How is ESOP taxed? Why should you be careful while exercising ESOP?

How is ESOP taxed? Why should you be careful while exercising ESOP? | Vrid
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Previously, we discussed how Employee Stock Ownership Plan (ESOP) is an unique way for you as an employee to own a slice of the company you work for and build wealth.

But there are some tax obligations associated with ESOPs. Which can be complicated sometimes.

We’ll break down the ESOP tax implications to help you grasp the concept.

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Buckle up, here we go!

How is ESOP taxed in India?

When it comes to ESOP, two significant events trigger taxation – the exercise and sale of shares. Let’s break it down further with examples:

1. Taxation at Exercise of ESOP:

Let’s say your employer has granted you ESOPs. 

Exercise of ESOP refers to the process of converting your vested ESOPs into actual shares by paying the exercise or strike price. 

Here’s the catch – the difference between the fair market value (FMV) of the shares at the time of exercise and the exercise price is taxable as a perquisite in the year of exercise.

Remember, the exercise or strike price is predetermined, as mentioned in the grant offer you received from your employer while opting for ESOP. 

Whereas the fair market value (FMV) of the company keeps changing. If your company is listed in the public market, they take FMV from the share price in the stock market. For unlisted companies, a merchant banker decides the FMV.

Moving on. 

For example, let’s say you exercise 100 shares when the FMV is ₹500 per share and the exercise price is ₹200 per share. The taxable perquisite amount would be (500 – 200) * 100 = ₹30,000. This amount will be added to your income and taxed at the applicable slab rate.

Yes, first, you pay ₹20,000 to convert the options and own the shares (100*200). Then you have to pay tax on the perquisite (unrealised gains). 

Now, your employer will deduct the tax amount from your salary as TDS. Because they are obligated to do so. 

Why do you have to pay tax on perquisite (unrealised gain)? 

According to Income Tax rules, at the time of exercising your stock options, you receive an additional asset at a cheap price compared to the fair market value. 

Therefore, you have to pay tax on the additional benefit you received. 

As per the Income Tax, they consider the additional benefit being added under the head of salary income. That is why the employer deducts the tax as TDS from your salary. You might receive a low in-hand salary for a month or so. So, you need to properly plan the time of exercising the ESOP. 

Now, this seemed to be unfair to startups. Startups are often heavily dependent on ESOPs for attracting and retaining talent. Because most employees didn’t have the liquidity to deal with the exercise price and TDS at the same time. Startups faced practical difficulties in taxing ESOPs as perquisites.

And to solve this problem to some extent in budget 2020, to incentivise startups and, as a relief to their employees, a concession was provided for the period of withholding of taxes on ESOPs.

Remember, they amended the Income Tax Act to provide relief to eligible startups only. 

Eligible startups for this purpose refer to a startup that is a private limited company or a limited liability partnership. Incorporated on or after 1st April 2016 but before 31st March 2023. And registered with the government and holding a certificate of eligible business from the Inter-Ministerial Board of Certification called the IMB Certificate. 

Employees of such eligible startups need not pay tax in the year of exercising the option. The employer can defer the deduction of TDS on the perquisite amount up to the occurrence of the following events, whichever is earlier:

  • Expiry of 5 years from the year of allotment of ESOP
  • Date of sale of ESOP shares by the employee
  • From the date the employee resigns

If you work for an eligible startup, you have at least 5 years to pay tax on the perquisite income unless you either resign or sell the shares before that.

2. Taxation at Sale of ESOP Shares:

When you decide to sell the shares acquired through ESOPs, capital gains tax comes into play. The tax liability depends on the holding period and whether the company shares are listed or unlisted.

a. Capital Gains Tax on Listed Shares:

When you own ESOP shares of a listed company, the calculation of capital gains is similar to your equity investments.

If you sell the ESOP shares within 12 months, the resulting gain is considered a Short-Term Capital Gain (STCG). You are liable to pay a 15% tax on STCG.

And, if you hold the ESOP shares for over 12 months and then sell them, the resulting gain is considered a Long-Term Capital Gain (LTCG). You are liable to pay a 10% tax on LTCG over a profit of ₹1 lakh.

b. Capital Gains Tax on Unlisted Shares:

If you sell the ESOP shares of an unlisted company within 24 months, the resulting gain is considered an STCG. You are liable to pay a tax on STCG as per your tax slab.

And, if you hold the ESOP shares for over 24 months and then sell them, the resulting gain is considered an LTCG. The LTCG is taxed at a flat rate of 20% with the benefit of indexation.

Short and long-term capital gain tax on sale of listed and unlisted ESOP shares | Vrid

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Still Curious?

If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.

Labour Law Advisor – Employee Stock Option Plan ESOP explained

Sarthak Ahuja – How do ESOPs Work?

Quicko – ESOPs Taxation in the hands of an Employee

Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.

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