What are ESOPs?
ESOP (Employee Stock Ownership Plan) is an Employee Benefit Plan provided by the company/employer. ESOP allows an employee to buy a stock of their company at a below-market price. It also offers ownership interest to employees. ESOPs can be issued in as Direct Stock, Profit-Sharing Plans or Bonus. ESOPs is the three-step process:
- The company/employer decides to issue shares,
- The employee decides to exercise/buy issued shares,
- The employee decides to sell shares.
Before granting ESOPs to employees, an employer needs to follow Rules and Regulations relating to ESOPs are as per the Companies Act 2013.
An employee needs to understand ESOP taxation before exercising the option. ESOPs are taxed twice in the hands of an employee:
- At the time of exercising right i.e purchasing the shares,
- At the time of selling the shares.
Hence it is important to understand the tax implications of ESOPs before filing ITR of that financial year.
Prerequisites of ESOPs
Following are the prerequisite of ESOP:
- An employer has the right to decide who can avail ESOP,
- An employee needs to go through the pre-defined vesting period ie., an employee has to work for the company until a part or the entire stock options could be exercised,
- The company/employer grants ESOPs to its employees for a Specified Number of Shares of the company at a Pre-determined Price after the option period (a certain number of years).
Employer: Contributions to the ESOP are tax-deductible as they are made to repay the loan amount. Both principal and interest are tax-deductible. But once ESOPs are executed, the employer/company needs a proper administration including the third-party administration, trustee, valuation, legal costs. Hence it will be the burden of ongoing cost for a company/employer.
Benefits of ESOPs
The purpose of ESOP is to give benefit to both the Employer/Company and Employee. Startup eco-systems widely use ESOPs.
Following are the benefits of ESOP to the Employer/Company:
- For attracting and retaining high-quality employees,
- Making employees stakeholders of the company,
- The company can avoid cash compensation as a reward, thus saving on immediate cash outflow.
Following are the benefits of ESOP to an Employee:
- The benefit of acquiring the shares of the company at the nominal rate, and sell them (after a defined tenure set by his employer) and make a profit,
- Compensation of hard work in the form of ownership interest in the company.
Tax Implications of ESOPs
It is important to understand the tax implications of ESOPs in India before the employer considers implementing an ESOP scheme.
Employee: ESOPs are taxed at the following two times:
- At the time of Exercising ESOP: It is considered as a Prerequisite under Salary Income Head. Hence when an employee exercises his option, the difference between Fair Market Value (FMV) as on date of exercise and the exercise price is taxable as a prerequisite.
- At the time of Selling: It is considered as Capital Gain. An employee might sell his/her shares after buying them. In case he/she sells these shares at a price higher than FMV on the exercise date, he/she would be liable for capital gains tax.
ESOPs Taxation on Purchase of Shares
When an employee buys the shares of a company, it is treated as Perquisite. The shares are credited to a Demat Account of an employee once shares are purchased. Following are the tax implications when you buy the shares:
- Perquisite is the difference between the Fair Market Value (FMV) and exercised price/buy price.
- Perquisite is a part of taxable salary and taxed under the Salary Income Head.
- It will be taxed in the year in which ESOP is exercised by an employee. An employer/company will deduct TDS on the same.
- Form 16 issued by an employer/company will reflect the prerequisite amount and TDS on the same.
Example: Neha works in a startup in India. During FY 2019-20 her company announces ESOPs for all the current employees. Neha decides to exercise her option to buy the shares of the company. Under this scheme, Neha received 2000 shares at INR. 20 per share. The FMV of the shares is INR. 65 per share. Following are the tax implication on the above transaction:
Purchase Price: INR. 20
FMV: INR. 65
Perquisite: INR 45 (65-20)
Taxable Perquisite Amount: INR. 90,000 (2000X65)
Now the company will treat INR. 90,000 as a taxable salary of Neha and will deduct TDS on the same. While filing her ITR Neha needs to show INR. 90,000 as Perquisites under Salary Income Head.
ESOP Taxation on Sale of Shares
When an employee sells the shares, it is treated as Capital Gains. Following factors are considered for calculating Capital Gain Income:
- The Period of Holding: In case of ESOPs period of holding is from the exercise date up to the date of sale. Short Term or Long Term Capital Gain is determined by taking into account the period of holding.
- Taxable Amount: The difference between Sale Price and FMV on the exercise date is taxed as Capital Gains.
The tax treatment is different depending on whether the company is listed on the stock exchange or not.
Tax Treatment on sale of Listed Shares
- Long Term Capital Gains(LTCG): Taxed at a special rate of 10%. (Shares held for more than 12 months).
- Short Term Capital Gains(STCG): Taxed at a special rate of 15%.(Shares held for less than 12 months).
Tax Treatment on Sale of Unlisted Shares
- Long Term Capital Gains(LTCG): Taxed at a special rate of 20% with Indexation (Shares held for more than 24 months).
- Short Term Capital Gains(STCG): Taxed at applicable slab rate (Shares held for less than 24 months).
Example: Arya is a salaried individual. She works for a startup(listed Company) She received 2000 shares from her company under the ESOPs scheme in FY 2018-19. And she sales the shares on 20/01/2020. Following are the information to keep in mind:
Date of Purchasing Shares/Exercising the ESOPs: 25/02/2019
FMV as on 25/02/2019: INR. 50
Sales Price as on 20/01/2020: INR. 75
In the above case, the following will be the taxability:
Period Of Holding: 25/02/2019 to 20/01/2020 i.e, less than 12 months (Listed Company). Hence there will be Short Term Capital Gains.
Taxable Amount: INR. 50,000 [2000X25(75-50)]
Tax Rate: 15%. Since this is STCG from shares of Listed Company it is taxable at a special rate of 15%.
Tax Amount: INR. 7,500 (50000 X15/100)
-When an employee buys the shares of a company, it is treated as Perquisite. And thus taxable under the head Salary. In this case, the taxpayer is required to file ITR-1.
-When an employee sells the shares, it is treated as Capital Gains and thus taxable under Capital Gain head. In this case, the taxpayer is required to file ITR-2.
Since you’ll have to exercise your option through your employer, your employer will usually report the amount of your income as ordinary wages or salary and the income will be included when you file your tax return on Income Tax Portal.
If you quit or are laid off, the ESOP distributions are deferred for six years . Once those six years pass, you may receive the value of your ESOP shares in either one lump sum, or in basically equal payments made over five years.