Detailed Tax Treatment of ESOP with New Rules and Provisions

By | April 3, 2013

Why and What is ESOP?

ESOPs are one of the important tools to attract and retain employees. The feeling of ownership encourages employees to have long-term career aspirations in the organization.

It is important to ensure that the ESOP is attractive for employees, simple to understand and administer and compliant with various tax and regulatory requirements. An appropriate plan that is compliant with the current provisions of income-tax, corporate law, foreign exchange regulations, listing requirements, etc. has to be drafted. In recent times, accounting implications relating to ESOPs have also undergone substantial changes and have become a critical factor in the decision-making process.

Companies have substantial flexibility to design the plan catering to their needs. Usually, companies adopt one or more of the following types of plans, with variations in the specific terms to make it relevant to its business needs and objectives.

Although ESOPs are widely used but there are few more like ESPP, RSU, PEP etc. So before jumping onto the taxation of ESOPs, let us first understand the meaning of various perquisites:

1.Employee Stock Options (ESOP) / Employee Stock Option Scheme (ESOS)

Tax Treatment of ESOP in IndiaAn ESOP/ESOS is a right to buy shares at a pre-determined price. The option granted under the plan confers a right but not an obligation on the employee. Stock options are subject to vesting, requiring continued service over a specified period of time. Upon vesting of options, employees can exercise the options to get shares, by paying the pre-determined exercise price.

Exercising the option or leave the option is totally depending upon the Employee Discretion. In case the option price is lower than the Market Price at the time of exercising option then it would be beneficial for employee to exercise option and in case the option price is higher than market price than it would be wise to leave the option.

Let’s say that an employee joins a company on 1st Jan 2013. His company gives him 500 ESOPs with vesting period of 3 yrs and at the vesting price of Rs 200. What this means is that his vesting date is 1st Jan 2016 (after 3 yrs), on that date, he has an OPTION to buy 500 stocks of the company at Rs 200 if he wishes. Now let’s say on 1st Jan 2016 …

Case 1 – The stock price is Rs 800

In this case, the employee can exercise his option and he can get 500 stocks at only Rs 200 . At this moment, the employee will make a clean profit of Rs 600 each shares and a cool Rs 3,00,000 . Note that he does not have to pay anything here, when he exercises his option, he will automatically get his profit without putting anything from his pocket. It makes sense to exercise his option in this case, because vesting price is less than market price.

Case 2 – The stock price is Rs 130

In this case, it does not make any sense to exercise, because you will be in loss, because the price you have to pay is less than market price, so you let this option go.

2. Employee Stock Purchase Plan (ESPP)

An ESPP allows employees to purchase company shares, often at a discount from FMV at grant or exercise. The plan term determines the date and price at which the employee is entitled to purchase company stock.

In an ESPP plan, an employee has to contribute a part of this salary in ESPP plan each month. An employee can choose how much of his salary he wants to contribute by himself. It can range from 1% to 15% of his salary. All the money which he contributes gets accumulated for few months and then in one go, stocks are purchased for him at some discounted price.

3. Stock Appreciation Right (SAR) / Phantom Equity Plan (PEP)

Under SAR/PEP, the employees are allotted notional shares/units at a pre-determined price. On completion of vesting conditions, the employee is paid cash equivalent of the net gain i.e. appreciation in the price of underlying shares without any cash investment. These plans generally result in cash out-flow for the company.

4. Restricted Stock Award (RSA)

Under RSA, an employee receives an award of stock subject to certain underlying conditions. If the underlying conditions are not met, the shares are forfeited. The employee is considered to be the owner of the shares from the date of award with entitlement to receive dividends and voting rights. The forfeiture conditions may be based on continued service over a specified period of time. The employee may be required to pay for RSA at grant which may be at a discount or more usually is awarded the stock at no cost.

5. Restricted Stock Unit (RSU)

Under RSU, an employee is awarded an entitlement to receive stock at some specified date in the future subject to certain conditions. These conditions may relate to performance or tenure of employment. Until shares are actually delivered, the employee is not a shareholder and does not have voting rights or rights to receive dividends. It is important to note that RSU is not an immediate transfer of shares subject to forfeiture, but a promise to give shares in the future. RSUs are generally entitled to quasi-dividends.

ESOPs – Tax implications in India and Abroad

Taxation of ESOPs in India has witnessed continuous change. Up to the financial year ending March 1999, there were no specific provisions for taxing the benefits arising from ESOPs. The ESOPs were generally taxed as a perquisite in the hands of the employees on the difference between the FMV of the stock on the date of vesting of the options and the exercise price. Subsequently, there was a concessional tax treatment for ESOPs, which were designed in accordance with prescribed ESOP Guidelines. The taxation triggered only at the time of sale of the shares for such qualified ESOPs. Unqualified ESOPs were taxable as a perquisite on the difference between the FMV on the date of vesting/exercise and the exercise price.

During the period April 2007 to March 2009, employer was required to pay Fringe Benefit Tax (FBT) on benefit derived by employee from ESOPs. The employer was allowed to recover such FBT from the employees.

Currently, ESOP benefits are taxable as perquisite and form part of employees salary income. The employer is required to withhold tax at source in respect of such perquisite, also called as Perquisite Tax.

The perquisite value is computed as the difference between the FMV of the share on the date of exercise and the exercise price. There are specific valuation rules prescribed for listed and unlisted companies. Unlisted companies need to determine the FMV by a Category I Merchant Banker registered with SEBI.

Resident and ordinarily residents have to pay tax on their global income. Hence, the entire perquisite value is taxable in India. But, in case of residents but not ordinary residents or non-residents, only the perquisite value proportionate to their accrual in India is taxable in India. This is of utmost importance in case of internationally mobile employees.

The incremental gain (i.e. difference between sale consideration and the FMV on the date of exercise), on sale of shares is considered a capital gain for the employee.

For computing capital gains, the FMV on the date of exercise becomes the cost base. The capital gains tax treatment further depends on the holding period and whether the shares are sold on a recognized stock exchange in India.

If stocks are listed in Indian stock exchanges, then you have just have to pay 15% tax on Short Term Capital Gains and no tax on long term capital gains. However if stocks are not listed on Indian stock exchanges, but some foreign country, then you will have to add the short term capital gains tax in your income and pay tax as per your slab rate, and 20% with indexation on the long term capital gains, which is the case when STT is not paid when the transaction is done.

Below is the simple table which will explain things to you

Listed/Gain-TypeShort Term Capital Gain (Less than 1 yr)Long Term Capital Gain (More than 1 yr)
Stocks Listed on Indian Stock Exchange15% Tax on ProfitsNo Tax
Stocks NOT  Listed on Indian Stock ExchangeProfits will be treated as your Income and taxed as per your Slab20% with Indexation

There are cases where stocks are listed in some foreign country and at the time of sale, the tax is directly deducted by that foreign country. After that when you receive the money back in India, you might have to pay the tax on the income again if the double tax treaty is not available with that country.

Let understand taxation on ESOPs with an example:

A company announces an ESOP plan under which company will allot 500 shares of company to certain employees at a price of Rs 100. Those eligible employees will have option of getting allotment of 100 shares on 1st day of October every year starting from 1/4/2012 for next five years. Let us say, Mr. X an employee fills out the ESOP application form on 1.7.2012 for allotment of shares. He is allotted 100 shares on 1/10/2012. The market value on 1/10/2012, (vesting date) is Rs. 600. These 100 shares, let us think, hypothetically, sold by the employee on 31/3/2013 at a price of RS 1000. Then

Tax 1. On allotment day i.e. 1st October 2012, your employer will deduct TDS or Perquisite Tax @ the slab rate you fall in, on the amount of FMV minus Exercise Price. The income and the taxes paid will reflect in the Form 16 and you should report it as part of salary in your personal tax return.

In our case, let us assume Mr. X falls in highest tax bracket i.e. of 30%, now

(600-100) x 100 x 30.9% = Rs.15,450

Tax 2. On sale day i.e. 31st March, 2013, Short Term Capital Gain will be levied on the difference between Sale Proceed and FMV at the time of exercise of option, @ 15%, now

(1000-600) x 100 x 15% = Rs.6,000.

The tax treatment on ESOPs under the proposed Direct Taxes Code Bill, 2010 (DTC) is expected to be similar, though the Valuation Rules are yet to be prescribed

Terms associated with ESOP

Grant Date: It is the date on which the employer and employee agree to the terms of the ESOP.

Vesting Date:  It is the date when an employee is entitled to receive the shares after satisfying the specified conditions.

Vesting Period: It is the period between the grant date and vesting date, also known as the “lock-in period” of the plan.

FMV for listed companies: FMV shall be the average of the opening price and closing price of the share on the date of exercise by the employee on a recognized stock exchange where there is highest trading volume.

If there is no trading on any recognized stock exchange, then the FMV shall be the closing price of the share on a recognized stock exchange, where there is highest trading volume, on a date closest to the date of exercising of the option and immediately preceding such date.

FMV for unlisted companies: FMV shall be such value of the share in the company as determined by a merchant banker on the date of exercise of options or any date within a period of 180 days prior to the date of such exercise.

The process of getting a merchant banker certification is the same as was earlier prevalent during the FBT regime.

4 thoughts on “Detailed Tax Treatment of ESOP with New Rules and Provisions

  1. Kannan

    What is the tax liability for a resident Indian on US stock options, say 100 granted at $10 per share on Jan 1st 2013 with 50% vesting every year, (I) on 1st Jan 2014 @ $15 MV if these are not exercised, (ii) exercised all on 2nd Jan 2015 at $20 per share and (iii) exercised all on 2nd Jan 2016 at $30 per share?

  2. Ramesh

    Dear Sir/Madam,

    My company allotted some shares under ESOP in year 2004. Till now the company didnt went public. The company has plans to go IPO in US but so far didnt go. Now the company has given me an option to exercise the ESOP and transfer the shares on my name as i’m leaving the current company. I’m going to pay the amount based on the grant price. Even though the company not listed in US and I have not realized any profits, the company is asking to pay the tax. Is this correct? Do I still need to pay the tax even though the company is un-listed and i have not sold any shares. Please clarify.

    Note: my grant price is lower than the FMV.

    Thanks, Ramesh.

  3. tarun


    Have a question on ESOP Taxation –

    Example 0

    Vesting Date – 1, Jan , 2010 – Average Stock Price on that date 20

    Exercise Date 1, Jan 2012 – Average Stock Price on that date 40

    Sale Date : 1 Jan , 2012 – Sale at 40.5 ( Same day cashless sale )

    In this case the gain for Long Term or Short Term Gain will consider FMV based
    on Exercise Date , or Vesting Date ?

    Thanks for your time.

    1. thesanyamjain

      Period of holding shall be reckoned from the date of exercise, in your case it will be short term capital gain since your holding is period is only a day.

      For calculation of STCG, FMV of Exercise date shall become the basis.

      The taxation is simple terms:

      TDS is to be deducted on Rs.20 (40-20) by employer because the same is treated as perquisite and shall be added in salary.

      Short term Capital Gain is to be paid @ 15% on Rs.0.5 (40.5-40) by the seller.


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