ESOPs and Their Taxation

As the startup ecosystem is growing in India, companies often offer ESOPs or similar compensation plans to incentivize and retain employees. While ESOPs are commonly discussed, companies use various methods to reward employees, including ESOPs (Employee Stock Option Plans), ESPPs (Employee Stock Purchase Plans), RSUs (Restricted Stock Units), Phantom Stocks, Stock Appreciation Rights (SARs), and more. Some Indian subsidiaries of MNCs also offer their parent company’s stocks as part of compensation packages.

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Let’s simplify the various stock-based compensation methods and their taxation.

1. Key Stock-based Compensation Terms:

• Employee Stock Option Plan (ESOP): ESOPs allow employees to buy company shares over time at an agreed price, ESOPs typically vest over a period determined by the company, providing benefits to employees in a phased manner.
• Employee Stock Purchase Plan (ESPP): Lets employees purchase company shares at a discount, with payments deducted from their salary or bank account.
• Restricted Stock Units (RSU): Typically issued by foreign-listed companies, these shares are given to employees for free upon vesting.
• Phantom Stock Units (PSU): Provides employees with cash payments based on the company’s stock price appreciation. Employees do not own shares but receive cash awards mirroring the value of the company’s shares. Common Types of Phantom Stocks in India:
  • Appreciation Only Phantom Stock: Provides cash payments based on stock price appreciation over a specific period.
  • Full-Value Phantom Stock: Provides cash payments based on the full value of the company’s stock price over a specific period.

This method rewards employees with stock price appreciation without issuing shares directly to them, helping the company avoid dilution.

• Stock Appreciation Rights (SAR): They are similar to Phantom stocks but the key difference lies in how they are taxed at different events. This method rewards employees with stock price appreciation without issuing shares directly to them, helping the company avoid dilution.
• Grant Date: The date of the agreement between the employer and employee to grant the option to own shares in the future.
• Vesting Date: The date the employee becomes entitled to buy shares after fulfilling the agreed-upon conditions. This is also the agreed-on grant date.
• Vesting Period: The period between the grant date and the vesting date.
• Exercise Period: The time frame during which the employee can exercise their vested options to buy shares.
• Exercise Date: The date on which the employee exercises the option to buy shares.
• Exercise Price: The price at which the employee buys the shares upon exercising the option. This price is usually lower than the prevailing Fair Market Value (FMV) of the stock.
• Fair Market Value (FMV): The value of the shares on the exercise date, which is crucial for calculating both perquisite tax and capital gains tax. In case of a listed company, it is calculated as the average of opening and closing price of the day prior to the exercise date. In case of unlisted companies FMV is determined by a SEBI-registered merchant banker.

2. Taxation of ESOPs:

 ESOPs are Taxed in Two Instances:

• At the Time of Exercise (Perquisite Tax): 

When the employee exercises the option to buy shares, the difference between the Fair Market Value (FMV) on the exercise date and the exercise price is taxed as a perquisite. The employer deducts TDS on this perquisite, which is shown in the employee’s Form 16 and included in the total income from salary in the tax return.

From FY 2020-21, employees receiving ESOPs from eligible startups do not need to pay tax in the year of exercising the option.

•  At the Time of Sale (Capital Gain Tax): 

When the employee sells the shares, the difference between the sale price and the FMV on the exercise date is taxed as capital gains. The capital gains tax rate will depend on the holding period, calculated from the date of allotment to the date of sale of shares.

Example: Suppose an employee at Infosys. Ltd. exercises their ESOPs to buy 100 shares at an exercise price of ₹50 per share, while the Fair Market Value (FMV) on the exercise date is ₹150 per share. The difference of ₹100 per share (₹150 – ₹50) results in a perquisite of ₹10,000 (100 shares * ₹100). This perquisite is taxed as part of the employee’s salary, and Infosys deducts TDS on this amount, which is then reflected in the employee’s Form 16.

Later, the employee decides to sell these shares when the sale price has increased to ₹200 per share. The difference between the sale price (₹200) and the FMV on the exercise date (₹150) is ₹50 per share, resulting in a capital gain of ₹5,000 (100 shares * ₹50). Since the employee held the shares for less than a year, this is classified as a short-term capital gain and is taxed at the applicable short-term capital gains rate.

3.Taxation also differs based on country and whether the company is listed or unlisted:

•  Indian Listed Companies

Perquisite Tax is paid at the time of exercising the option. The difference between the Fair Market Value (FMV) and the selling price is taxed as capital gains at the time of sale.

•  Indian Unlisted Companies

For employees in Indian startups or other unlisted companies, taxation approaches can vary:

New Age Startups: Employees often defer perquisite tax until liquidity is available, typically through a buyback of vested options.

Other Companies: Employees may need to pay perquisite tax out of pocket at the time of exercise, which can be challenging due to the illiquid nature of the shares.

Additionally, unlisted companies are required to obtain FMV determinations from SEBI-registered merchant bankers for perquisite tax calculations. 

•  Unlisted Foreign Companies

When dealing with stocks from unlisted foreign companies, the tax treatment differs due to the smaller size of these entities.

Perquisite Tax: Ideally paid at the time of exercise. However, smaller companies may not comply with Section 17(2) provisions, which can result in capital gains tax becoming due at the time of sale.

Capital Gain: Tax is applied on the gains realized above the fair market value (FMV) at the time of sale.

•  Foreign Listed Companies

Employees in Indian subsidiaries of companies like Google, Microsoft, Adobe, Intel, and AMD often receive stock options in the parent company, which is listed in the U.S. These options are typically in the form of RSUs (Restricted Stock Units) or ESPPs (Employee Stock Purchase Plans).

• RSUs

• Acquisition Cost: No cost to the employee.
• Perquisite Tax: Paid through a “sell to cover” arrangement, where a portion of the stock is sold to cover tax liabilities.
• Capital Gain: Taxed at the time of sale, with no capital gains tax in the U.S.
• Foreign Asset Disclosure: Employees must disclose these assets under the Foreign Asset Schedule.
• CRS Compliance: Information is shared under the Common Reporting Standard (CRS) by OECD, involving 160+ countries.
• Dividend: Dividend income is subject to tax withholding in the U.S., and credit is available in India under Section 90 of the Income Tax Act and Article 10 of the India-U.S. Tax Treaty.

• ESPPs

• Acquisition Cost: Shares are issued at a discounted price.
• Perquisite Tax: Similar to RSUs, this is typically handled via “sell to cover.”
• Dividend Income: Tax withheld in the U.S. can be credited in India under Section 90 and Article 10 of the India-U.S. tax treaty.

 Conclusion

Understanding the provisions under various taxation rules is crucial for accurately assessing the true value of the compensation received and staying compliant with the rules, thereby avoiding penalties, interest, etc.

A qualified financial advisor can help you understand the true value of your ESOPs and the associated compliance requirements. To optimize your taxes, download the 1 Finance app and book a consultation with a qualified financial advisor for a seamless, hassle-free tax planning experience.