additional exemption under Section 54F can also be claimed on long-term capital gains
from Esops for buying a residential property, subject to the compliance of conditions as
stipulated under section 54F of the Income-tax Act, 1961.

“At the time of exercise—as a prerequisite—when the employee has exercised the option,
basically agreed to buy; the difference between the FMV (fair market value) (on exercise
date) and exercise price is taxed as perquisite. The employer deducts TDS on this
perquisite. This amount is shown in the employee’s Form 16 and included as part of the
total income from salary in the tax return,” says Gupta.

The Budget 2020 amendment, however, said that from FY 2020-21, an employee
receiving Esops from an eligible startup need not pay tax in the year of exercising the
option. The TDS (tax deducted at source) on the ‘perquisite’ stands deferred to the earlier
of the following events:

Expiry of five years from the year of allotment of Esops

Date of sale of the Esops by the employee
Date of termination of employment
If the employee sells these shares, another tax event happens. The difference between the
sale price and FMV on the exercise date is taxed as capital gains.

Other considerations
To properly calculate tax on the sale of ESOPs certain aspects need to be kept in mind.

Short- or long-term gains: The rates at which your capital gains shall be taxed depends
on the period of holding. The period of holding is calculated from the exercise date up to
the date of sale. Equity shares listed on a recognised stock exchange (where securities
transaction tax or STT is paid on sale) are considered as long-term gains when held for
more than one year. If sold within one year, they are considered as short-term gains.
“At present, short- term capital gain is assessed at normal tax slab, long-term capital gain
is taxed at 20 per cent (for unlisted) or at 10 per cent (for listed) as the case may be.
Further, long-term capital gain on listed shares up to Rs 1 lakh per annum is exempted,”
says Singh.

When you have incurred a loss: In case you have incurred a loss, you are allowed to carry
forward short-term capital losses in your tax return and adjust and set them off against
gains in future years.

Listed or unlisted shares: The Income-tax Act differentiates between tax treatment of
listed and unlisted shares. The tax treatment for shares that are unlisted in India or listed
out of India remains the same. That is, if you own shares of an American company, they
will not be listed in India. They may be considered unlisted for the purpose of taxes in
India.
Starting FY2016-17, unlisted equity shares shall be short-term capital assets when sold
within 24 months of holding them, and long-term capital assets when sold after 24 months
of holding (applicable for sales made on or after 1st April 2016).

Disclosures: Several disclosures have been added in income tax return forms for foreign
assets. If you own Esops of a foreign company, you may have to disclose your foreign
holdings under schedule FA of your income tax return. These disclosure requirements are
applicable to a resident taxpayer.