A brief guide on tax on ESOPs

Prabhat Nigam

15 Apr, 2022

Nowadays it has become very common on part of the companies to issue stocks to their employees to retain them, incentivise them to perform better and longer for the company. The scheme under which the stocks are issued to the employees is called an Employee Stock Option Plan (ESOP). The fact that employees have been given some compensation, taxes too come along with it. Tax on ESOPs takes place both at the time of exercise of the stock purchase option and also at the time when such shares are sold by the employee.      

What are ESOPs?

ESOPs provide a right to certain employees of the company to purchase certain amount of stock of the company over a specified period at a pre-determined price. This price is often called as the exercise price. However, it must be noted that there is no obligation on part of the employee to purchase the stocks from the company. ESOPs, these days, have a common tool to attract, incentivise and retain talent for the companies.    

Tax on ESOPs

Tax on ESOPs is calculated on the amount which is arrived deducting the exercise price from the market price as on the date of such ESOPs are exercised by the employee. The difference amount that the employee received after selling the stocks of the company is considered as a perquisite under law and taxed under the head of Income from Salary.

The employee holds the stocks under ESOPs as a perquisite which is included within head of income from salary and taxed accordingly. The rate of tax on ESOPs will be levied on the employee according to the applicable tax rate and the employee needs to pay tax accordingly. It must be made clear that no special tax rates are applicable while computing tax on ESOPs.

The time when the tax on ESOPs becomes applicable is when the employee exercises the right to purchase stocks of the company under the ESOP scheme and the differential price is added to the salary of the employee. This makes the employer duty bound to compute withholding tax on salary amount (which include the perquisites received by the employee after exercising the ESOPs) and make deductions accordingly.

Whatever amount the employee receives after exercising of ESOPs, there arises no further implication on employee since the employer has withheld the taxes on the entire amount of perquisite as TDS.

Further, when the employee sells the stocks in the market, tax will be accrued on the capital gains made by the employee on sale of such stock and then it becomes the employee’s personal tax liability and taxes will be paid accordingly by the employee.  

This shows that tax on ESOPs takes place at two instances. The first instance of such taxation takes place on the employment income which is taxed at the normal slab rate along with the applicable surcharge, health cess and education cess. The second instance of taxation takes place when the employee sells the stocks in the market and the earns capital gain and accordingly tax on capital gains needs to be submitted to the state.

What are the tax saving opportunities in tax on ESOPs

Tax on ESOPs can be deferred if not saved by the employee if the employee is able to stretch the exercise period a bit longer and bring it parallel to the event of selling of shares in the open market. This action of the employee will mitigate the outflow of tax because of deduction of withholding of tax with the money made by sale of stocks in the open market. The capital gains accrued on such sale of shares does not have an immediate tax effect and the same can be included in tax computation at the time of filing of annual income tax returns.

Further, in order to save tax on Long Term Capital Gains, the employee can save tax on capital gains by reinvesting the capital gains into specified securities under section 54EE of the Income Tax Act^[1] (where the maximum limit is Rupees 50 lakhs) or the same can be invested in purchase of a residential house under section 54F subject to the conditions mentioned in these two respective sections.   

Tax on ESOPs of start-ups

For the employees of eligible start-ups, relaxations have been provided where payment of taxes can be deferred which arose on the date of allotment. Tax is payable for these employees on the employment income earned from exercising the option under ESOP scheme within 14 days from earliest of the following events:

• Expiry of 5 financial years from the end of the financial year in which the stocks were allotted to the employee
• The date on which the employee leaves the employment
• The date which such stocks are sold by the employee

Tax on ESOPs of foreign firms

Tax on global income is dependent on the residential status of the person. So, any income accrued from ESOPs of foreign entities will be taxed in India. The scheme of Income Tax Act provides that any form of benefit or compensation received by any employee resident in India would be taxed as per Indian taxation laws irrespective of the source and in what form such benefit or compensation is received.

Treatment of tax on ESOPs of foreign entities

The tax treatment of ESOPs of foreign entities is not very different from the tax treatment of ESOPs of Indian entities. The first instance of taxation is when the resident employee entitled to ESOPs of a foreign company exercises the ESOP. Here the difference between the fair market value of the stocks and the predetermined price paid by the employee is taxed as a perquisite in the hands of the resident employee. The second instance is the capital gains made by the employee at the time of sale of such stocks in the open market. Such capital gains are taxed under Income from Capital Gains.

Period of holding of stocks of foreign entities

The period of holding of foreign stocks for the tax purposes is of 24 months. The short term capital gains are taxed at the slab level whereas long term gains are taxed at the rate of 20% along with the indexation benefit (where the cost of acquisition is revised taking inflation into account).

Foreign compliance of tax on ESOPs

ESOPs from foreign entities are also taxed in the country in which the stocks are listed or where such foreign entity is headquartered. Where such taxation takes place, the resident employee can claim refund if a Double Taxation Avoidance Agreement (DTAA) is in place.

Generally, if DTAA exists between the two countries, then ESOPs are taxed by the country where employment is exercised. In such a case, that would be India. This is the reason why in most countries where DTAA exists, no tax is levied on the ESOPs granted. However, on sale of such stocks, the capital gains would be taxed in the foreign country.

Filing of returns

Since stocks of a foreign company are considered as foreign assets, the employee here in India needs to file either ITR2 or ITR3 depending on the income earned by the employee. According to the exchange control regulations of India, proceeds of sale of stocks under ESOPs have to be repatriated back to India within a period of 90 days from the date the sale has been made.    

Conclusion

In order to find out the income tax liability on the ESOPs received, the employee must take into account certain considerations such as eligibility of the start-up, whether the conditions are met for claiming deferred tax  payment by the eligible start-up or not. Further, before ascertaining tax on ESOPs, the employer must know the fair market value of such ESOPs on the date of exercising the option. All these details are very important for claiming tax liability.

Read Our Article:Tax exemptions for start-ups and other incentives