ESOP Taxation in India: Understanding the Tax Implications of ESOPs

This article highlights the tax implications of ESOP, Taxation of ESOPs at the Time of Sale, and Inclusion of ESOP.

Employers in India frequently provide ESOPs (Employee Stock Option Plans) as a long-term incentive to entice, keep, and reward employees. ESOPs allow staff members to eventually become equity owners of the business and gain from its expansion. The ESOP process entails several processes, including creating the ESOP scheme or plan, receiving board approvals, adhering to legal requirements, giving options to qualified workers, establishing the vesting time, exercising options, and converting options into business shares. This article highlights the tax implications of ESOP, Taxation of ESOPs at the Time of Sale, and Inclusion of ESOP.

ESOP in India

ESOPs are well-liked long-term incentive programs businesses in India utilize to entice, keep, and reward employees. It allows staff members to eventually become the company’s equity shareholders and profit from its expansion.

In India, ESOPs are subject to regulatory frameworks and must abide by several rules and regulations. Businesses in India and worldwide may benefit from the services provided by consulting organizations to develop, implement, and manage ESOPs efficiently. These services cover everything from ESOP plan design and paperwork through execution, employee communication, administration, accounting and value, regulatory compliance, tax consulting, and more.

What is ESOP?

ESOPs are employee benefits that grant employees stock shares representing ownership in a firm. It aims to balance the interests of employees and shareholders by giving employees a stake in the company’s performance.

How Does ESOP Work in India?

ESOPs can be offered to a firm’s permanent workers and directors but not to promoters or individuals owning more than 10% of the company’s equity shares unless the company is a startup within ten years of formation.

Section 62(1)(b) of the Companies Act of 2013 and Rule 12 of the Companies (Share Capital and Debentures) Rules of 2014 apply to the issue of ESOP in India. The procedure entails the following actions.

  • Create the ESOP draft.
  • Obtain the requisite shareholder and board of directors authorization.
  • Put the ESOP agreement into action and give the qualified employees their options.
  • Choose the vesting schedule, exercise price, and other terms and conditions.
  • Inform the staff of the specifics of the ESOP.
  • Maintain accurate records and adhere to legal standards.

Types of ESOP

In India, ESOPs come in a variety of forms. These are the primary categories.

Employee Stock Option Scheme (ESOS)

Under certain conditions and performance targets, ESOS gives employees the option to directly purchase shares of the business at a set price. Employees have the option to exercise their right to buy shares after the vesting period at a predetermined price that may be less than the market value.

Example: Alex, an employee at InnovateCorp, was granted 1,200 stock options on January 1, 2018, as part of the company’s Employee Stock Option Scheme (ESOS). These options allowed him to purchase shares of InnovateCorp at an exercise price of $40 per share.

  • Exercise price = $40
  • Vesting period = 4 years

After the vesting period, the market price of InnovateCorp’s stock has risen to $60 per share. Alex decides to exercise his 1,200 options, and his profit per share is $60 – $40, which equals $20 per share.

Alex’s profit from exercising these options amounts to $20 x 1,200 shares, which is $24,000. This illustrates how ESOS can allow employees to benefit from the company’s stock price appreciation over time.

Employee shares Purchase Plan (ESPP)

An ESPP enables staff members to buy business shares at a reduced or below-market price, thereby boosting their ownership stake and entitling them to dividends.

Example: Here’s an example of how an ESPP might work. Let’s assume InnnovateCorp has an ESPP with the following specifics:

The company has a 6-month offering period, and the market price of InnovateCorp stock at the beginning of the offering period is $50 per share. Alex participates and contributes 5% of his $50,000 annual salary, which is $2,500 during the offering period.

The purchase price for Alex is the lower of the market price at the beginning or end of the offering period, which is $50 per share (15% less than $60). He can buy $2,500 / $50 per share = 50 shares of the InnovateCorp stock.

If the market price had been $60 at the end of the offering period, Alex’s 50 shares would be worth $60 each, for a total of $3,000, costing him only $2,500.

His profit would be $3,000 (current value) – $2,500 (actual cost) = $500.

This example demonstrates how ESPPs allow employees to purchase company stock at a discount, potentially benefiting from the stock’s appreciation over time. The specific terms and conditions of ESPPs can vary between companies.

Restricted stock units (RSUs)

Employees who receive RSUs often have a vesting period before receiving awards for company stock. They receive the shares after the vesting requirements are satisfied. Employees do not have full ownership rights to the shares prior to vesting.

Example: Alex works for InnovateCorp as an analyst. He gets 1,000 Restricted Stock Units as part of his remuneration package. 25% of the RSUs vest annually during the four-year vesting period. Alex will be given 250 company stock shares after the first year. He will get all 1,000 shares if he stays with the company for the whole four-year vesting period.

When RSUs vest, they are considered taxable income. The value of the vested RSUs is added to Alex’s income, and he is responsible for paying income taxes on this amount. Once RSUs are vested, he will receive actual InnovateCorp stock shares, which he can either hold or sell. Also, If he leaves the company before the RSUs fully vest, he may forfeit the unvested RSUs, depending on the terms of his employment contract.

Phantom stock plans

Employees who participate in phantom stock plans get notional or phantom units that are equivalent to business shares, with cash or stock bonuses dependent on the appreciation of the phantom stock. These plans are not equity-based.

Example: Let’s understand this with the help of an example:
InnovateCorp implements a phantom stock plan for its senior executives. Alex, a senior executive, is granted 500 PSUs. Each PSU’s worth is tied to the stock price of the business. The price per share of the company’s stock at the time of grant is $60. Consequently, the initial value of each PSU is $60.

Over a period of three years, the PSUs will vest according to a predetermined schedule. The shares vested over three years, with 200 vesting in year one, 150 in year two, and the remaining 150 in year three.

When the PSUs vest, John becomes eligible to receive a cash payout equivalent to the value of the vested PSUs. If, after three years, the company’s stock price has increased to $75 per share, each vested PSU would be worth $75. Sarah is entitled to a cash payout equal to the appreciated value of her vested phantom shares: ($75 – $60) * 500 shares = $7,500. It’s important to note that the cash payout is subject to applicable taxes and any other terms and conditions outlined in the phantom stock plan.

This example demonstrates how a phantom stock plan can provide executives with a financial incentive tied to the company’s performance and stock price appreciation without actually granting them ownership of company stock.

Benefits of ESOP

Benefits of ESOP

Both the business and its workers gain from ESOP.

For Businesses

  • Employee Engagement – ESOPs foster a sense of ownership and commitment among employees, leading to increased productivity and loyalty.
  • Retain Talent – Offering an ownership stake can help retain key talent, reducing turnover costs and maintaining institutional knowledge.
  • Succession Planning – ESOPs provide a structured exit strategy for business owners, ensuring continuity and preserving the company’s legacy.
  • Tax Benefits – Companies with ESOPs may enjoy tax advantages, including deductions on contributions to the plan and potential tax deferrals.
  • Enhanced Performance – Employee ownership often leads to improved company performance and profitability.

For Employees

  • Wealth Accumulation – Employees can build wealth over time as the company’s value increases, thanks to their ownership stake.
  • Retirement Security – ESOPs serve as a retirement savings vehicle, offering financial security and an additional source of income upon retirement.
  • Profit Sharing – Employees share in the company’s profits, which can lead to additional income through dividends or stock appreciation.
  • Voice in Decision-Making – ESOP participants may have a say in the company’s decisions, fostering a sense of involvement and influence.
  • Asset Diversification – ESOP holdings provide a diversified asset in addition to other retirement investments, spreading risk.

ESOPs create a win-win situation, promoting financial well-being and a thriving business environment.

Tax Implications of ESOP in India

For both businesses and workers, ESOPs (Employee Stock Option Plans) entail tax implications in India. Here is a thorough breakdown of how ESOPs affect taxes in India.

  • Taxation of ESOPs at the Time of Exercise – Taxation of ESOPs at the time of exercise includes the tax assessment of ESOPs at the time an employee exercises the option, computation of the taxable amount, incorporation of ESOP income in the total earnings for tax purposes, and deduction of costs associated with the acquisition of the shares.
  • The Tax Treatment of ESOPs when An Employee Exercises The OptionWhen an employee exercises his ESOP, he has essentially consented to purchase, and it will be taxed as a perk.
  • Calculation Of The Taxable AmountThe difference between the exercise price and the Fair Market Value (FMV) of the allocated shares is recognized as a prerequisite and is subject to income tax when employees exercise their ESOPs and purchase shares.
  • Inclusion of ESOP Income In The Total Income For Tax PurposesThe employer deducts TDS from this perk. This sum is disclosed on the employee’s Form 16 and included in the tax return’s total income from salary.
  • Deduction of expenses related to the acquisition of the sharesThe price paid for shares might be regarded as the acquisition cost. This covers the cost of buying the shares. Legal fees, professional fees, stamp duty, and registration costs that were incurred throughout the acquisition procedure may be deducted. These costs can be written off as deductible expenses since they are often included in the cost of purchase.

Taxation of ESOPs at the Time of Sale

The following are the components of ESOP taxation at the time of sale. The way that ESOPs are taxed when an employee sells the shares they purchased via ESOPs, determining taxable capital gains, tax purposes which include ESOP income as part of total income, and deduction of costs associated with selling the shares.

  • The tax treatment of ESOPs when an employee sells the shares acquired through ESOPs – After exercising the options and receiving shares assigned to his name, the employee can keep the shares for a while or sell them and make a profit. These profits or gains will be subject to capital gains tax upon realization.
  • Calculation of the taxable capital gains – The difference between the sale consideration and the share’s fair market value on the date of exercising the option will be used to calculate capital gains tax. Depending on how long you held the shares, you may establish whether your capital gains were short-term (STCG) or long-term (LTCG).

Inclusion of ESOP Income In The Total Income For Tax Purposes

In India, the inclusion of ESOP (Employee Stock Option Plan) revenue in the total income for tax reasons is decided depending on certain laws and regulations. From this benefit, the employer deducts TDS. The total earnings from salaries reported on the tax return include this amount, which is stated on Form 16 of the employee.

  • Deduction of expenses related to the sale of the shares – There are a few things to take into account when deciding whether or not to deduct costs associated with the selling of shares in India. India’s stock exchanges are responsible for collecting Securities Transaction Tax (STT), a tax on the buying and selling of shares that is dependent on the value of the transaction and is due to the government.
  • Tax Deductions for Employers Offering ESOPs – When an employee exercises their ESOP, the perquisite will be taxed in that year. On such an amount, the employer will deduct TDS and provide the employee a Form 16. In order to claim TDS Credit and pay tax on such income at slab rates, the employee must disclose it as salary income in the ITR.
  • Explanation Of The Tax Deductions Available To Employers Offering ESOPs – The tax deductibility of ESOP expenses in the hands of the employer assessee is the impediment in the ESOP between the employer Assessee and the tax department. The employer Assessee asserts that it is a tax-deductible business cost and that the employer should be entitled to deduct it as a salary expense. There are various arguments placed in favor of the employer assessment. Considering the double taxation effect, tax deduction was allowed.
  • Conditions for claiming the deductions – The conditions include adhering to the lock-in period rules and possessing the required documents such as a share warrant, PAN (Permanent account number) of the assessee, and TAN (Tax deduction and collection account number) of the employer.
  • Calculation of the deductions – The amount of the exercise will be subject to TDS, which the employer will deduct and record on Form 16. Employees may claim this deduction while filing their IT returns.
  • How to calculate FMV of ESOP? – Using option-pricing methods like the Black-Scholes or Binomial model, the fair value of an ESOP may be determined. Commonly, the Black-Scholes model is used to calculate the fair value of ESOPs, taking into consideration a number of variables including Time Value, Interest Rate, Volatility, Dividend Yield, and so forth.

Manage your ESOP with Eqvista

ESOPs have become a crucial component of the Indian corporate environment, giving businesses a strong tool to entice, keep, and inspire employees. They help create high-performing workplaces by bringing employee interests and corporate aims together through an ownership stake. However, to reap the benefits of these programs, organizations must negotiate the regulatory landscape, manage legal and reporting duties, and establish successful ESOP strategies.

Eqvista offers powerful software designed specifically for stock option management. The program manages all shareholder activities. Additionally, we assist you with starting your company and managing the ESOPs on the platform. Contact us for more information. Click here to sign up.

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