Brief guide to ESOP taxation in IndiaBrief guide to ESOP taxation in India

This post is part of our series on taxation for investors in India by Sandeep Koonaparaju. Sandeep is a practicing Chartered Accountant based out of Bangalore.

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Understanding ESOP taxation in India

The term ESOPs needs no introduction, (well if you are reading this article we presume either you are holding ESOPs or know what they are).  But few people understand the tax implications of Employee Stock Options. The purpose of this article is to explain in brief, how ESOPs are taxed, from an employee's perspective.

How are ESOPs taxed in India:

As an employee, your liability to pay tax from ESOPs arises on two occasions, 

• first, when the shares are allotted upon exercising the vested options (taxed as salary income) 
• second on sale of the shares allotted (taxed as capital gains).

On allotment, the difference between Fair Market Value of shares (computed as on the exercise date) and the exercise price is taxed as a perquisite (considered part of salary income). The employer deducts TDS from the value of perquisite so computed. This has an adverse impact on your cash flows as a higher amount of tax gets deducted from your salary without any incremental inflow. It is pertinent to note that the incidence of tax arises only on allotment of shares and not at the time of allotment of options (known as grant of options in common parlance). Shares are allotted when an employee chooses to exercise the vested options and that’s when tax kicks in.

For example, Mr X is allotted 10,000 shares by company A (employer), as part of the company’s stock option plan. If the Fair Market Value of the shares on the date of exercise is ₹ 200 per share and the exercise price is ₹ 10, the value of taxable perquisite for Mr X would be (200 - 10)*10,000 = ₹ 19,00,000

Assuming Mr. X falls in the highest tax bracket with 10% surcharge tax would be deducted at 34.32% (including cess of 4%) on 19,00,000. This results in an additional TDS deduction of ₹ 6,52,080.

In order to meet this obligation due at vesting, the employee has to either sell few shares or make alternate arrangements. 

Moving on to the second instance of taxation- on sale, capital gains tax arises, which could be long term or short term depending on the period of holding. If you are wondering what would be the cost of acquisition for computing capital gains, it's the Fair Market Value on exercise date (used to calculate the perquisite value).

Changes in Budget 2020

Startups (which are heavily dependent on ESOPs for retaining talent) faced practical difficulties in taxing ESOPs as perquisites. As explained above, to meet the TDS obligation an employee has to either sell a part of his shares or arrange for money from his own sources. Finding buyers for shares of a Startup can be tricky as these are generally not listed and there may not be an active market. After considering various representations and understanding the genuine hardship faced by startups, Income Tax Act was amended to provide relief to ‘eligible startups’.  

What are eligible startups? 

In simple terms, an eligible startup is either a company or a LLP incorporated after 1st April 2016 but before 1st April 2022. In addition to this, it must meet the condition related to turnover (cannot exceed 100 crores) and carry on eligible business as defined. 

What is the relief provided?

An eligible startup can deduct TDS within 14 days:

1. After expiry of 48 months from the end of the relevant assessment year or
2. From the date of sale of such shares or 
3. From the date the employee resigns.

So if you are allotted shares in FY 2020-21 the earliest date on which your employer (being an eligible startup) is obliged to deduct TDS would be 14th April 2026 (assuming you continue to hold the shares and are in employment with the company till that date).

It’s a good move, an employee now has at least 5 years to pay tax on the perquisite income unless he chooses to either resign or sell the shares before that. It gives an option to the employee to hold on to the shares and he/she will not be forced to sell a part of them to meet the tax obligations. What’s not fair is that the relief is provided only to employees of eligible startups. The proportion of eligible start-ups to the total number of companies issuing ESOPs is negligible. Well, maybe the intention of the government probably is to help startups and not salaried class in general.

Perquisite tax and capital losses:

Taxing ESOPs in the year of allotment might result in another potential loss from tax perspective if the value of the share drops significantly after paying tax on fair value. 

In the example discussed above, if Mr X decides to hold on to the shares by paying tax of ₹ 6,52,080 (assuming Company A is not an eligible start up)  from his personal savings and within a few year’s time if the value of share drops to say ₹ 20 (possible sometimes) he will have a capital loss of ₹ 18,00,000 (10,000*(200-20)). 

Capital loss cannot be offset against salary income. So if Mr X does not have enough capital gains to offset the loss, he might end up carrying forward the loss for the permitted period and write it off after that. Permitting to set off capital losses against salary income, to the extent these losses pertain to ESOPs, definitely helps.

ESOPs issued by Foreign Companies:

Many times, employees of Indian companies are issued ESOPs of the parent company headquartered abroad. This doesn’t alter the tax treatment on allotment. It’s still taxed as a perquisite, and the employer (Indian company) is supposed to deduct TDS. It adds to the compliance burden as these shares should be declared in ITR as foreign assets and you cannot file ITR 1.

A question that arises on selling these shares is, whether the capital gains are taxable in India or the foreign country in which you hold these shares. The answer depends on your residential status, a resident pays tax on his worldwide income. So, if you are a resident you might end up paying tax in both countries. You may be eligible for relief under the Double Taxation Avoidance Agreement though (if India has such an agreement with the foreign country). This needs to be checked on a case-to-case basis. 

To conclude, ESOPs play a significant role in structuring an employee’s compensation plan. The benefit of deferment of tax should not be restricted to ‘eligible startups’ alone. If not as attractive as the relief provided to ‘eligible startups’ a scaled-down version of the same might still be needed. 

Other Popular Taxation Articles:

How taxation works for AIF and PMS Investors

The Basics of Capital Gains Taxes

How to set-off and carry forward losses

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