What Is The Tax Treatment Of ESOPs (Employee Stock Ownership Plans)?

Employee Stock Ownership Plans (ESOPs) are a form of employee benefit where companies grant their employees the option to purchase company shares, usually at a discounted rate. While ESOPs are a popular incentive tool, the tax treatment associated with them is complex, with taxes applicable at different stages such as grant, vesting, and sale of the shares. It’s important for employees to understand the tax implications of ESOPs to manage their finances effectively.

Tax Treatment of ESOPs:

Tax at the Time of Grant:

There is no tax when ESOPs are granted. At this stage, employees are only given the right to purchase shares at a later date, typically at a discounted price. Since no transaction occurs, there is no immediate tax liability.

Tax at the Time of Vesting:

Vesting refers to the process where the employee gains the right to exercise their ESOPs. The tax liability arises when the options are exercised—i.e., when the employee buys the company shares at a price lower than the market value.

• Taxable as Salary Income: The difference between the market value of the shares on the date of exercise and the exercise price paid by the employee is considered as perquisite (salary income).
• For example: If the market value of a share is ₹500 and the employee exercises the option to buy the share at ₹300, the difference of ₹200 per share is taxable as salary income.
• Tax Deducted at Source (TDS): The employer is required to deduct TDS on the perquisite value (the difference between the market price and exercise price) at the applicable income tax rates. This amount will be included in the employee's taxable income for the year.

Tax at the Time of Sale:

When the employee sells the shares acquired through ESOPs, capital gains tax is applicable.

• Short-Term Capital Gains (STCG): If the shares are sold within 2 years from the date of exercise, the gains are treated as short-term capital gains and taxed at a rate of 15% (plus applicable cess).
• Long-Term Capital Gains (LTCG): If the shares are sold after 2 years, the gains are treated as long-term capital gains and taxed at 10% (if the gains exceed ₹1 lakh in a financial year). No indexation benefits are available for LTCG on listed shares.

Example of Taxation at Different Stages:

Grant:

No tax is paid at the time of granting ESOPs.

Vesting:

Assume an employee is granted 100 shares at an exercise price of ₹200 per share. The market price at the time of exercise is ₹500 per share.

• The perquisite value (taxable income) is ₹500 - ₹200 = ₹300 per share.
• The total salary income to be taxed is ₹300 × 100 shares = ₹30,000.
• TDS will be deducted by the employer on ₹30,000 as per the employee's income tax slab.

Sale:

If the employee later sells the shares at ₹700 per share, the capital gains will be calculated as:

• Selling Price: ₹700 × 100 = ₹70,000.
• Cost of Acquisition: ₹200 × 100 = ₹20,000.
• Capital Gain: ₹70,000 - ₹20,000 = ₹50,000.
• If the sale occurs within 2 years of exercising the options, the gains of ₹50,000 will be taxed as short-term capital gains at 15%.
• If the sale occurs after 2 years, the gains will be taxed as long-term capital gains at 10%.

Tax Considerations for Employees:

• Tax Planning: Employees should plan the sale of ESOPs carefully, as the tax liability can vary significantly depending on the holding period of the shares (short-term vs. long-term capital gains).
• TDS Compliance: It’s essential for employees to ensure that the employer is deducting TDS correctly on the perquisite value at the time of vesting, as failing to comply could lead to additional tax liabilities.
• Filing of Income Tax Return (ITR): Employees must include the salary income from the ESOP exercise and capital gains from the sale of shares in their annual ITR.

Example:

Scenario: An employee is granted 200 ESOPs at an exercise price of ₹150 per share. The market price at the time of exercise is ₹400 per share.

• Vesting (Exercise): The difference between the market price and exercise price is ₹400 - ₹150 = ₹250 per share, which is taxable as salary income.
• Perquisite Taxable: ₹250 × 200 = ₹50,000. This amount is taxed as part of the employee’s salary income and TDS is deducted by the employer.
• Sale: Later, the employee sells the shares at ₹500 per share after 3 years.
• Capital Gain: ₹500 - ₹150 = ₹350 per share.
• The long-term capital gains tax of 10% will apply on the total gain exceeding ₹1 lakh.

Conclusion:

The tax treatment of ESOPs involves taxation at three main stages: when the options are granted (no tax), when they are exercised (taxable as salary income), and when the shares are sold (capital gains tax). Employees must carefully plan the exercise and sale of their ESOPs to optimize tax liability and comply with tax laws.