Understanding the Taxability of ESOP Gains

Taxblock | Last updated: 13 September 2021

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Employee Stock Option Schemes (ESOPs) offer employees a stake in the company's profits, with tax implications arising at two key points: when the options are exercised and when the shares are sold. The tax at exercise is based on the difference between the share's fair market value and the exercise price, treated as a perquisite. When shares are sold, capital gains tax applies, calculated on the difference between the sale price and the cost basis (exercise price plus any amount paid). The holding period for shares determines whether gains are short-term or long-term, with different tax rates applying.

According to Section 2(37) of Companies Act, 2013, Employees stock option schemes is an option given to the directors, employees or officers of the company or its holding and subsidiary company, the right to purchase or benefits or subscribe for the shares of the company at the predetermined price for a future date. Therefore ESOPS are issued to motivate their current employees or directors by giving them stake in the profits of the company

According to section 12(1) of Companies (Share Capital and Debenture) Rules, 2014, ESOPs can be issued to

Permanent employees of parent or subsidiary company working in India or outside India
Directors of the company including whole time or part time director but not including independent director.

ESOP Taxability: Understand Your Gains and Obligations

TAX DEDUCTIBLITY OF ESOPS

ESOPS are taxable at two instances

At the time of exercise
At the time of sale

(i) At the time of exercise

The amount of perquisites shall be determined on the difference between the fair market value of shares (FMV) with that of the exercised price of the shares. This perquisite forms the part of total income from salary and should be filed in employee’s Form 16

(ii) At the time of sale

At the time of sale: The amount of capital gain shall be determined on the difference between the fair market value of shares (i.e. the cost price of the share when the same were allotted (Perquisites plus Paid amount by the assesse) with that of consideration received on sale of these shares. This forms the part of capital gain (whether LTCG or STCG depends upon the period of holding of these shares)

(iii) How to calculate FMV Of shares

In case of Listed shares: If the shares a listed or traded on recognised stock exchange the face value of each shares will be the average of opening plus closing price on that of listed in the stock exchange. However if the shares are not traded on the stock exchange the closing price of the preceding date of exercise will be considered as FMV.
In case of Unlisted shares: The FMV should be the value of shares that is determined by a merchant banker.

DETERMINING THE NATURE OF THE GAIN

In case of listed company: According to section 111A of Income tax Act, if the shares are held for a period that is less than or equal to 12 months, the gain arising out of sale of shares is considered to be short term capital gain. If the shares are held for more than 12 months it is considered to be long term capital gains. According to section 112A if the capital gain is more than 1 lakh a rate of 10% without indexation is applicable.
In case of Unlisted Company: If the shares are held for a period that is less than or equal to 24 months, the gain arising out of sale of shares is considered to be short term capital gain. If the shares are held for more than 24 months it is considered to be long term capital gains. According to section 112A the capital gain is chargeable at the rate of 20% with indexation benefits.

Taxability on behalf of the employer

In the case of CIT vs. Lemon Tree Hotels Limited, ITA 209/DEL/2014 it was held by the high court of Delhi, the expense related to ESOPS was to be allowed as an expense and thus the company can claim deduction for it.

Taxability of ESOPs from an eligible startup

According to Finance amendment act, 2020 in case employees receives ESOPS from an eligible startup, tax on the perquisite shall be deductible on earlier of the following events

After the expiry of 5 years from allotment
On the date of sale
On the date of exit from the company.

Authored by CA Madhuri Marne

FAQ :

An ESOP (Employee Stock Option Scheme) gives employees, directors, or officers the right to buy company shares at a predetermined price on a future date, intended to motivate them by giving them a stake in the company's profits.

ESOPs are typically taxed at two instances: at the time of exercising the option (when you buy the shares) and at the time of selling the shares.

At exercise, the taxable amount (perquisite) is the difference between the Fair Market Value (FMV) of the shares and the price you paid to exercise the option. This is usually added to your salary income.

When you sell ESOP shares, capital gains tax is calculated on the difference between the sale price and your cost price (which includes the exercise price plus any amount paid). This can be short-term or long-term capital gain depending on how long you held the shares.

For listed shares, FMV is usually the average of the opening and closing price on the stock exchange. For unlisted shares, it's determined by a merchant banker.

For listed companies, gains are short-term if held for 12 months or less, and long-term if held longer. For unlisted companies, gains are short-term if held for 24 months or less, and long-term if held longer. Tax rates and indexation benefits differ between the two.

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Understanding the Taxability of ESOP Gains