What is ESOP Taxation

ESOP (Employee Stock Option Plan) is an employee benefit plan that allows the employees to have ownership rights in the organisation. It is similar to the profit sharing plan and under these plans the company offers stocks to the employees at negligible or discounted prices.Generally, the start-up companies use ESOPs as part of the employee salary package to attract the best employees. ESOPs give the employers or the companies the flexibility to offer a lower salary and use these options as an incentive.Recently, during the COVID-19 pandemic, many companies in India offered ESOPs to their employees to compensate for the loss of pay they endured.

Initially, the ESOPs were taxed within the scope of fringe benefit tax. However, in 2009, post the amendments made to the Finance Act, the taxability of ESOPs lies in the employees’ hands. ESOPs taxation can arise at two stages. One, when the shares are allocated to the employees. And, two, when the employees sell the shares. Let us look at the taxability in detail.

Under this, the difference between the fair market value (FMV) of the shares allocated to the employees and the exercise price under ESOP is treated as a prerequisite. The Rule 3(8) of the Income Tax Rules states that when the shares allotted are of listed companies, the FMV shall be the average of the opening prices and closing price as on that date.If the shares allotted are of unlisted companies, the value of the shares determined by a merchant bank on a specified date will be taken as FMV. As per the recent amendment announced in Budget 2020, if the employee receives ESOP from an eligible start up, the tax on the ‘perquisite’ will be deducted on earlier of the following events:

• After five year from date to ESOPs allotment
• On the date of sale of ESOPs
• On the date of quitting the organisation

Taxation on ESOPs when employees sell the shares

When the employee exercises the option to get the shares of the company, the employer allocates the shares in their name. At this stage, the employee has the option to either hold the share for some time or they can sell the off and earn profits from the sale. The profits they may earn will be considered as capital gains.The capital gains tax on the sale of the shares will be calculated based on the difference between the sale consideration and the fair market value of the share on the date of the sale. And, based on how long the employee holds the shares before they sell them for profits, STCG (short-term capital gains) or LTCG (long-term capital gains) will be levied. The holding period is calculated from the date of shares allocation.

Tax implication on shares of listed companies

When the employees hold the shares for 12 months or less before selling them, the profits gained from sales are termed as short-term capital gains. Therefore, as per the provisions of Section 111A of the Indian Income Tax Act, 1961, the gains will be taxed at 15%.If the employees hold the shares for more than 12 months, the gains from the sales of shares is considered as long-term capital gains. The gains are taxed at 10% without indexation if the gains are more than Rs. 1 lakh under Section 112A of the IT Act.

Tax implication on shares of unlisted companies

If the employees hold the shares for 24 months or less before selling them, the gains earned are considered as short-term capital gains. The returns earned are treated as regular income and it is taxed as per their regular tax slab.If the employees hold the shares for more than 24 months, the gains will be considered long-term capital gains and it is taxed at 20% with indexation benefit under Section 112 of the IT Act.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.