Getting ESOP as Salary Package? Know about ESOP Taxation

ESOPs have become common in India and the jobs gaining popularity. Several international companies with employees in India also offer ESOPs.

ESOP (Employee stock option plan)  is an employee benefit plan offering employees an ownership interest in the organisation in the form of equity shares. It is similar to a profit-sharing plan. Under these plans, the company, which is an employer, offers its stocks at negligible or low prices. These stocks remain in an ESOP trust fund till the vesting period and exercise these options or retire/leave the company.

Budget 2024 Latest Updates

Budget 2024 has passed the following amendments effective from FY 2024-25 - 

• For classifying assets into long-term and short-term, there will only be two holding periods: 12 months and 24 months. The 36-month holding period has been removed.
• The holding period for all listed securities is 12 months. All listed securities with a holding period exceeding 12 months are considered Long-Term. The holding period for all other assets is 24 months.
• Unlisted bonds and debentures are brought in line with the taxation on debt mutual funds and market-linked debentures. They will attract tax on capital gains at applicable slab rates. (i.e., they will be treated as short-term irrespective of the period of holding.)
• The taxation of Short-Term Capital Gain for listed equity shares, a unit of an equity-oriented fund, and a unit of a business trust has been increased to 20% from 15%. Other financial and non-financial assets which are held for short term shall continue to attract the tax at slab rates.
• For the benefit of the lower and middle-income classes, the limit on the exemption of Long-Term Capital Gains on the transfer of equity shares or equity-oriented units or units of Business Trust has increased from Rs.1 Lakh to Rs.1.25 lakh per year. However, the rate at which it is taxed has increased from 10% to 12.5%. The exemption limit to Rs.1.25 lakhs has been increased for the whole of the year, whereas the tax rate changed on 23rd July 2024.

Let’s understand how ESOPs are taxed.

Terms on ESOPs 

Before you understand the taxation of ESOPs and RSUs, here are some key terms you must know:

1. ESOP – Employee Stock Option Plan, allows an employee to own equity shares of the employer company over a certain period. The terms are agreed upon between the employer and employee.
2. ESPP - Employee Stock Purchase Plan allows an employee to own equity shares of the employer based on the agreed purchase price. Employees pay for such stock at a discounted price which is paid directly from their bank account or deducted on a monthly basis from the payroll or payslip.
3. RSU - Restricted Stock Units are usually issued by those companies listed outside India. In the case of RSU, it is issued to employees as a reward when the employee achieves a milestone or target. Hence you need not pay any to your employer. 
4. Grant Date –The date of the agreement between the employer and employee to give the option to own shares (at a future date).
5. Vesting Date – The date the employee is entitled to buy shares after conditions agreed upon earlier are fulfilled. This date is also the agreed-on grant date.
6. Vesting Period – The period between the grant date and the vesting date.
7. Exercise Period – Once options have ‘vested’, the employee now has a right to buy (but not an obligation) the shares for a period of time. This period is called the exercise period.
8. Exercise Date – The date on which the employee exercises the option.
9. Exercise Price – The price at which the employee exercises the option. This price is usually lower than the prevailing FMV (fair market value) 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 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. In that case, no tax is payable.

Calculating Taxes

ESOPs are taxed in 2 instances –

1. At the time of exercise – as a perquisite – When the employee has exercised the option, basically agreed to buy; the difference between the FMV (on exercise date) and the exercise price is taxed as perquisite. The employer deducts TDS on this perquisite. This amount is shown in the employee’s Form 16 and included as part of the total income from salary in the tax return.

Note: From the FY 2020-21, 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:

• Expiry of five years from the year of allotment of ESOPs
• Date of sale of the ESOPs by the employee
• Date of termination of employment

2. At the time of sale by the employee – as a capital gain – The employee may choose to sell the shares once these are bought by him. If the employee sells these shares, another tax event happens. The difference between the sale price and FMV on the exercise date is taxed as capital gains. 

Capital Gain computation is as follows:

Example: Mr Z is employed at ABC Ltd. He was offered ESOPs of 2000 shares at Rs 80 /share on 1st April 2021. He exercised the option on 1st January 2023. He sold his shares once on October 1st 2023 and second on March 3rd 2024.

** STCG @ 15% and LTCG @ 10% exceeding ₹100,000

How to Calculate FMV

The Fair Market Value (FMV) of a stock is the Fair value or market price of such stock at the time of exercise. This becomes relevant since when such Stock options are sold, the FMV at the time of exercise will be considered the cost of acquisition. 

Advance Tax on Capital Gains

Advance Tax rules require that your tax dues (estimated for the whole year) must be paid in advance, which is paid in installments. TDS is deducted when you exercise your options and deposit advance tax if you have earned capital gains on subsequent sales. 

For FY 2023-24 for individuals instalments are due on 15th June, 15th September, 15th December, and 15th March. By 15th March, 100% of your taxes must be paid.

Non-payment or delayed payment of advance tax results in penal interest under sections 234B and 234C. However, it may be hard to estimate advance tax on capital gains for this year. 

Therefore, when advance tax installments are paid, no penal interest is charged where the installment is short due to capital gains. The remaining installment (after the sale of shares) of advance tax, whenever due, must include a tax on capital gains.

Other Considerations

To properly calculate tax on the sale of ESOPs certain other aspects need to be considered as well.

1. Sell to Cover the transaction 

When the stocks are exercised after vesting is complete, the employer is liable to deduct TDS u/s 192 on the fair market value of such exercised option. FMV of such stocks are considered as Perquisite and is taxable under the head Income from Salary.

Now the question is, since this is non-monetary compensation (in the form of stocks), how will the employer deduct and pay the TDS? Employers can either ask you to pay the TDS on such allowed stocks via Bank transfer to the company account or, in the majority of cases Employer will do a sell-to-cover transaction. It involves selling a part of the shares from the allotted stocks to cover the taxes.

An example for sell to cover transaction for stock listed in the US Exchange is given below

Transaction in your Demat

Since in the above transaction, stocks are being sold, this might give rise to notional capital gain or loss which is necessary to be declared in your Income tax return.

It is important to note that as an employee, attention is required only when you subsequently sell such shares in the market where capital gains will be attracted.

2. Capital Gains/ Losses

The rates at which your capital gains shall be taxed depend on the period of holding them. The period of holding is calculated from the exercise date up to the date of sale. Equity shares listed on a recognized stock exchange (where STT is paid on sale) are considered long-term gains when held for more than one year. If sold within one year, they are considered as short-term gains. Currently, long-term gains on listed equity shares are taxed at 10% without indexation on LTCG above Rs 1 lakh, whereas short-term capital gains are taxed at 15%. With effect from 23rd July 2024, ong-term gains on listed equity shares are taxed at 12.5% without indexation on LTCG above Rs 1.25 lakh.

When you have incurred a loss, you are allowed to carry forward the short-term capital losses in your tax return and adjust & set them off against gains in future years.

3. Listed or unlisted shares 

The Income Tax Act differentiates between tax treatment of listed and unlisted shares. The tax treatment for shares that are unlisted in India or listed out of India remains the same, i.e. if you own shares of an American company, they will not be listed in India. 

They may be considered unlisted for the purpose of taxes in India. The shares are short-term when held for less than 3 years and long-term when sold after 3 years. Starting FY 2016-17, Unlisted Equity Shares shall be short-term capital assets – when sold within 24 months of holding them and long-term capital assets – when sold after 24 months of holding them [Applicable for sales made on or after 1st April 2016]. 

The period of holding begins from the exercise date and ends on the date of sale. In this case, short-term gains are taxed at income-tax slab rates, and long-term gains are taxed at 20% after indexation of cost.

Summary of Tax implications on the sale of stocks is as follows

5. Buyback of Stock Options

Buyback of stock options involves where the company decides to buy back the option before exercise of such option into equity shares. This is quite common in Indian Unlisted companies/startups. Indian startup incentivises its employees by giving ESOP but, as a condition, allows conversion into equity only on liquidation events (like IPO, Further investment rounds).  Since the shares are not liquid due to an inactive market employer might decide to buy back the options even before such options are exercised to provide liquidity to its employees.

Employers consider such buyback income under the head ‘Salary’ and deduct TDS u/s 192. Thus it will be reflected in your Form 16, and it need not be separately disclosed in your ITR.

6. Residential status 

Your income is taxable in India according to your residential status. If you are a resident, all your income from anywhere in the world is taxed in India. On the other hand, if you are a non-resident or resident but not ordinarily resident and have exercised your options or sold your shares outside India, you are not liable to pay tax in India. Thus determination of Residential status becomes crucial.

7. Disclosures 

Several disclosures have been added to income tax return forms for foreign assets. If you own ESOPs or RSUs of a foreign company, you may have to disclose your foreign holdings under schedule FA of your income tax return. These disclosure requirements are applicable to a resident taxpayer.

8. When options are not exercised 

On the vesting date, the employee gains a right to exercise his option or buy the stocks. But there is no obligation, the employee can choose not to exercise his option. In such a case there shall be no tax implication for the employee.