Understanding Tax And Regulatory Implications of ESOPs In India

In recent times, the strategy of granting ESOPs (Employee Stock Option Plans) has been employed by many companies as a method of incentivizing and retaining key employees.

What are ESOPs?

An Employee Stock Option Plan (ESOP) is a scheme which offers employees the chance to obtain equity shares in the company at a predetermined price, allowing them to benefit from the organization's growth. ESOPs and their variations hold significant appeal amongst established corporations and startups serving as a vital instrument to attract and retain key employees.

ESOPs are generally issued at a discounted price or at the fair market value (FMV) of the underlying share at the time of their grant.

In some instances, particularly within conglomerates or group enterprises, employees from subsidiary entities are also presented with the option to acquire shares of the parent company.

Process

The ESOP process begins with the employer drafting the ESOP policy, identifying eligible employees, specifying terms related to the grant of options, vesting periods, determination of exercise price, and conditions that may lead to the lapse of options due to employee resignation or termination.

Once formulated, employers must obtain necessary board or shareholder approvals and ensure all secretarial and regulatory compliances are met.

Subsequently, grant letters specifying details like the grant date, vesting information, and exercise price are issued to the selected employees. The vesting period, which may differ based on factors such as service duration and performance, determines when an employee can exercise these options. After the vesting period concludes, employees can choose to exercise their options within a defined timeframe, converting these "options" into actual "shares" of the company.

Nowadays, it is popular amongst startups to create an ESOP pool typically about 10% to 15% of the capital before fundraising. Creating an ESOP pool helps especially when a company has to attract and retain talent with minimal cash outflow.

Tax implications

In the hands of the Employee:

1. At the time of exercising the option: The date on which the employee exercises the options is called the "exercise date". On the day the options are exercised, the difference between the stock's Fair Market Value (FMV) and the price at which the employee acquires it ('Exercise price') will be taxable as a perquisite, forming a component of the employee's salary and hence, taxable as per normal slab rates.

2. At the time of selling the shares: If an employee decides to sell the shares, the difference between the sale price and the FMV from the exercise date is taxable under the head capital gains.

Note: There will not be any tax implications on lapsed options.

Example:

Grant date: April 1, 2023
Maturity date: April 1, 2025
Number of options exercised: 100
FMV as on April 2025: INR 100
Exercise price: INR 10
Sale date: April 1, 2027
Sale price: INR 500

In this case, at the time of exercise of options, the employee will be subject to perquisite tax under the head salary income as follows:

April 1, 2025 (Financial year 2025-26)

Perquisite tax = FMV - Exercise price
= 100 - 10
= 90 per share x 100 options
= INR 9,000

April 1, 2027 (Financial year 2027-28)

Capital gains = Sale price - FMV on April 1, 2025
= 500 - 100
= 400 per share x 100 shares
= INR 40,000

Capital gains can be classified as long-term capital gains or short-term capital gains based on the period of holding of the shares. For ESOPs, the period of holding of shares is from the exercise date (date of allotment of shares) till the date they are sold.

Period of holding

For listed shares, the period of holding to be qualified as a long-term capital asset is 12 months, while for unlisted shares, the period of holding to be qualified as a long-term capital asset is 24 months.

Shares held for less than 12 months in the case of a listed company or 24 months in the case of an unlisted company will be considered as short-term capital assets.

Tax rates

Listed shares	Long-term capital gains exceeding INR 100,000 will be taxed at the rate of 10%
	Short-term capital gains are taxed at 15%
Unlisted shares	Long-term capital gains arising in the hands of a) Residents are taxed at 20%, b) Non-residents are taxed at 10% without any indexation benefit
	Short-term capital gains are subject to taxation at normal slab rates applicable to individuals

Notes:

• The above rates are excluding applicable surcharge and cess
• Subject to Securities Transaction Tax (STT)
• The benefit of adjusting the cost of the inflation index will not be available ('indexation benefit’) will not be available. Also, for non-residents, the benefit of computing long-term capital gains in foreign currency will not be allowed.

In the hands of the Employer:

The amount treated as a perquisite in the hands of the employee on exercise of option as explained above is considered as salary cost and is allowed as a deduction while computing business profits of the employer. The employer is required to withhold taxes on the perquisite tax as per the provisions for TDS on salary.

Deferment of tax payment for ESOPs offered by startups

There are also some instances where the ESOP benefit provided to an employee might be more than the salary of the employee. Considering such difficulties faced by the employees, an option is given to defer the tax liability on perquisites till 14 days from the earlier of the below events instead of the date of exercise of the option.

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

Date of allotment	Date of Sale	Date of termination of employment	Expiry of 5 years	Perquisite tax trigger
				Event	Date
01-Oct-23	01-Jul-26	01-Jan-27	01-Apr-29	Date of Sale	01-Jul-26
01-Oct-23	01-Mar-27	01-Jan-27	01-Apr-29	Date of termination of employment	01-Jan-27
01-Oct-23			01-Apr-29	Expiry of 5 years	01-Apr-29

Please note the above relaxation is available only for ESOPs of eligible startups as defined under Section 80-IAC of the Income-tax Act, 1961.

Global ESOP Considerations

Global corporations are increasingly offering ESOPs of the foreign holding company to reward employees of their Indian subsidiaries. This strategic initiative aligns the employees' interests with the parent company's overarching objectives, fostering deep-rooted loyalty. As the competitive environment in India escalates, these incentives become crucial for attracting and retaining elite professionals. From a regulatory standpoint, the FEMA Overseas Investment Rules allow residents to acquire shares or interests via ESOPs or Employee Benefit Schemes. Furthermore, when an employee's ownership in the foreign company constitutes less than 10% of its equity capital without exerting control, it is designated as an Overseas Portfolio Investment, enhancing its appeal.

The views and opinions stated in the content belong to Jitesh Agarwal, Founder, Treelife (legal and finance advisor for startups).

Disclaimer

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