Employee Stock Ownership Plans (ESOPs) Taxability

Employee Stock Ownership Plans (ESOPs) are a popular tool used by companies to attract, retain, and motivate their employees by offering them an opportunity to own a stake in the company. ESOPs grant employees the right to purchase shares of their employer's company at a predetermined price, often referred to as the exercise or strike price. While ESOPs offer numerous benefits, understanding their tax implications, particularly at the time of allotment, is crucial for employees looking to maximize their gains effectively.

What is ESOP Allotment?

ESOP allotment occurs when an employee exercises their right to purchase shares of the company at the predetermined price. This typically happens after a vesting period, during which the employee accrues the right to exercise their options. Once exercised, the employee becomes a shareholder of the company and is entitled to the rights and privileges associated with ownership.

Taxability of ESOP

• Grant of ESOP

  When the ESOP is granted to the employee, it is not taxable as income. However, when the employee exercises the ESOP and acquires the shares, the difference between the fair market value of the shares on the date of exercise and the exercise price paid by the employee is taxable as perquisite in the hands of the employee.

         Budget 2020 Amendment for ESOPs

As per the amendments under budget 2020 from FY 2020-21 onwards, when an employee receives ESOPs from an eligible startup, they need not pay tax in the year of exercising the option. The employer can postpone this deduction of TDS up to any of the following events, which occurs first

• • Expiry of 5 years from the year of allotment of ESOP
  • Date of sale of ESOP by the employee
  • Date of termination of the employment

According to the Official Gazette by the Central Government, the startup holds a certificate of eligibility from the Inter-Ministerial Board of Certification. This strategy intends to attract and retain talented employees.

It is a big relief for employees even though the benefits last until they switch jobs. The step is to ease the rigidity since there were no cash benefits; rather, the employee had to pay additional taxes.

Fair Market Value - it represents the value of the company’s shares. Determining the fair market value requires a comprehensive understanding of the company’s financial position, market conditions, and potential future earnings.

Exercise Price - The price on which employees exercise the option is the exercise price. This price is usually below the fair market value of the stock.

• Sale of ESOP shares

  When the employee sells the ESOP shares, the difference between the sale price and the fair market value of the shares on the exercise date is treated as capital gains.
  
  For Listed Shares If the shares are held for less than 12 months, the short-term capital gains are taxed at the applicable rate.If the shares are held for more than 12 months, the capital gains are long-term and are taxed at a lower rate. Currently, long-term gains on listed equity shares are taxed at 10% without indexation on LTCG above Rs 1 lakh, whereas short-term capital gains are taxed at 15%.
  
  For Unlisted Shared if the shares are held for more than 24 months the gains will be taxed at 20% with indexation and treated as “long-term capital gains” and if If the holding period is less than 24 months, the gains will be taxable according to the slab rate of the holder. Therefore, the gains are considered short-term capital gains.
  
  In case you have incurred a loss, you are allowed to carry forward the short-term capital losses in your tax return and adjust & set them off against gains in future years.

• Tax deduction for employers

  Employers can claim a tax deduction for the cost of the shares issued to employees under the ESOP scheme. The deduction is allowed in the year the employee exercises the option and acquires the shares.
  
  On the vesting date, the employee gains a right to exercise his option or buy the stocks. But there is no obligation, the employee can choose not to exercise his option. In such a case there shall be no tax implication for the employee.

Example

On July 1, 2022, Mr. A exercised his option to purchase 10,000 shares of XYZ Ltd. at an exercise price of ₹ 40 per share. The fair market value (FMV) of the shares on the exercise date was ₹ 100 per share. Therefore, the perquisite value would be calculated as follows

Perquisite value = (FMV per share – Exercise price per share) x number of shares allotted
= (100 - 40) x 10,000
= Rs. 600,000

So, ₹ 600,000 would be added to Mr. A's taxable income as perquisite in the financial year 2022-23.

On September 30, 2023, Mr. A sold the shares at  Rs. 120 per share. Therefore, the capital gain on the sale of shares would be calculated as follows

Capital gain = Sale price per share - FMV per share on the date of exercise
= 120 - 100
= Rs. 20 per share i.e Rs. 200000 capital gain

Since the shares were held for more than 12 months, the capital gain would be treated as a long-term capital gain. If the total capital gains on the sale of shares in the financial year 2023-24 exceed Rs. 1 lakh, Mr. A would have to pay long-term capital gains tax at the rate of 10% on the amount exceeding Rs 1 lakh.