What Are The Tax Implications Of ESOPs (Employee Stock Ownership Plans)?

Employee Stock Ownership Plans (ESOPs) are a popular compensation tool where employees receive company shares at a predetermined price. However, ESOPs are taxed at two stages—when exercised and when sold. Understanding these tax implications helps employees make informed financial decisions.

Taxation of ESOPs in India

1. Tax at the Time of Exercise (Perquisite Tax)

When an employee exercises ESOPs, the difference between the Fair Market Value (FMV) on the exercise date and the exercise price is treated as a perquisite (salary income).

This amount is taxed as per the employee’s income tax slab rate under Section 17(2) of the Income Tax Act.

Example: If FMV is ₹500 per share, exercise price is ₹200, and 1,000 shares are exercised, taxable perquisite = (₹500 - ₹200) × 1,000 = ₹3,00,000.

2. Tax at the Time of Sale (Capital Gains Tax)

When the employee sells the shares, capital gains tax applies based on the holding period:

• Short-Term Capital Gains (STCG) Tax (If sold within 12 months) → 15% tax.
• Long-Term Capital Gains (LTCG) Tax (If sold after 12 months) → 10% tax on gains above ₹1 lakh (under Section 112A).

Cost of acquisition is considered as the FMV on the exercise date.

3. Special ESOP Tax Deferment for Startups

Eligible startups (recognized by DPIIT) can defer perquisite tax for up to 5 years or until the employee leaves the company or sells shares, whichever is earlier.

This helps in reducing immediate tax burden for employees.

Tax Planning Strategies for ESOP Holders

• ✔ Exercise ESOPs in a lower tax bracket year to minimize perquisite tax.
• ✔ Hold shares for over 12 months to qualify for LTCG tax instead of STCG tax.
• ✔ Sell shares in installments to stay within the ₹1 lakh LTCG tax exemption limit.
• ✔ Use capital gains exemptions by reinvesting under Section 54F (if eligible).

Legal Actions and Protections

• TDS Deduction by Employer: ESOP perquisite tax is deducted as TDS under Section 192.
• Reporting ESOP Gains in ITR: Employees must report ESOP income and capital gains while filing their Income Tax Return.
• Avoid Blackout Period Sales: Ensure compliance with company policies and SEBI regulations before selling shares.

Example

An employee receives 2,000 ESOPs at an exercise price of ₹100. The FMV on the exercise date is ₹400, and after two years, the shares are sold for ₹600.

At Exercise:

Perquisite Income = (₹400 - ₹100) × 2,000 = ₹6,00,000 (Taxed as per slab rate).

At Sale (After 2 Years, LTCG Applicable):

Capital Gains = (₹600 - ₹400) × 2,000 = ₹4,00,000.

LTCG Tax Calculation: ₹4,00,000 - ₹1,00,000 (exemption) = ₹3,00,000 × 10% = ₹30,000 tax.

By holding for more than 12 months, the employee avoids 15% STCG tax and benefits from LTCG tax treatment.