Taxation of ESOP

Employee stock ownership or employee share ownership means a company’s employees own shares in that company. Either they acquire shares through a selective plan or all-employee plan. Selective plans are available to only senior executives. All employee plan offers participation to all employees of the company. 

This employee benefit plan gives employees ownership interest in the company. By making the employees-shareholders of the company they are encouraged to do what’s best for the company as they themselves are the owners. The stocks of the company are offered at negligible costs that remain in the ESOP trust fund, until the option vests and the employee exercise them or the employee leaves/retires from the company. 

Usually, this benefit works as an incentive for the employees. If a company wants to retain the employees for a long term and to make them stakeholders at the same time, what could be the best option other than ESOP?  IT companies and Start-ups offer such stocks often for attracting and keeping talent.

ESOP and its effect applicable to the Company-

The company that offers ESOP to its employees will be taxed according to the accounting method it uses to calculate the same as an expenditure.

Accounting of ESOP as per old GAAP-The Institute of Chartered Accountants of India has laid down accounting principles and practices of ESOP. Accordingly,

I) Fair Value Accounting: The offer being made to the employees is valued bases upon the Black and Scholes Model, whereby the fair value of the option is charged to profit and loss account over the vesting period. 

II) Intrinsic Value Accounting: It is the amount is the difference between the quoted market price of underlying shares and the ESOP price. The difference amount is treated as a discount and charged to the profit and loss account over the vesting period of ESOP.

Tax effect when ESOP is part of salary package-

Before understanding how ESOP is taxed in the hands of the employees, it is important know a few things.

  • The terms between the employer and employee are agreed upon at the time of allowing an employee to own the shares/stock of the company. 
  • The date on which this agreement is made between the employer and employee to give an option to own shares at a later date is known as grant date. 
  • As per the conditions prescribed in the agreement, the employees become entitled to buy the shares, this date is known as vesting date. 
  • The gap between the grant date and vesting date is the vesting period. 
  • Once the stocks have ‘vested’, the employee gets a right to buy the shares for a certain period. This is known as exercise period.
  • The date on which employee exercises the option is the exercise date.
  • The price at which employee exercises the option is known as the exercise price. It is usually lower than the prevailing fair market price. As per the terms agreed upon, the grant date is fixed. On fulfillment of the conditions by the employee or elapsing of the relevant period the employees stock options get vested. The employee can now buy them. The employee is allowed some time for buying. When he decided to buy, these stock options are allotted to him/her at an exercise price which is lower than the fair market value. If the employee doesn’t exercise the option to buy, there shall be no tax. 

ESOP will be taxed in either of the following ways,

  • At the time of exercise, as a perquisite: When the employee decides to buy, the difference between the fair market value on the date of exercise and the exercise price becomes taxable as a perquisite. The employer deducts TDS on the same and the amount is shown in the employee’s Form 16 and included as part of his/her total income from salary in the Income Tax Return.

There is an important amendment becoming effective from the FY 2020-21.  An employee who receives ESOPs from an eligible start-up need not pay tax in the year of exercising the option. And the amount of TDS also stands deferred to earlier of the following:

  1. Expiry of five years form the year of allotment of ESOPs.
  2. Date of sale of the ESOPs by the employee.
  3. Date of termination of employment. 
  • At the time of sale by the employee-as a capital gain: The employee can even decide to sell the shares bought by him. In that case, the difference between the sale price and fair market value or FMV on the exercise date is taxed as capital gains. The rates at which this capital gain becomes taxable, depends on the period of holding them. The holding period starts from the date of exercise to the date of sale. If the listed shares are held for more than a year, the gains are treated as long term. But if sold before one year, then they are taxed as short-term gains. Long term gains on listed shares are not taxable but short-term gains are taxed at 15%.

The losses arising from such transactions can be carried forward as short-term capital losses and they can be adjusted against gains in future.  Long term capital gains on equity shares cannot be claimed or carried forward as the gains arising from them are tax-free.

If unlisted equity shares are sold within 24 months of holding them at a gain, the gain thus arising shall be treated as a short-term capital gain and taxable at applicable income tax rates. Whereas long term capital gains arising by selling them after holding them for more than 24 months, shall be taxed at 20% after indexation of cost.

For all residents, income from anywhere in the world is taxed in India, but for non-residents and not ordinarily residents the tax liability may not arise if they exercise the option or sell their shares due to Double Taxation Avoidance Agreement. Advance tax treatment: As the employer deducts the TDS when the employee exercises the option, the latter must deposit the advance tax on capital gains. But where the advance tax instalment is short due to capital gains, no penal interest is charged. The remaining instalment after the sale of shares must include the tax on capital gains in that case.          

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Krishna Rath is a SEBI Registered Investment Adviser, and since 2015 has been educating netizens on investments and insurance. Krishna is a fee only SEBI RIA and is Odisha's first SEBI RIA. With background in IT, Krishna is changing the advisory space with new innovations in AdvisoryTech.

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