ESOPs have been a point of discussion in many salary negotiations, especially for startups. Companies have been offering ESOPs as rewards as well as part of their salary to attract talent and retain it as well. So what are these ESOPs and do you have to pay tax on them just like salary? Discussed hereunder are answers to these questions and related details for the same.
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What are ESOPs?
ESOPs (Employee Stock Option Plans) are a form of employee benefit where employees are given the option or the right to purchase shares in the company they work for. These plans are designed to align the interests of employees with those of the company’s shareholders and can be used as a tool for employee retention and motivation.
ESOPs are governed by the Securities and Exchange Board of India (SEBI) and the Companies Act and are typically offered to employees of publicly-listed companies or start-ups. These shares are bought by the employees at predetermined rates and have to be exercised within the specified period, which is also known as the vesting period.
Important dates that need to be understood and adhered to by the employees in relation to the ESOPs.
- Grant Date
The date on which the ESOPs are granted to employees is known as the grant date. The grant date determines the exercise price of the options and the vesting schedule.
- Vesting Date
The date on which the employee becomes entitled to exercise their options and purchase shares in the company is the vesting date for the ESOP. Every trench of ESOP vests typically occurs over a period of time, known as the vesting period.
- Exercise Date
The date on which the employee decides to exercise their options and purchase shares in the company is the exercise date for ESOPs. The exercise price is usually the fair market value of the shares on the grant date or the predetermined exercise price as per the terms of the agreement.
- Expiration Date
This is the date on which the options expire and can no longer be exercised. The expiration date is typically a few years after the grant date.
- Lock-in Period
Usually, employees are not allowed to sell the shares they have purchased through the ESOPs for a specific period of time known as the lock-in period. The lock-in period is usually in compliance with the SEBI regulations and is about 1-2 years.
- Blackout Period
This is the period of time during which the employee is not allowed to exercise their options, usually due to some restricted period like financial results, mergers, etc.
What are the benefits of ESOPs?
There are several benefits ESOPs for employees and the company. Some of these benefits are highlighted below
- Employee Motivation and Retention
ESOPs can be used as an excellent tool to align the interests of employees with those of the company’s shareholders and can help to motivate and retain employees. This practice is particularly used by startups to attract good talent and retain them over the long term.
- Employee Ownership
Employees get a sense of ownership and engagement in the company through ESOPs. This can lead to increased productivity and job satisfaction.
ESOPs provide employees with an opportunity to convert their options into cash by selling the shares they have purchased through the plan.
ESOPs can be a cost-effective way for companies to raise capital, as they do not dilute the existing shareholders’ equity and do not require the company to raise additional funds.
ESOPs can provide employees with an opportunity to diversify their investment portfolio by purchasing shares in the company they work for.
- Long-term wealth creation
ESOPs can provide employees with an opportunity to create long-term wealth, as the value of their options and shares can appreciate over time.
How are ESOPs taxed?
ESOPs are taxed on two occasions as per the Income Tax Act, namely, at the time of exercising the ESOP on the completion of the vesting period and at the time of sale of such shares. The details of the taxes levied on such occasions are mentioned hereunder.
- At the time of exercising the ESOP
When the employee exercises the ESOP after the completion of the vesting period, the same is treated in the nature of a perquisite and is taxable in the hands of the employee. The value of the perquisite is determined to be the difference between the FMV (Fair Market Value) on the exercise date and the exercise price of the ESOP. The employer is liable to deduct TDS on the perquisite value and the same will be reflected in Form 16.
As per an amendment in the Budget of 2020, employees of eligible startups who receive ESOPs do not have to pay tax at the time of exercising such an option and the TDS on the perquisite will be levied at any of the following specified dates.
- The date on which the employee sells the ESOP
- Completion of 5 years from the year of allotment of the ESOP
- At the date of termination of the employment of such employee who was granted the ESOPs.
- At the time of the sale of ESOP
When the ESOPs are sold by the employees they are subject to capital gains tax depending on the period of holding of such stocks. The holding period will be calculated from the date of exercising the option till the sale date of such shares. The levy of short-term capital gains and long-term capital gains on ESOPs are detailed below.
The rate of taxation and the period of holding for calculation of Short term capital gains are further determined based on the shares being of an unlisted or a listed company. The tax treatment for shares of companies listed outside India will be similar to that of unlisted shares.
The holding period for gains from the sale of shares of a listed company to be treated as short-term gains is less than 12 months and they are taxed at the rate of 15%.
In the case of shares of an unlisted company, gains are treated as short-term gains when the holding period is less than 2 years (24 months) and will be taxed at the applicable slab rates.
- Long-term capital gains
Capital gains from the sale of ESOPs of listed companies held for a period of more than a year (12 months) will be treated as long-term gains and will be taxed at a flat rate of 10% without the benefit of indexation. Long-term capital gains from the sale of shares up to Rs.1,00,000 is exempt from taxation. Furthermore, LTCG on equity shares listed on the stock exchange (where STT is levied upon sale) is tax-free.
In the case of shares of an unlisted company, gains are treated as long-term gains when the holding period is more than 2 years (24 months) and will be taxed at 20% after the benefit of indexation.
Employees are also allowed to carry forward short-term capital loss on the sale of ESOPs. Such loss can be carried forward for a period of 8 years and can be set off against future gains. LTCL on listed equity shares cannot be carried forwards as the LTCG is also considered tax-free.
- Tax treatment of ESOPs based on Residential status
When the employee is a resident of India, all the income is subject to taxation as per the Income Tax Act, 1961. In the case of a non-resident employee or a resident but not an ordinarily resident employee, when ESOps are exercised or sold, they will have to pay taxes outside India as per the applicable tax laws of their country. Such employees can get the benefits of DTAA (Double Taxation Avoidance Agreement) to avoid any cases of double taxation on their income.
The Income Tax Act requires several disclosures in case of an assessee owning foreign assets or ESOPs or RSUs of foreign companies. Such disclosures should be in accordance with the FA schedule in the ITR and are applicable to resident assessees.
ESOPs have been a common practice among companies within India and outside. The multiple benefits of ESOPs to the employee and companies alike make them an attractive option. The tax treatment of ESOPs is subject to the prevalent tax laws at the time of exercise and sale of such shares and therefore, it is necessary to evaluate them correctly before exercising these options to avoid any case of penalties.
Certain limitations of ESOPs include lack of liquidity, volatility of the share prices, lack of control and transparency, and regulatory compliance issues.
The share price of ESOPs of unlisted companies is determined by the merchant banker based on various valuation methods like the book value method, fair market value method, earnings multiplier method, discounted cash flow method, or the market capitalisation method in consultation with the company.
The vesting period is the period of time over which an employee becomes entitled to exercise their options and purchase shares under an Employee Stock Option Plan (ESOP).
There is no tax liability in the hands of the employees in the case of ESOPs that are not exercised.