Taxation of ESOPs in India: From Grant to Exercise and Sale

ESOPs are taxed twice: once as salary when the employee exercises, and again as capital gains when the shares are sold. Nothing is taxed at grant or vesting. Exercises on or after 1 April 2026 fall under the Income-tax Act, 2025. Earlier exercises stay under the 1961 Act.

The timeline

How FMV is fixed

• Listed shares: the average of the opening and closing prices on the exercise date on the exchange with the highest volume.
• Unlisted shares: a valuation by a Category I merchant banker as of the exercise date, or as of a date not more than 180 days earlier.
• Rules: Rule 15 of the Income-tax Rules, 2026 now governs this, replacing Rule 3 of the 1962 Rules. Stale valuations are the most common error.

A worked example (illustrative)

An employee exercises 1,000 options at ₹100 when the unlisted FMV is ₹500.

• Perquisite: (500 − 100) × 1,000 = ₹4,00,000, taxed at slab rates. At the 30% slab that is about ₹1,20,000 plus surcharge and cess, deducted by the employer.
• Sale: 26 months later at ₹800, the gain is (800 − 500) × 1,000 = ₹3,00,000. It is long-term because the holding period exceeds 24 months, so the tax is about ₹37,500 at 12.5%, plus surcharge and cess.
• Total: the same shares were taxed twice, on different bases.

Capital gains rates

The 2025 Act is policy-neutral, so these rates are carried forward.

The startup deferral

Employees of eligible startups need not pay the perquisite tax at exercise. The employer defers it until the earliest of:

• the sale of the shares
• the employee leaving
• expiry of the window

For shares allotted on or after 1 April 2026 the window is reported as 60 months from the end of the tax year of allotment, up from 48 months under the 1961 Act (s. 392(3) read with s. 289(3)).

Conditions for the deferral:

• The company must be DPIIT-recognised and also certified as an eligible startup under s. 140 (formerly 80-IAC).
• It must have been incorporated between 1 April 2016 and 31 March 2030.
• Its turnover must be below ₹100 crore.

The deferred tax becomes payable within 14 days of the triggering event.

Special situations

• Sell-to-cover: the employer sells some shares to fund the TDS. Any small gain or loss on that lot goes in the capital gains schedule.
• Buyback of ESOP shares: from 1 April 2026, buyback proceeds are taxed as capital gains in the shareholder's hands rather than as deemed dividends. Employees therefore follow the capital gains route.
• Foreign ESOPs: the same two stages apply, in INR. The foreign shares must be disclosed in Schedule FA, and foreign tax credit needs the prescribed form filed before the ITR due date.
• Capital losses: a loss on sale cannot be set off against the salary income that was already taxed at exercise.

Common mistakes

1. Stale valuations. An old merchant banker report can fail the 180-day test.
2. Missed deferral opt-in. An eligible company fails to apply the deferral, so employees pay tax on illiquid shares.
3. Wrong cost of acquisition. The cost is FMV at exercise, not the exercise price.
4. Old section references. Plan documents, grant letters and payroll still cite s. 192 and Form 16.
5. Foreign shares not disclosed. Missing Schedule FA invites penalties.

Checklist

1. Refresh the FMV report within 180 days of every exercise window.
2. Update plan documents for s. 392, Form 130 and Rule 15.
3. Confirm startup deferral eligibility and record the opt-in.
4. Reconcile Form 130 with the ITR.
5. Report foreign ESOPs in Schedule FA and claim foreign tax credit on time.