The past decade has seen many companies offering their employees shares in the company, as a benefit, known as Employee Stock Option Plan (ESOP). Read this guide to know more about ESOP and the taxation laws applicable.
Employee Stock Option Plan (ESOP) is a benefit given to employees from the company, where the employee receives “x” number of shares after completing a specified task or tenure with the company. The employee gets company shares at a reduced rate as compared to the market rate.
By giving employees shares in the company, the employee, feeling a sense of ownership, works with a vested interest in the growth and well-being of the company, thereby increasing his/her productivity. Also, companies, in their startup stage, opt for giving stock options to employees, in lieu of high salary, to save money (cash outflow), as resources are already limited. This means employees at all levels will work at optimum levels to ensure the company’s growth, as they also benefit from the success of the company.
A well-known example of this is when Infosys started in India and opted to award its employees in shares instead of cash. Shares were given to all employees including, clerical, secretarial, drivers, etc., who are now millionaires.
Apart from, directors and promoters of the company, who have more than 10% equity in the company, all employees are eligible for ESOP, provided they meet the criteria set such as:
This refers to the employer making a commitment to the employee about their rights and the benefits of the scheme, known as “letter of grant”. The price at which the employee buys the shares from the company is known as the “Grant Price”, which is usually significantly lower than the market price.
This is the time when an employee puts his efforts to become eligible to acquire the shares promised to him/her. In other words, it is the time during which the employee fulfills the vesting conditions (conditions subject to which the employee becomes entitled to purchase of shares at a discounted price). The employee, depending on the company’s protocols, may release the shares over a period of time or all at once or once a particular target is achieved or tenure reached. For example, if a company has promised 500 shares, the employee may get 200 today, 100 after one year from now and another 200 after 2 years from now.
When an employee decides to exercise his option once it is vested with him, then it is known as “Exercise”. This is a crucial time, as once the employee opts to exercise, he/she must pay for them and then the tax implications begin. The price at which he/she buys the shares is known as “Exercise Price”, which is lower than the market value. This price is usually predetermined. The time given to the employee after the vesting period to exercise his option is known as “Exercise Period”. The employee may choose to delay exercise, if he/she feels the market value may rise.
The perquisite is known as the difference between the fair value of the share on the date of exercise and the actual exercise price. The perquisite is added to the employee’s salary and tax is deducted by the employer when the employee exercises the option.
|Align Interests – work together for growth of company||Higher Pay|
|Motivated Workforce||Increase in Wealth/ Wealth Generation|
|Cash Reserve Not Affected for small companies/startups||Participate in Company’s Decision-Making Process|
|Increased Productivity||Job Security and Satisfaction|
|Improved Trust in Management||Sense of Ownership|
An employee can purchase shares below the market price (usually at a fixed discount) at grant or at exercise. The price and date at which the employee can purchase shares is determined by the plan term.
Under this scheme, the employee is under no obligation, but has the right to exercise shares, at a previously decided price. The employee must complete a target or tenure before vesting and the employee upon exercise can buy the shares at the determined price.
Employees are issued shares in theory under PEP/SAR, which he/she can get the cash value (equal to the price appreciation over the grant price) once he/she achieves the vesting conditions.
Provided set conditions are met, an employee is awarded stocks in the company along with voting rights and is entitled to dividends. However, if the set conditions are not met, then he/she is no longer eligible to receive the shares. The conditions could be for tenure or to achieve a specific target. The RSA can be bought at a lower cost than market value, however, there is usually no cost attached. In case of RSA the employee becomes the owner of the shares from the first day and is eligible to dividends and bonus during the vesting period.
Similar to RSA, except that the employee has no voting rights or a right to dividends. The shares granted can only be exercised by the employee once conditions are met. RSU’s do not get transferred to the employee immediately, but in the future and in certain cases, he/she may also be entitled to partial-dividends.
There are generally two tax implications on Employee Stock Option Plan’s. The first is when the employee exercises his/her right to buy the shares and the second when he/she is ready to sell the shares.
When the employee chooses to exercise his option, the perquisite is added to his/her salary and is taxed by the employer. The value of the allotted shares is treated at the average of the market value (highest and lowest) if they are listed in India. In situations where the company is not listed, then a certificate must be obtained from a merchant banker, valuating the market value of the allotted shares. Additionally, if an employee is issued shares of a listed foreign company, it is treated the same as an unlisted Indian company and a certificate must be obtained from the merchant banker.
Second Stage – Sale of Shares Under Employee Stock Option Plan
When an employee decides to sell his/her shares, he/she will be liable to capital gains tax. The tax rate is dependent on the duration the employee held the shares, as either short term or long-term capital (LTCG)gain tax will be levied. Additionally, depending on whether the shares are listed or unlisted will have a bearing on whether they are treated as short term or LTCG.
Listed shares held for more than one year and with Security Transaction Tax (STT) paid is subject to 10% LTCG tax, if value of gain is in excess of Rs 1,00,000. For gains valued less than Rs 1,00,000 it is exempt from capital gains tax. Short term Capital Gains (STCG) tax tax of 15% is applicable to listed shares that are held for less than one year, with STT paid.
For unlisted shares LTCG tax of 20% with indexation and 10% without indexation is applicable if held for more than two years. Unlisted shares held less than two years are treated as STCG and taxed as per slab rate.
Namrata gets the option to vest 100 shares from her company at Rs. 100 and the stock prices subsequently rises to Rs 200. She chooses to vest the allotted shares at Rs 100 and the fair market value at time of exercise would be Rs 200. The difference (20,000 – 10,000) of Rs 10,000 would be the perquisite, which would get added to her income at time of exercise.
If an employee holds foreign shares, they are treated as unlisted shares and taxed as either LTCG or STCG, depending on the duration the shares are held. Additionally, foreign taxation laws will need to be understood and applied to avoid double taxation to the employee, as per the Double Taxation Avoidance Agreement(DTAA).
Taxation is never simple and filing of income taxes can be just as complicated, especially when there are multiple sources of income, such as ESOP. To ensure your tax return is filed accurately, enlist the aid of the international tax experts at H&R Block India, who will make sure the maximum tax deductions you are eligible for are availed.