Taxation on ESOPs

Important Keyword: Capital Gains, ESOP, Form 16, Salary Income.

Taxation on ESOPs

Employee Stock Ownership/Option Plans (ESOPs) stand as a strategic approach for companies aiming to foster a deeper sense of engagement and commitment among their employees. These initiatives operate by granting employees a direct stake in the company, often in the form of shares. By doing so, ESOPs cultivate a vibrant workplace culture where every team member feels personally invested in the company’s success.

This approach not only offers employees tangible financial rewards but also cultivates a shared sense of purpose and unity. With each staff member motivated by a common goal of advancing the company’s interests, ESOPs can serve as a powerful driver of employee satisfaction and organizational growth.

What are ESOPs?

ESOPs, or Employee Stock Ownership Plans, represent a valuable employee benefit program offered by companies to their workforce. These plans enable employees to acquire company stock at a price lower than the prevailing market rate, thereby providing them with an opportunity to become shareholders in the organization. ESOPs can take various forms, including direct stock issuance, profit-sharing schemes, or bonuses.

The process of issuing ESOPs typically involves several steps:

1. Decision by the Company: The company or employer decides to issue ESOPs as part of its employee compensation strategy.
2. Employee Exercise: Employees who are eligible for ESOPs have the option to exercise them, which involves purchasing the allocated shares at the predetermined price.
3. Share Sale: Following the exercise of ESOPs, employees may choose to sell the acquired shares at a later date, potentially realizing a profit if the stock price has appreciated.

Before implementing an ESOP program, employers must adhere to the rules and regulations outlined in the Companies Act of 2013. These regulations govern the issuance, administration, and reporting requirements associated with ESOPs, ensuring transparency and fairness in their implementation.

Tax Implications of ESOPs

SOPs entail taxation at two significant junctures:

1. At the Time of Purchase/Exercising: When an employee exercises their stock option by agreeing to purchase the shares, it is regarded as a perquisite under the salary income category. The taxable amount is determined by the disparity between the Fair Market Value (FMV) on the exercise date and the exercise price.
   • This perquisite is taxed in the fiscal year when the employee exercises the ESOP.
   • The employer is responsible for deducting Tax Deducted at Source (TDS) on this amount and providing Form 16 to the employee.
   • It is incumbent upon the employee to report this income as Salary Income in their Income Tax Return (ITR), claim TDS Credit, and pay tax on such income at the applicable slab rates.

Example

Neha, an employee at Zomato, exercised her ESOP options during the financial year 2023-24. She chose to purchase shares of the company on 07/07/2023, acquiring a total of 2000 shares at a price of INR 120 per share. The Fair Market Value (FMV) of these shares at the time of exercise was INR 165 per share. Let’s delve into the tax implications of this transaction:

• Purchase Price: INR 120
• FMV: INR 165
• Perquisite: INR 45 (FMV – Purchase Price)
• Taxable Perquisite Amount: INR 3,30,000 (2000 shares * INR 165)

In this scenario, the company will treat the INR 3,30,000 as taxable salary and deduct TDS accordingly. When filing her Income Tax Return (ITR), Neha must report the INR 3,30,000 as Perquisites under the head “Income from Salaries”.

Budget 2020 Amendment

In the Budget 2020 announcement, the finance minister introduced a significant change regarding the taxation of shares allotted to employees by startups under Employee Stock Ownership Plans (ESOPs). Starting from the financial year 2020-21, employees receiving ESOPs from eligible startups no longer need to pay tax in the year of exercising the option. Instead, the deduction of Tax Deducted at Source (TDS) on the perquisite amount can be deferred by the employer until one of the following events occurs, whichever is earlier:

• Expiry of 5 years from the year of ESOP allotment
• Date of sale of ESOP by the employee
• Date of termination of employment
• At the time of sale or transfer of shares

When an employee sells the shares, it is treated as Capital Gains. Here’s the tax treatment for the sale of shares under ESOP:

• Capital Gain is calculated as the difference between the Sale Price and the Fair Market Value (FMV) as on the exercise date.
• The period of holding is calculated from the exercise date to the date of sale.
• Capital Gains are taxed in the financial year in which the employee sells the shares.
• The employee must report Capital Gains in their Income Tax Return (ITR) and pay tax on such income at the applicable rates.

Furthermore, in the case of ESOPs from a foreign company, the tax treatment is similar to that of domestic securities. However, it is obligatory for employees to disclose their holdings under Schedule Foreign Assets (FA) while filing their ITR.

Example

In the given scenario, Neha sold her ESOPs on 20/01/2024, after exercising them on 07/07/2023, with an FMV of INR 165 per share on the exercise date and a sales price of INR 225 per share.

Here’s how the tax treatment and calculation of tax liability unfold:

• Period of Holding: 07/07/2023 to 20/01/2024 (less than 12 months)
• Type of Capital Gain: Since the shares are from a company listed on a recognized stock exchange in India and the holding period is less than 12 months, it qualifies as a Short-Term Capital Gain.
• Tax Rate: The applicable tax rate is 15% under Section 111A.
• Capital Gain per share: Sales Price – FMV = 225 – 165 = INR 60 per share
• Total Capital Gains: 2000 shares * INR 60 per share = INR 1,20,000
• Tax Liability: INR 1,20,000 * 15% = INR 18,000

Thus, Neha’s tax liability on the Short-Term Capital Gains from the sale of her ESOPs amounts to INR 18,000 for the financial year 2023-24.

How to calculate FMV for ESOPs?

Treatment of Loss from Sale of ESOPs

When it comes to losses incurred from the sale of shares obtained through ESOPs, they are treated as Capital Losses. Here’s how the taxation and treatment of such losses unfold:

• Loss on the sale of listed shares held for over 12 months or unlisted shares held for over 24 months qualifies as a Long-Term Capital Loss.
• Long-Term Capital Loss (LTCL) can be set off against Long-Term Capital Gain (LTCG) exclusively. Any remaining loss can be carried forward for up to 8 years and set off against LTCG only.
• Loss on the sale of listed shares held for up to 12 months or unlisted shares held for up to 24 months is termed a Short-Term Capital Loss.
• Short-Term Capital Loss (STCL) can be set off against both Short-Term Capital Gain (STCG) and Long-Term Capital Gain (LTCG). Any remaining loss can be carried forward for up to 8 years and set off against both STCG and LTCG.

Read More: Section 112A: Tax on Long Term Capital Gain on Shares

Web Stories: Section 112A: Tax on Long Term Capital Gain on Shares

Official Income Tax Return filing website: https://incometaxindia.gov.in/