Saving Income Tax on ESOPs (for Employees) in India

Employee Stock Ownership Plans (ESOPs) have gained significant popularity in India as a form of employee compensation.

ESOPs not only provide employees with an opportunity to own a stake in the company but also offer potential financial rewards tied to the company’s success.

However, navigating the complex landscape of taxation related to ESOPs is crucial for employees to optimize their benefits and save on income tax liabilities.

By understanding the intricacies of ESOP taxation, employees can make informed decisions regarding their ESOPs and leverage them as a valuable tool for wealth creation.

This comprehensive guide aims to shed light on the taxation aspects of ESOPs in India and provide employees with valuable insights on how to effectively manage their ESOPs to minimize tax burdens and maximize their overall financial gains.

What is ESOP?

ESOP stands for Employee Stock Ownership Plan. Under an ESOP, employees are allowed to acquire shares of the company at a predetermined price, usually lower than the market price.

The employees typically receive these shares or stock options as part of their overall compensation package or as a reward for their performance.

ESOPs are a popular form of employee compensation and are designed to align the interests of employees with the long-term growth and success of the company.

In India, ESOPs are governed by the Companies Act, 2013. The Act provides for a number of requirements that must be met in order for a company to offer ESOPs to its employees.

The process for applying for an ESOP typically involves the following steps:

1. The company will notify eligible employees of the ESOP and the terms and conditions.
2. Employees will then indicate their interest in participating in the ESOP.
3. The company will then grant shares to eligible employees.
4. Employees will then have the option to exercise their right to purchase the shares.

How is ESOP taxed?

ESOPs in India are subject to taxation at various stages, including the time of exercise, vesting, and sale of the acquired shares. The tax treatment of ESOPs can vary depending on factors such as the type of company (listed or unlisted) and the holding period of the shares. Here is an overview of the general tax implications of ESOPs:

1. Taxation at the time of Exercise: When an employee exercises their ESOPs, the difference between the fair market value (FMV) of the shares on the date of exercise and the exercise price (if any) is treated as a perquisite and added to the employee’s income for that financial year. This perquisite is subject to income tax at the applicable slab rates. Since the financial year 2020-2021, the government has amended the provisions, giving the employee leeway not to pay taxes in the year of exercising the option. Perquisite can be deferred to earlies for the following dates:

• Expiry of 5 years from the year of allotment of ESOPs
• Date of sale of the ESOPs by the employee
• Date of termination of employment

1. Taxation at the time of Vesting: In certain cases, when the ESOP vest and the employee acquire the shares, it may trigger a tax liability even before exercising the options. If there is a taxable event at the time of vesting, the difference between the FMV of the shares on the date of vesting and the exercise price (if any) is considered as a perquisite and subject to income tax at the applicable slab rates.
2. Taxation at the time of Sale: When the employee sells the shares acquired through ESOPs, the resulting gain or loss is categorized as either short-term capital gains or long-term capital gains, depending on the holding period of the shares:

• Short-term Capital Gains: If the unlisted shares are held for 24 months or less from the date of allotment or exercise, the resulting gain is considered as short-term capital gains. In the case of listed shares, a period of 12 months or less is considered for short-term capital gains.
• Long-term Capital Gains: If the shares are held for more than 24 months from the date of allotment or exercise, the resulting gain is considered as long-term capital gains.

There are some exceptions to the above taxation rules. For example, ESOPs that are granted to employees as part of a startup company’s employee stock purchase plan (ESPP) may be exempted from TDS on the perquisite income.

Additionally, ESOPs that are granted to employees as part of a merger or acquisition may be subject to different taxation rules.

It’s important to note that ESOPs are also subject to other taxes, such as Securities Transaction Tax (STT) and Goods and Services Tax (GST) in specific cases.

The specific tax implications of ESOPs can vary based on individual circumstances, the type of company, the nature of the shares, and the prevailing tax laws.

EXAMPLE

• Example 1: An employee is granted 100 shares of stock under an ESOP with an exercise price of Rs.10 per share. The fair market value of the shares on the date of exercise is Rs.20 per share. The employee’s taxable income will increase by Rs.1000 (100 shares * Rs.10 per share), and they will owe tax on this amount at their marginal tax rate.
• Example 2: The employee in Example 1 sells the shares they acquired through their ESOP one year after the date of exercise. The fair market value of the shares on the date of sale is Rs.30 per share. The employee’s capital gain will be Rs.2000 (300 shares * Rs.10 per share), and this gain will be taxed as a long-term capital gain.

How can you save Taxes?

• Stretch the exercise period: The tax on ESOPs is typically due when you exercise your options, which means you have to pay tax on the difference between the fair market value of the shares on the exercise date and the exercise price. However, you can defer the tax by stretching the exercise period. This means that you can wait to exercise your options until you sell the shares. The capital gains will not have any immediate effect and need to be included while filing for the annual income tax returns.
• Invest in long-term capital gains funds: When you sell ESOP shares that you have held for more than a year, you will be taxed at the long-term capital gains rate, which is currently 10% (or 20% for high earners). You can save even more money by investing in long-term capital gains funds. These funds invest in assets that are expected to appreciate in value over the long term, and the capital gains from these investments are taxed at the long-term capital gains rate. Some specific options can be securities under section 54EE (Max limit: 50 lakhs) of the Income Tax Act or investing the sales consideration in a residential house u/s 54F. However, it is subject to specified conditions mentioned in Section 54EE and 54F, respectively.
• Reinvest your capital gains: If you reinvest your capital gains in qualified investments, such as stocks, bonds, or mutual funds, you can defer the tax on the capital gains until you sell the reinvested assets.
• Contribute to a retirement plan: You can save money on taxes by contributing to a retirement plan, such as a 401(k) or IRA. When you contribute to a retirement plan, you can deduct your contribution from your taxable income. This can reduce your tax bill and help you save for retirement.
• Leveraging Other Tax Planning Opportunities: Employees can consider additional tax planning strategies to minimize their overall tax liability, such as:

1. Capital Loss Offset: If an employee has incurred capital losses from other investments, they can offset those losses against the capital gains arising from the sale of ESOPs, thereby reducing the taxable amount.
2. Gift to Family Members: Transferring ESOPs to family members can help distribute the capital gains among multiple individuals, utilizing their tax exemptions and reducing the overall tax liability.
3. Tax-Saving Investments: Investing in tax-saving instruments like Equity Linked Saving Schemes (ELSS) or National Pension Scheme (NPS) can help reduce taxable income and potentially offset the tax liability on ESOP gains.

EXAMPLE:

Let’s say you are granted 100 ESOP shares with an exercise price of $10 per share. The fair market value of the shares on the exercise date is $20 per share.

If you immediately exercise your options and sell the shares, you will have to pay $1,000 in taxes (the difference between the fair market value of the shares and the exercise price).

However, if you stretch the exercise period and sell the shares after they have appreciated in value, you can defer the tax on the capital gains.

If you sell the shares after a year, you will only have to pay $200 in taxes (the capital gains tax on the $1,000 gain). And if you reinvest the capital gains, you can defer the tax on the capital gains even further.

Conclusion

Understanding the taxation aspects of ESOPs and implementing effective strategies is paramount for employees in India to make the most of their ESOP benefits while minimizing their tax obligations.

By navigating the intricacies of ESOP taxation, employees can unlock the true potential of these plans as valuable tools for wealth creation and long-term financial growth.

However, it is essential to remember that tax laws and regulations are subject to change, and individual circumstances may vary.

Therefore, it is highly recommended to consult with a qualified tax advisor or professional to ensure compliance with the latest tax laws and to tailor tax planning strategies to one’s specific situation.