Employee Stock Ownership Plans (ESOPs) were subject to fringe benefit tax. However, after the amendments introduced by the Finance Act of 2009, the taxability of ESOPs shifted to the employees.
An Employee Stock Ownership Plan (ESOP) is a valuable employee benefit program that grants workers ownership stakes in their company through shares of stock. ESOPs motivate employees to perform at their best, as the company’s success directly impacts their financial rewards. This sense of ownership fosters a greater appreciation for their roles and enhances their compensation.
ESOPs are established as trust funds and can be financed by companies in various ways. Companies may issue new shares, contribute cash to purchase existing shares, or borrow funds through the trust to buy company shares. Typically, employees receive these shares without any upfront costs. The company holds the shares in a trust, ensuring their safety and potential growth until the employee retires or leaves the company.
Upon retirement or resignation, fully vested employees can sell their shares back to the company. The payout is made either as a lump sum or through periodic payments, depending on the specific plan. ESOPs thus provide a secure and rewarding path for employees to benefit from the company’s growth and success.
Implication of Taxes on ESOPs
Initially, Employee Stock Ownership Plans (ESOPs) were subject to fringe benefit tax. However, after the amendments introduced by the Finance Act of 2009, the taxability of ESOPs shifted to the employees.
From an employee’s perspective, the tax implications of ESOPs occur at two distinct stages:
1. At the time of exercise of option:
When an employee exercises their Employee Stock Ownership Plan (ESOP) options, the tax implications become significant. The difference between the Fair Market Value (FMV) of the shares at the time of allotment and the exercise price is considered a perquisite. Consequently, employers must deduct TDS (Tax Deducted at Source) under Section 192.
Given that ESOPs are a form of non-monetary compensation, deducting TDS can be complex. Employers typically handle this in one of two ways: they may ask employees to pay the TDS amount via bank transfer or, more commonly, they may execute a sell-to-cover transaction. In this process, a portion of the allotted shares is sold to cover the tax liability.
According to Rule 3(8) of the Income Tax Rules, 1962, the FMV for listed company shares is determined by averaging the opening and closing prices on the allotment date. For unlisted shares, a Merchant Banker determines the FMV on a specified date. The tax deduction on this perquisite follows the same procedure as TDS on salary.
A notable update came with the Budget 2020 amendment to Section 192, effective from FY 2020-21. For eligible start-ups under Section 80-IAC, the timing for deducting or paying TDS on ESOPs is specified as within fourteen days of the earliest of the following events:
- The end of forty-eight months from the end of the relevant assessment year.
- The date the employee sells the specified security or sweat equity share.
- The date the employee ceases employment with the company.
2. At the time of Selling of Shares by Employees:
After an employee exercises their ESOP options and the shares are allotted to their name, they can choose to hold onto the shares or sell them for a profit. When these shares are sold, the employee is liable for capital gains tax on the realized profits.
The capital gains tax is calculated based on the difference between the sale price and the Fair Market Value (FMV) of the shares on the exercise date. The classification of these gains as either short-term capital gains (STCG) or long-term capital gains (LTCG) depend on the holding period of the shares. This holding period starts from the date the shares were allotted.
In case of a loss, employees can carry forward short-term capital losses in their tax return, allowing them to offset these losses against future gains. This provision helps in optimizing tax liabilities and managing investments more effectively.
(i) In the case of companies whose shares are listed:
If shares are held for 12 months or less, any gains from their sale are classified as short-term capital gains (STCG). Under Section 111A of the Income Tax Act, 1961, these gains are taxed at a concessional rate of 15%.
For shares held longer than 12 months, the resulting gains are considered long-term capital gains (LTCG). Section 112A, effective from April 1, 2018, taxes LTCG at a rate of 10% without indexation for gains exceeding Rs. 1 lakh.
Before the Finance Act, 2018, LTCGs from listed shares were exempt under Section 10(38) if the sale transaction was subject to the Securities Transaction Tax (STT). However, this exemption was removed with the introduction of Section 112A, changing the tax landscape for long-term capital gains on shares.
(ii) In the case of companies whose shares are unlisted:
If shares are held for 24 months or less, any resulting gain from their sale is considered short-term capital gain (STCG). The tax on these STCGs is treated like regular income, with the applicable income tax slab rates applied based on the employee’s income.
For shares held for more than 24 months, the resulting gain is classified as long-term capital gain (LTCG). According to Section 112 of the Income Tax Act, LTCGs are taxed at a rate of 20% with indexation benefits, which can significantly reduce the tax liability by accounting for inflation during the holding period.
Also Read: ESOP – Income Tax Perspective
Eligible Start-up as referred under Section 80-IAC:
To qualify as an eligible start-up under Section 80-IAC of the Income-tax Act, 1961, the following criteria must be met:
- The entity must be a limited liability partnership (LLP) or a company engaged in an eligible business. An “eligible business” refers to one that innovates, develops, or enhances products, processes, or services, or adopts a scalable business model capable of substantial job creation or wealth generation.
- The LLP or company must be incorporated between April 1, 2016, and March 31, 2025.
- The annual turnover of the company or LLP should not exceed Rs. 100 Crore in the year preceding the assessment year for which the deduction is claimed under Section 80-IAC.
- The entity should not be formed by splitting up or reconstructing an existing business.
- The business should not be established by transferring used plant or machinery to the new business.
- The start-up must focus on innovation, development, or improvement of products, processes, services, or scalable business models that have significant potential for job creation and wealth generation.
- The start-up must be recognized by the Ministry of Commerce and Industry, Department of Industrial Policy and Promotion (DIPP), and the Government of India.
- According to the Income-tax Act, 1961, the deduction under Section 80-IAC will be calculated by computing the gains and profits of the eligible business as if it were the sole income source of the assessee for the previous years.
The start-up must obtain a certificate of eligible business from the Inter-Ministerial Board of Certification, as published in the Official Gazette by the Indian Central Government.
Also Read: Tax Implications of ESOPs under Income Tax Act 1961
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