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Getting an ESOP? Know the tax implications

While this type of compensation structure gives employees a share in the company’s future growth prospects, one has to carefully analyze its tax implications.

ESOP compensation for employees is increasingly becoming common, especially among start-ups. In the light of COVID disruptions, many firms introduced non-cash compensations such as ESOPs to tide over the cash crunch and to be fair to their employees.

While this type of compensation structure gives employees a share in the company’s future growth prospects, one has to carefully analyze the tax implications. 

What is an ESOP?

ESOP is an acronym for Employee Stock Option Plan. Here, an employer gives ESOPs to a set of employees at a pre-determined price that is usually below its Fair Market Value (FMV). Once the waiting (or vesting) period is over, he or she gets the right (but not an obligation) to buy the shares at a pre-determined price and later sell it in the market. In case of an unlisted share, the employer provides the exit option by periodically buying back its shares. Sometimes, the vesting conditions might be linked to performance metrics of employee or employer.

Twin tax 

ESOPs are taxed in two ways. One, at the time of allotment (when you buy that is) as ‘income from salary’ and later at the time of sale as ‘income from capital gains’. 

Let’s understand it with an example. Say employer ‘Z’, gives ESOP of 10,000 shares to its employee Shridhar on 12th April 2018 at a price of Rs 50 per share with a one-year lock-in (or vesting) period. Its FMV at that time is estimated to be Rs 75 per share.

There is no tax to be paid for the year 2018-19 on account of ESOPs, since Shridhar has not yet purchased the shares.

After one year, in April 2019, the vesting period gets over. Assume, Shridhar now decides to exercise the option and purchases all its shares, when it is estimated to have a FMV of Rs 100 per share. Any difference between the exercise price and FMV is considered as a perquisite for tax purposes and added to his income. So, Rs 5 lakh (10,000 shares*(100-50)) is added to the income of the employee and taxed according to the income slab of Shridhar. TDS is usually deducted by the employer on this income.

Since Shridhar is in the highest tax bracket (30%), Rs 1.5 lakh (30% of Rs 5 lakh) will be his tax liability. Of course, Shridhar has an option to not exercise the option and remain free of tax liabilities.

Budget 2020 sop

From the financial year 2020-21, an employee receiving ESOP from an ‘eligible’ start-up can defer taxes up to five years at the time of exercising the option, provided he doesn’t sell the shares or quit the company. However, very few start-ups are actually ‘eligible’, since it also requires the certification of the Inter-Ministerial Board of the Government of India. 

Listed or Unlisted 

Whenever there is a sale of shares, capital gains have to be paid. The tax rates differ based on whether the company is listed or not. Say, in Jan 2021, Shridhar decided to sell all his shares at Rs 200. If the company is listed in the stock exchanges, Long-Term Capital Gains (LTCG) becomes applicable, if sold after a year of purchase. While LTCG rate is 10%, gains of up to Rs 1 lakh exempt in a financial year. Short-term capital gains (sold within a year) in turn are subject to a higher tax rate at 15%. 

So, in the case of Shridhar, if ‘Z’ is a listed company, then the difference between sale price and FMV on the exercise date is taxed as capital gains. Total capital gains thus work out to Rs 10 lakh (10,000 shares * (Rs 200-100). Since, he sold after a year of purchase, 10% LTCG will become applicable and accordingly he has to pay Rs 1 lakh as capital gains taxes.

However, if the company is unlisted, short-term tax rates become applicable when held for less than two years. While short-term capital gains (STCG) are taxed at the income tax slab rates, long-term capital gains are taxed at 20% after providing for indexation of cost. 

Accordingly, if ‘Z is unlisted, STCG will become applicable on capital gains of Rs 10 lakh, since Shridhar sold the shares within two years of purchase.

The tax treatment for shares listed outside of India is similar to unlisted stocks in India. 

Takeaway

There are twin taxes while dealing with ESOPs. One, at the time of allotment and another at the time of sale. Moreover, the tax liabilities differ for the listed and unlisted firms. Employees should therefore do the necessary due diligence.

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