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ESOP

Taxation in the hands

of employees

Background

ESOP allows an employee to own equity shares of the employer company over a certain period. ESOPs have recently gained popularity in India especially in the startup space. Since the startups are operating with limited liquidity, at least, in the initial stages, they attract talent with comparatively less payout in cash with an option to purchase the equity shares of the company at a later stage decided based on mutual agreement.

Before we venture into the ESOP taxation, it is pertinent to familiarize ourselves with the specific terminologies used under ESOP.

Grant Date

The date of agreement between the employer and employee to give an option to own shares (at a later date).

Vesting Date

The date the employee is entitled to buy shares, after prescribed conditions (mutually agreed upon) are fulfilled. This date is also the agreed-on grant date.

Vesting Period

The time period between the grant date and vesting date.

Exercise Period

Once stocks have ‘vested’, the employee now has a right to buy (but not an obligation) the shares for a period of time. This period within which an employee can exercise its option is called exercise period.

Exercise Date

The date on which employee exercises the option.

Exercise Price

The price at which employee exercises the option.

Exercise price is usually lower than the prevailing FMV of the stock. An employer and employee agree on ESOP terms on the grant date. Once the employee has fulfilled the conditions or the relevant time period has elapsed, these employee stock options are vested. At this time the employee can exercise them or put simply – buy them. The employee is allowed some time period during which this option to buy can be exercised. Once the employee decides to buy, these stock options are allotted to him at an exercise price which is usually lower than the FMV of the stock. Of course, the employee can choose not to exercise his option.

Trigger Point for Taxability


There are two trigger points for ESOPs to be taxed –
1. At the time of exercise – Taxable as a perquisite under the head ‘salary’

What is taxable? – Difference between the FMV (on the exercise date) and exercise price is taxable as perquisite. The employer deducts TDS on this perquisite. This amount is shown in the employee’s Form 16 and included as part of total income from salary in its ITR.

Exception for eligible startups An employee receiving ESOPs from an eligible start-up need not pay tax in the year of exercising the option. The TDS on the ‘perquisite’ stands deferred to earlier of the following events:
  • 5 years from the year of allotment of ESOPs
  • Date of sale of the ESOPs by the employee
  • End of employment with the eligible startup
Eligible startups shall have the same meaning as defined under section 80-IAC of the IT Act.

2. At the time of sale by employee – Taxation as capital gain

What is taxable? – Difference between sale price and FMV (on the exercise date) is taxed as capital gains in the hands of the employee.

Calculation
of FMV