How are ESOPS taxed in India

We know that ESOPs are taxed but most of us are rather not certain on the nuances of taxes that are levied, in this article lets break it down and understand the tax treatment on ESOPs.  

ESOPs are equity compensation that allows employees to buy shares in the company. Stock options are not actual shares of the company—they’re instead the right to buy a set number of shares at a fixed price, usually called as exercise price or strike price. Your purchase price (exercise price x number of options) stays the same over time, so as the share price goes up, you make money on the difference. And you have to pay taxes on that difference.   

How are ESOPs Taxed in India?

ESOPs are taxed twice, first when you exercise your ESOPs, and then again when you sell.  

When you exercise your tax liability is calculated as the difference between your exercise price and the current FMV (Fair Market Value) of the shares. This is the perquisite value earned upon exercising your options and treated as salary income and the regular taxation rates (Income Tax) are applied based on the income level (perquisite value is added to your income to arrive at the tax slab) and deducted by the employer as TDS. The tax on the perquisite value is the Perquisite Tax.

For unlisted companies, FMV is based on the valuation certificate given by a merchant banker. Note that the valuation certificate should not be older than 180 days from the date of exercise.

For listed companies, the share value is calculated as the average of opening and closing on the exercise date on a recognized stock exchange that records the highest volume.

When you sell your shares (post exercise) your tax liability is calculated as the difference between Sale value of the shares and the market value at the time of exercising. This is the Capital Gains earned upon selling the shares. And this sale attracts the Capital Gains Tax.  

There are two types of capital gains viz., Short-Term Capital Gains (STCG) and Long-Term Capital Gain (LTCG). Determining the STCG and LTCG varies for unlisted and listed companies.  

For unlisted companies, if the employees hold the shares for less than 24 months before selling them, it becomes a short-term capital gain. Short-term capital gains are treated as any other income and taxed at the applicable income tax slab rate.

However, if shares are held for more than 24 months before their sale, the gains are taxed as long-term capital gains. The long-term capital gains arising from the sale of unlisted shares are taxed at a rate of 20% with indexation (Refer to Sec 112 A of the IT Act). Or you can choose to pay a tax at a flat rate of 10% without any indexation benefits.

For listed companies, if the employees hold the shares for less than 12 months, it is considered STCG. And it is taxed at a flat rate of 15%.

However, if the shares are held for more than 12 months, the gains arising from the sale of the shares are considered LTCG. And is taxed at the rate of 10% in excess of Rs. 1,00,000 gains.

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Example of how ESOPs are taxed for Unlisted company.  

Imagine you allot 10,000 ESOPs to an employee at a particular date (grant date).  

The exercise price = Rs. 1

After two years, the employee chooses to exercise all the options.  

Suppose at that time, the FMV of a share is Rs. 51.

Amount to be paid by the employee = 1 x 10,000 = Rs 10,000/-

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Related Article: Tax Consideration

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Now, let’s calculate the taxes at the time of exercising the option.

Here, the perquisite = No. of shares x (FMV - Exercise price) = 10,000 x (51-1) = Rs. 500,000

Assuming the employee falls under the 20% tax slab,

The TDS deducted by employer = 500,000 x (20%) = Rs. 100,000

After 20 months (less than 24 months - STCG), the FMV is Rs 351. And the employee chooses to sell the shares, he has to pay the capital gains tax.

Here, capital gains = No. of shares x (sale price of the share - FMV)

Capital Gains = 10,000 x (351 - 51) = Rs. 30,00,000

Now, let’s calculate the taxes at the time of selling the option.

STCG (Short-Term Capital Gains) tax will be applicable based on income tax slab.

Other Factors While Calculating ESOP Taxes

Changes in Taxation: Budget 2020-2021 changed the taxation regime for start-ups (provided exemption under sec 80 - IAC). These guidelines were put forth by the DPIIT (The Department of Promotion of Industry and Internal Trade) for all DPIIT start-ups.

Here, employees of the budding start-ups are exempted from paying taxes for a particular period under certain circumstances:

• Tax on perquisite will come into effect only after 48 months of exercising the stock option.

• When an employee sells the shares.
• When an employee resigns.

The tax deduction due to the above reasons will be taken care of by the company within 14 days of fulfilling the conditions.

The advantage of the budgetary changes is that:

• Employees need not pay any upfront taxes by burning their pockets.

While calculating ESOP taxes, there are other considerations, like the residential status, loss incurring ESOPs, disclosures, and more.

Residential Status: If you reside in India or outside India, your ESOP transactions are liable to taxation. As an employer, be aware if there is a double taxation avoidance agreement (DTAA) signed between two countries, your employees can avoid being taxed twice: one in India and one abroad.

Disclosures for Foreign Assets: When employees receive shares from a parent, foreign company, the shares are treated as foreign assets. Employees need to show these assets by filing ITR-2 or ITR-3. Also, the disclosures need to be made in the IT Act’s schedule FA (Foreign Assets).

Taxation of Loss Incurring ESOPs: If the sale of an ESOP results in a loss, an employee can carry it forward for the next eight financial years. The loss can subsequently be adjusted with the gains as and when it takes place.

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Also Read: ESOP Surrender vs. ESOP Buyback