ESOP

ESOP full form is Employee Stock Ownership Plan. Under this plan, employers offer their
employees the stock of the company at a low or no additional cost that they can encash after a
specified period at a specific price.

ESOP taxation in India is done as a prerequisite and is subject to tax at the time of exercise or
transfer of shares to the employee. ESOP example in India includes those offered by Flipkart,
Myntra, and other companies when they were starting up.

How Does an Employee Stock Ownership Plan (ESOP) Work?

Employers decide the number of shares to be offered under ESOPs, their price, and the
beneficiary employees. ESOPs are then granted to employees, and a grant date is provided.

Once ESOPs are offered, they remain in a trust fund for a specific period, called the vesting
period. Employees should stay with the organization for the vesting period to avail the
ownership of stock by exercising the ESOP.

Once the vesting period expires, employees get the right to exercise their ESOPs. The date on
which the vesting period expires is called the vesting date.

Employees can exercise their ESOPs and buy the company shares at allotted prices, which
are lower than the market value. Employees can also sell the shares that they have bought
through ESOPs and make a gain on their holdings.

If the employee leaves the organization or retires before the vesting period, the company is
required to buy back the ESOP at a fair market value within 60 days.
Benefits of ESOPs for Employees

ESOPs are beneficial for employees in the following ways-

 Stock Ownership

Employees can enjoy ownership in the company that they work for as ESOPs give them the
right to own a part of the company’s share capital.

 Dividend Income

A part of the profit earned by the company is distributed among the shareholders in the form
of dividends. Employees can, therefore, earn additional dividend income and also get the
direct benefit from the efforts that they put toward the company’s profitability.

 Buy Shares at a Discounted Rate

At the time of exercising the ESOPs, employees usually pay a nominal amount to buy the
shares allotted to them. This, therefore, allows them to invest in the company at a preferential
rate.

 Flexibility in Acquisition

Unlisted shares present an opportunity for investors to obtain equity in a company without the
constraints of a public market. This flexibility can lead to better value for the purchase price.

 Pre-IPO Potential

Unlisted shares often represent ownership in pre-IPO companies. Investing at this stage
allows individuals to become stakeholders in a company before it goes public, potentially
reaping rewards as the company grows and succeeds.
Benefits of ESOPs for Employers

 Employee Retention

Since employees have to wait out the vesting period before they can exercise their ESOPs, it
becomes easier to retain employees.

 Better Productivity

Since employees themselves stand to gain from the profits earned by the company, ESOPs
can boost employee productivity and make the company more profitable.

 A Tool for Attracting Talent

ESOPs are additional compensation plans that help employers attract and retain talented
employees. In fact, for start-ups, ESOPs help lure in good talent in the initial days when high
pay packages are not feasible.

Tax Implication of ESOPs

There are dual tax implications of ESOPs.

1. When the employee exercises his/her rights and buys the shares of the company

2. When the employee sells the shares after buying them

Tax Treatment at the Time of Buying the Shares

Employees can buy the shares after the vesting date at a rate lower than the Fair Market
Value (FMV) of the share as of that date. As such, the difference between the FMV and the
exercise price of the share is treated as a prerequisite in the hands of the employee and taxed
at his income tax slab rate.
ESOP Example

Exercise date January 1, 2022

FMV Rs. 150/share

Exercise price Rs. 85/share

Taxable value of perquisite 150 − 85 = Rs. 65/share

Number of shares exercised 1,000

Total taxable perquisite 1,000*65 = Rs. 65,000

Tax payable (assuming a tax slab of 30%) 30% of 65,000 = Rs. 19,500

For unlisted companies, selling shares bought through ESOPs is a challenge as there
might be a few takers, and the FMV is determined by merchant bankers. Moreover,
capital gains are taxed as per debt funds.

This means that shares sold within 24 months of exercising them attract short-term
capital gains wherein the gains are taxed at your income tax slab rates. Long-Term
Capital Gains, i.e., those earned from selling the stock after 24 months, are taxed @20%
with indexation.

According to “CBDT Notification No. 94/2009 dated 18.12.2009, the fair market value of
any specified security or sweat equity share, being an equity share in the company not
listed at any recognized stock exchange, shall be the value of the share in the company
as determined by a merchant banker on the specified date for the purpose of clause (vi)
of sub-section (2) of section 17.”

“Specified date” means the date of exercise of the options or any date earlier than the
date of the exercise of the options. It is pertinent to note that such earlier date should be
within 180 days prior to the date of the exercise of option.
Two widely employed methods for valuing unquoted shares, commonly used by unlisted
companies, are the Book Value Method and the Discounted Cash Flow Method. In this
process, companies have the flexibility to opt for either a merchant banker or a valuation
officer to accurately compute the fair market value.

THE TABLE BELOW IS TO UNDERSTAND THE TAX LIABILITY OF EMPLOYEE

AT THE TIME OF EXERCISE , SELLING, SELLING AFTER LONG TERM.

At the Units Date Exercise FMV Tax Rate of Tax to be paid In

time of Price of impact tax income
share* tax
return
Exercise 100 1- 100 170 Taxable Income Tax = 30% x Under
Jul- amount tax slab 100 shares x (Rs Income
14 = FMV rate 170 - Rs 100) = from
on Rs 2100 and 3% Salary
Exercise cess on it
date (1st
July
2014)
less
Exercise
Price
Sale of 20 1- 250 Taxable Income Tax =30% x 20 Under
shares if Oct- amount tax slab shares x (Rs250 Capital
unlisted 14 = Sale rate - Rs170)= 480 Gains
Price on and 3% cess on (short
date of it term
sale less capital
FMV on gains)
exercise
date
Sale of 80 1- 300 Taxable 20% tax Tax = 20% x 80 Under
shares if Sep- amount on long shares x (Rs Capital
unlisted 16 = Sale term 300-Rs 170*CII Gains
Price on capital for 2016-17/CII (long
date of gains after for 2014-15) = term
sale less indexation 20% x 80 x (300 capital
FMV on of cost - gains)
exercise 170*1125/1024)
date = Rs 1811 and
3% cess on it
RSU

Restricted Stock Units (RSUs) are a restricted form of equity incentive that an employer
grants to its employees. These are equity shares of the company that come with a vesting
period attached to them. Since the employee in question gets them in the form of an
incentive, they are not liable to pay any money for it.
However, the vesting period bars the employee from selling that stock until they complete a
specified tenure with their employer. The employer can also impose this restriction on the
employee's performance, where he would only be able to redeem the shares on achieving a
set milestone.

Advantages of RSU

 It acts as a morale booster for employees to achieve their targets.

 It acts as an incentive for the employee to remain in the organisation.
 Employees do not need to make any payments to receive RSU.
 Employees get a part of the company’s ownership without having to actually buy it.

Disadvantages of RSU

 There is no dividend income attached to these stocks.

 The benefits of reserved stock units get revoked after the termination of employment.
That means if an employee leaves the organisation during the vesting period, he loses
his due RSU.
 If it takes too long for an employee to achieve the milestone, the vesting date can get
delayed for milestone-based RSU.

Restricted Stock Unit Example

Let’s say an employee Rishi is promised 3,000 company shares as RSU. As per the vesting
schedule, he will receive 1,000 shares every year for 3 years once he completes 1 lakh sales
and 1 year with his employer. Once he meets both these conditions, he will start receiving the
stocks as per the vesting schedule.
Taxation of RSU in India
RSU taxation in India is the same as any other equity share (SAME AS ESOPs). For the
purpose of taxation, we need to take into consideration the fair market value of the reserved
stock units. Fair market value is the price at which these shares are sold on the stock market
on the vesting date.
The tax on RSU is calculated both on vesting and when the employee sells his/her holdings.

Tax Implication on RSU on Vesting

There can be three scenarios in this regard:

Sell to Cover: Continuing with the above example, let’s say Rishi received 1,000 shares in
the first year and falls into the tax slab of 30%. Now, the company will sell 300 shares, i.e.,
30% of 1,000, on his behalf, and the proceeds shall be paid as tax. Rishi will therefore receive
700 net shares.

Same-day sale: It means that all the shares to be received by employees at vesting are sold
off on the same day. The applicable tax value is paid to the government, and the remaining
proceeds are transferred to employees. In this method, an employee receives no actual shares
but a cash equivalent of its sales proceeds.

Upfront payment: If the employee chooses this method, he/she will pay the tax value
applicable to him and get the holding of all the shares.

Tax Implication on the Sale of RSU Holdings

If an employee sells his/her RSU holdings, any profit made on that transaction is considered a
capital gain. The capital gain is taxable as per its period of holding. The tax is applicable
irrespective of whether those shares are listed on the Indian stock exchange.

The period of holding in context to RSU is from the date of vesting to the date when the
employee sells those shares. The rate of taxation has been discussed below:
 Shares not listed on Indian Stock
Exchange

Short-term capital gain If shares are held for less than 24 months,
gains are taxable as per the slab rate.

Long-term capital gain If shares are held for over 24 months, gains
are taxable at 20% with indexation

Exemption No exemption

Indexation Yes, in case of LTCG

The key differences between ESOPs and RSUs

Although both these kinds of employee-oriented stock issues have many similarities, there
are also several differences between ESOPs and RSUs.

Particulars ESOPs RSUs

ESOPs are options given to employees to RSUs are company shares given to
Definition buy company shares at a predetermined price employees, which vest over time and
after a vesting period. can be sold once vested.

Nature of issue Options are issued. Stocks are issued.

A grant price is fixed when the ESOPs are

Pricing No specific price is set for RSUs.
issued.

Payment ESOPs require employees to purchase shares, RSUs are usually paid in shares,
 typically at a discounted price. sometimes with a cash option.

Employees benefit from ESOPs if the stock Employees gain from RSUs if the
Financial Benefit price is higher than the option price at the company's stock value increases
time of exercise. after vesting.

Voting rights for Shares purchased via ESOPs come with RSUs allotted to employees do not
shareholders voting rights. carry any voting rights.

Shares purchased via ESOPs may offer RSUs do not give shareholders any
Dividends
dividends to shareholders. dividend benefits.

ESOPs allow employees to purchase shares RSUs have a vesting schedule, post
Option to purchase
only after options have vested and usually which employees receive shares or
shares
within a certain time frame. cash equivalent.

The nature of limitations associated

ESOPs typically come with a vesting period,
Nature of with RSUs can be time-based,
after which employees can purchase the
limitations milestone-based or a combination of
shares.
the two.

Lower risk as employees receive

Higher risk as benefit depends on stock price
Risk shares irrespective of stock price
exceeding the option price.
movement (post-vesting).

Nature of settlement Shares of the company Shares or cash equivalents

Taxed at exercise as income and as capital Taxed as income when vested, and
Tax Implications gains when sold, if the share value as capital gains when sold.
increases.