Esops are employee benefit plans that offer employees ownership interest in the organisation. In other words, Esops are the right/option given to eligible employees to buy equity shares of the company at a predetermined rate (mostly face value) within a stipulated time (exercise period).

There are some key terms that you should know to understand the concept. Exercise date is the one when the employee exercises the option of buying shares. Vesting period is the time period between the grant date and vesting date. Vesting date refers to the date the employee is entitled to buy shares, after conditions agreed upon earlier are fulfilled. Grant date is the date of agreement between the employer and employee to give an option to the employees to own shares (at a later date).

“In a way, Esop is like a profit-sharing plan. Under these plans, the company or the employer offers its stocks, typically, at low or negligible prices. These stocks remain in an ESOP Trust Fund until the vesting period and (employees usually) exercise these options when they retire/leave the company,” says Archit Gupta, founder and CEO, Cleartax, a tax portal.

Taxation of Esops

Tax is levied at two points in Esops. First, at the time of exercise of the Esop. Second, at the time of selling the shares.

Exercise of Esop is taxed under the head salary (perquisite) where the difference between fair market value of the shares and exercise price of shares is taxed as per the normal tax slab of the employee.

“Sale of shares are further subject to tax under the head capital gains where the difference between sales price and exercise price is taxed at capital gain (short- or long-term) rates,” says B.M. Singh, ESOP expert and managing partner, BMSA, a consultancy firm that specialises in tax planning and financial management for startups.

Additional exemption under Section 54F can also be claimed on long-term capital gains from Esops for buying a residential property, subject to the compliance of conditions as stipulated under section 54F of the Income-tax Act, 1961.

“At the time of exercise—as a prerequisite—when the employee has exercised the option, basically agreed to buy; the difference between the FMV (fair market value) (on exercise date) and exercise price is taxed as perquisite. The employer deducts TDS on this perquisite. This amount is shown in the employee’s Form 16 and included as part of the total income from salary in the tax return,” says Gupta.

The Budget 2020 amendment, however, said that from FY 2020-21, an employee receiving Esops from an eligible startup need not pay tax in the year of exercising the option. The TDS (tax deducted at source) on the ‘perquisite’ stands deferred to the earlier of the following events:

Expiry of five years from the year of allotment of Esops
Date of sale of the Esops by the employee
Date of termination of employment
If the employee sells these shares, another tax event happens. The difference between the sale price and FMV on the exercise date is taxed as capital gains.

Other considerations

To properly calculate tax on the sale of ESOPs certain aspects need to be kept in mind.

Short- or long-term gains: The rates at which your capital gains shall be taxed depends on the period of holding. The period of holding is calculated from the exercise date up to the date of sale. Equity shares listed on a recognised stock exchange (where securities transaction tax or STT is paid on sale) are considered as long-term gains when held for more than one year. If sold within one year, they are considered as short-term gains.

“At present, short- term capital gain is assessed at normal tax slab, long-term capital gain is taxed at 20 per cent (for unlisted) or at 10 per cent (for listed) as the case may be. Further, long-term capital gain on listed shares up to Rs 1 lakh per annum is exempted,” says Singh.

When you have incurred a loss: In case you have incurred a loss, you are allowed to carry forward short-term capital losses in your tax return and adjust and set them off against gains in future years.

Listed or unlisted shares: The Income-tax Act differentiates between tax treatment of listed and unlisted shares. The tax treatment for shares that are unlisted in India or listed out of India remains the same. That is, if you own shares of an American company, they will not be listed in India. They may be considered unlisted for the purpose of taxes in India.

Starting FY2016-17, unlisted equity shares shall be short-term capital assets when sold within 24 months of holding them, and long-term capital assets when sold after 24 months of holding (applicable for sales made on or after 1st April 2016).

Disclosures: Several disclosures have been added in income tax return forms for foreign assets. If you own Esops of a foreign company, you may have to disclose your foreign holdings under schedule FA of your income tax return. These disclosure requirements are applicable to a resident taxpayer.