This article has been written by Dimple Kheradiya pursuing a Diploma in US Corporate Law for Company Secretaries and Chartered Accountants from LawSikho.
This article has been edited and published by Shashwat Kaushik.
Table of Contents
Introduction
Employee compensation is the term for the compensation or monetary and non-monetary benefits received by employees in exchange for work. Employees received direct compensation in the form of Salaries and wages, bonuses, allowances, etc., i.e., monetary benefits directly paid to employees. Some indirect compensation is also paid to employees, which are non-monetary in nature, to retain top talents that are not directly paid to employees, they are in the form of stock options, company-profit sharing plans, etc.
In employee stock options, now briefly referred to as ESOP, companies offer some stock to employees at low cost or negligible price as terms agreed upon after a certain period of time. The employees become shareholders of the company, making them responsible for the company’s performance as they are now stakeholders and participants in the growth and success of the company. Thus, this plan is a long-term indirect compensation plan that companies use to retain and reward employees.
How does ESOP work
To understand the taxation of ESOP, we have to understand the basic terms involved in it:
- Grant- Grant means an issue of Option to employees under ESOP
- Grant date- The date of the agreement for grant of stocks.
- Vesting- Process by which employee gets full right to options
- Vesting date- The agreed-upon grant date is called Vesting.
- Vesting period- The time period between the grant date and the vesting date.
- Exercise period- Once the stocks are vested, employees have the right to buy shares for a period of time, which is called the exercise period.
- Exercise date- The date on which the employee exercises the option.
- Exercise price- The price at which the employee exercises the option.
- Amortisation- An accounting procedure that gradually reduces the cost or value of an asset through periodic charges against income.
On the basis of employer-employee conditions being fulfilled, this stock option has been vested. Usually, the employee has some time to exercise the option. If the employee decides to purchase the stock options, they are allotted to him at an exercise price that is usually lower than the fair market value of the stock. Amortisation is considered while taxing approximations of the employees who left the job over the prospective period of time. No Tax is payable if the employee chooses not to exercise this option.
Tax calculation of ESOP
Esop is taxed in two instances:
At the time of exercise of options by employees
Employee stock options (ESOs) are a type of employee compensation that gives employees the right to buy shares of the company’s stock at a set price in the future. ESOs are often used as a way to attract and retain employees, and they can be a valuable part of an employee’s overall compensation package.
However, ESOs also have tax implications. When an employee exercises an ESO, they are considered to have sold the stock at the exercise price and immediately repurchased it at the market price. This can result in a capital gain or loss, which is taxable.
The amount of tax that an employee owes on an ESO will depend on a number of factors, including the exercise price, the market price, and the employee’s tax bracket.
Here are the steps involved in calculating the tax on an ESO:
- Determine the exercise price of the ESO. This is the price at which the employee can buy the stock.
- Determine the market price of the stock on the date of exercise. This is the price at which the employee could sell the stock immediately after exercising the ESO.
- Calculate the capital gain or loss. This is the difference between the exercise price and the market price.
- Determine the employee’s tax bracket. This is the percentage of income that the employee will pay in taxes.
- Calculate the amount of tax owed. This is the capital gain or loss multiplied by the employee’s tax bracket.
Tax treatment of ESOs:
- ESOs are taxed as ordinary income when they are exercised.
- The amount of tax owed on an ESO will depend on the employee’s tax bracket.
- Employees can defer paying taxes on ESOs by holding onto the stock for at least one year.
- Employees can also sell ESOs to cover the cost of exercising them. This is known as a “cashless exercise.”
The difference between the fair market value of the stocks and the exercise price of the stocks is considered a perquisite benefit in the hands of employees and is calculated as taxable perquisites under the total salary of the employees while filing an income tax return, as well as TDS under Section 192 deducted from it.
This option is most popular among startups as they are unable to pay high salaries to highly talented employees and by adopting ESOPs, the employees feel responsible for growth as now they are involved in its ownership.
To promote the startup India campaign, the government of India came up with deferred taxation of perquisites amendment provisions while exercising the option of ESOPs by the employees of “Eligible Start Up,” as mentioned under Section 80 IAC, i.e., from Financial Year 2020-2021 i.e., Assessment Year 2021-2022, taxation of perquisites in the year of exercising option has been deferred for the employee receiving ESOPs from eligible startups, to be earlier of the following:
- Expiry of 5 years from the year of allotment
- Date of sale of stock by employees
- Date of termination of employment
“Eligible Startup” here means the entity registered with the government and having an IMB Certificate that is an inter-ministerial board certificate of the eligible business
As per income tax rules, the fair market value has been calculated as follows:
Fair Market Value For Listed Shares:
- If stocks are listed on one recognised stock exchange in India at the time of exercising the ESOP:
FMV = (Opening price of stock + Closing price of stock) on exercise date
- If stocks are listed on more than one stock exchange on the date of exercising the ESOP, then records of that stock exchange are considered to have the highest volume of trading of those shares, and the fair market value will be calculated as follows:
FMV = (Opening price of stock + Closing price of stock) on exercise date
- Where on the date of exercising the ESOP no share trading is done on the stock exchange, the closing price of shares on the date closest to the date of exercising the option and immediately preceding such date is considered.
Fair market value for unlisted shares
If shares are not listed on the recognised stock exchange in India on the date of exercise of the option, the FMV shall be determined by a merchant banker on the “specified date,” i.e., the date of exercise of the option or a date within 180 days of the exercise of the option.
Employer’s obligation to withhold tax on ESOP Perquisite: As stock options are an employee benefits scheme and are taxable as perquisites in the hands of employees, the employer has an obligation to withhold tax on them.
At the time of sale of allotted shares
Shares allotted are capital assets in the hands of employees and they attract capital gain tax on the sale of these shares. It may be classified as long-term or short-term based on the hoding of shares. It will be computed based on the difference between the date of allotment of such securities, the date of exercise of the option and the fair market value of the shares transferred by the employees.
Further, the fair market value of securities on the date of exercising the option shall be taken as the purchase cost of such stocks to compute the capital gain.
Let’s tabulate tax impact for better understanding:
| At the time of | Tax impact | Rate of tax |
| Grant | NIL | NIL |
| Vesting | NIL | NIL |
| Exercise | Taxable amount = FMV on Exercise date less Exercise Price. | Add to the total income and taxes as per Income Tax Slab Rate |
| Sale of Listed Shares held for less than 12 months | Taxable amount = Sale Price on date of sale less FMV on exercise date | 15% on short-term capital gains and applicable surcharge and cess on it. |
| Sale of listed Shares held for more than 12 months | Long-term capital gains in excess of INR 1,00,000/- are taxable. | 10% on long-term capital plus applicable surcharge and cess are taxable without any indexation benefit for capital gain in excess of INR 1,00,000/- |
| Sale of unlisted Shares held for less than 24 months | Taxable amount = Sale Price on date of sale less FMV on exercise date | Added to the total Income and taxed as per income tax slab rate |
| Sale of unlisted Shares held for more than 24 months | Taxable amount = Sale Price on date of sale less FMV on exercise date | 20% tax on long-term capital gains after indexation of cost to residents and 10% to non-residents |
Advance tax : Advance tax applicability should be evaluated in advance and paid within the prescribed timeline during the year to avoid late fees, interest and penalties regarding advance tax payments.
Reporting/ disclosure requirements in the tax return for holding shares
Unlisted share details need to be reported in the employee’s personal income tax return. Shares of foreign companies having Indian subsidiaries are also considered unlisted.
Foreign stocks issued by foreign companies to Indian employees are considered foreign assets and are disclosed in Schedule FA of the Income Tax Form. Schedule FA requires taxpayers to disclose details about their investments,including stocks,mutual funds and other financial instruments. If an employee’s total income exceeds INR 50 lakhs, reporting under Schedule Assets and Liabilities is also mandatory.
Conclusion
Employee compensation in the form of employee’s stock options has proven to be one of the best forms of providing long-term incentives to employees. Through ESOPs, highly talented employees are retained at the workplace and also get high-paying rewards in the future. Opting for this option allows employees to acquire company stock at a discounted price compared to the fair market value of that stock and become a stakeholder in the company, which keeps employees motivated and makes them feel responsible for giving the best performance for the company’s growth.
It is important for the employees to understand the tax implications of ESOPs, as the employee has to pay tax on ESOPs at the time of exercising the option in the form of perquisites to be included in the salary of the employee while filing an income tax return and at the time of the sale of this stock in the form of a short-term capital gain or long-term capital gain on the basis of the period of holding of shares. Non-payment of taxes results in heavy interest and penalties levied on employees.
Thus, ESOPs are one of the most beneficial and rewarding employee concession schemes in the hands of employees and are also very popular among eligible startups as they provide deferment of tax to eligible startups.
References
- https://incometaxindia.gov.in/Tutorials/50.Taxation-of-ESOPs.pdf
- https://www.bankbazaar.com/tax/employee-stock-option-plan.html#:~:text=Options%20provided%20by%20the%20company,bracket%20the%20employee%20falls%20under.
- https://cleartax.in/s/taxation-on-esop-rsu-stock-options
- https://www.investopedia.com/articles/active-trading/061615/how-stock-options-are-taxed-reported.asp
- https://www.zeebiz.com/personal-finance/news-employee-stock-options-how-it-works-and-understanding-tax-implications-calculation-esops-in-india-startups-223046
- https://icmai.in/TaxationPortal/upload/DT/Article/21.pdf
- https://www.investopedia.com/managing-wealth/get-most-out-employee-stock-options/
