Introduction

Employee stock ownership plans (ESOPS to employees) enable employees to hold equity in the firm they work for. However, Esops’ taxation is a little tricky. Could you continue reading to learn how it works?

Many organizations, particularly startups, have recently provided employee stock option plans (ESOPS employees) to their employees. Esops are growing more popular in India, with various local and foreign organizations providing them to their employees. 

ESOP Benefits For Employees

Employee Stock Option Plans (ESOPs) have become a popular tool for many businesses to attract and retain talent. ESOP startup attracts young talent and retains them for the long run in an organization. Under an ESOP plan, the firm grants some workers the opportunity to acquire a set quantity of stock in the company over a specified period at a pre-determined price (exercise price). Still, the employees are under no duty to do so. 

Taxes are associated with such payments. According to Kuldip Kumar, Partner – Price Waterhouse & Co LLP, taxation occurs at the time of exercise when ESOP shares are allotted and afterward when the shares are sold.

ESOPs are taxed on the amount computed as the difference between the exercise price and the market price on the day of exercise. Such a discrepancy is considered a perk in the employee’s eyes and is taxed under the head salary.

 

“ESOPs are treated as gratuities, which are included in pay computation and taxed appropriately. The appropriate slab rate applies to such people, and tax is due accordingly. Otherwise, there are no unique tax rates applicable to ESOPs.” 

-Saurav Sood, SW India’s Practice Leader (International Tax)

When an employee exercises its entitlement to employee ownership, the difference price is added to the employee’s compensation. The employer must compute withholding tax on the salary amount (including the prerequisite for exercising the ESOP) and subtract proportionately.

The employee has no additional repercussions because the company withholds taxes on the whole amount of such perk. 

 

“Furthermore, if the employee later sells such shares in the market, capital gains will apply on the sale of shares, and it will be the employee’s tax burden, and taxes will be paid appropriately.” 

-Sood

 

Employee ownership income treated as employment income in the first stage is taxed at the standard slab rate; plus any applicable surcharge, education and health cess. Income, on the other hand, is taxed as capital gains in the second stage.

Employees With ESOP

Employee stock ownership programs are frequently used by businesses to recruit and retain high-quality employees. With ESOPs, an employee gains the top benefits of acquiring firm ESOP shares at a minimal rate and selling them (after a fixed duration established by his employer) for a profit.  

There are countless success tales of employees amassing fortunes alongside company founders. Google’s first public offering is a significant example. Its founders, Sergey Brin and Larry Page became the wealthiest people in the world, and stockholder workers also made millions.

ESOP Taxation In India

The Income Tax Act of 1961 is the basic legislation controlling ESOP taxes in India. The Act’s requirements differ for both Salary Income and Capital Gains originating from ESOPs.

From the standpoint of the employees, ESOPs are taxed at two points in India:

1. When ESOPs are executed and transformed into shareholdings: 

The perquisite value gained when ESOPs are exercised is recognized as salary income. Regular taxes are applied based on income level, and the employer deducts TDS.

Perquisite income = market value of stocks on the execution date – total exercise sum

If the firm is not publicly traded, the market value is established by FMV (fair market value) based on an ESOP valuation certificate issued by a merchant banker. It should be noted that the value certificate cannot be more than 180 days old from the exercise date.

If the corporation is publicly traded, the share value is computed as the average of the opening and closing prices on the exercise date on the recognized stock exchange with the largest volume.

2. When the person sells the stocks, the proceeds are subject to capital gain taxes.

Capital gain = share sales price – The market value of shares when exercising Capital Gains Tax on ESOPs/ESPPs varies depending on factors such as:

• Whether the ESOP shares are kept for a short or extended period.
• Whether or whether the shares are traded on a stock exchange.
• The residence of the individual who owns the shares.

How Do You Know Whether Your Gains Are Short-Term or Long-Term?

The nature of the profits, whether short-term or long-term, differs between listed and unlisted shares.

For publicly traded companies: Short-term capital gains apply if the employee keeps the shares for less than a year (STCG). 

Short-term capital gains are taxed at a fixed rate of 15%.

However, if the shares are kept for more than 12 months, the gains from their sale are considered long-term capital gains (LTCG).

 Long-term capital gains over Rs. One million are taxed at a rate of 10%.

For unlisted shares: A short-term capital gain occurs when a corporation’s workers hold the shares for fewer than 24 months before selling them. Short-term capital gains are taxed at the corresponding income tax slab rate, just like any other income.

If, on the other hand, the shares are kept for more than 24 months before being sold, the gains are taxed as long-term capital gains. According to Section 112, A of the IT Act, long-term capital gains arising from the sale of unlisted shares are taxed at a rate of 20% with indexation.

Alternatively, you might pay a 10% flat tax with no indexation advantages.

ESOP for Private Companies Taxation Guide 

Startups were anticipating all of the restrictions mentioned earlier to be lifted in Budget 2022, as well as some tax parity between listed and unregistered companies (ESOPs in this case). While the inadequacies of previous reforms were not addressed, the Finance Minister reduced the levy on all long-term capital gains (LTCG) to 15% from 37%. This levy is comparable to the surcharge on listed stocks. While this reduces the LTCG on unlisted equity to 23.92 percent from 28.5 percent previously, it does not reduce the taxes on ESOPs as some startup founders and financial experts believe.

Here’s why it doesn’t make a difference in terms of ESOP taxation:

• ESOPs would still be taxed twice on exercise and liquidation.
• ESOPs would still be taxed according to the income bracket, reaching 42.7 percent.

When an ESOP is exercised, it is taxed at the Fair Market Value (FMV) and then again at the buyback or secondary depending on the selling price, which may be greater than the FMV.

Tax Calculation and ESOP Valuation

Let’s look at an example of how ESOPs are taxed,

Assume you give an employee 10,000 ESOPs on a specific day (grant date). Assume you are a publicly traded corporation.

The grant price/exercise price equals Rs. 10 per share.

The employee must pay a total of Rs. 100,000 to obtain all of the shares.

After two years, the employee decides to exercise all their choices. Assume the FMV of a share at the time is Rs. 50.

Let us now compute the taxes at the time of executing the option.

The perquisite = No. of shares (FMV – Exercise price) = 10,000* (50-10) = Rs. 400,000 in this case.

Assume the employee is subject to a 30% tax rate.

TDS deducted by the employer = 400,000*30% = Rs. 120,000

Employees must pay capital gains tax if they decide to sell the shares after a certain period.

Capital gains = number of shares (sale price of the share – FMV)

Assume the selling price is Rs. 300, 

Capital Gains = 10,000(300 – 50) = Rs.25,000,00,000.

If the holding term is shorter than or equivalent to 12 months, a 15% STCG (Short-Term Capital Gains) tax is levied = (Capital Gains * 15%) = Rs. 3,75,000

If the holding duration exceeds 12 months, an LTCG (Long-Term Capital Gains) tax of 10% is levied on 24 lakhs = (Capital Gains in Access of 1 lakh * 10%) = Rs. 2,40,000.

 

Let us stably summarise the preceding material. Entity                                  Value

Total Exercise Amount                                                                                    Rs. 100,000

Total Fair Market Value of Shares                                                                Rs. 500,000

Perquisite Amount                                                                                           Rs. 400,000

Tax Deduction at Source                                                                                  Rs. 120,000

Total Sales Value of Shares                                                                              Rs30,00,000

Capital Gains                                                                                                    Rs. 25,00,000

LTCG                                                                                                                  Rs. 240,000

STCG                                                                                                                  Rs. 375,000

 

Budget 2020-2021 altered the taxes framework for new businesses (provided exemption under sec 80 – IAC). The DPI proposed these guidelines (The Department of Promotion of Industry and Internal Trade).

Employees of emerging startups are excused from paying taxes for a certain time under specific conditions:

• Perquisite tax will be levied after 48 months of executing the stock option.
• When an employee sells their stock.
• When a worker resigns.

The tax deduction owing to the causes mentioned earlier will be handled by the firm within 14 days of meeting the prerequisites:

• The financial modifications allow startups to keep talented staff for a prolonged period without incurring additional fees.
• Employees are not required to pay upfront taxes by burning a hole in their pockets. 

Other Factors While Calculating ESOP Taxes

Other factors to consider when computing ESOP taxes include residence status, loss incurring ESOPs, disclosures, and more.

Residential Status: Whether you live in India or outside of India, your ESOP transactions are taxed. As an employer, you should be aware that if two nations sign a double taxation avoidance agreement (DTAA), your employees can escape being taxed twice: once in India and once overseas.

Overseas Asset Disclosures: When workers receive shares from a parent or foreign business, the shares are classified as foreign assets. Employees must demonstrate these assets by completing ITR-2 or ITR-3 forms. Furthermore, the disclosures must be made in Schedule FA of the IT Act (Foreign Assets).

Taxation of ESOP Losses: If an employee sells an ESOP and incurs a loss, the loss can be carried forward for the next eight fiscal years. The loss can then be modified with the profits as and when they occur.

ESOP for Private Companies: Calculating Tax

Scenario 1: An employee has 100 ESOPs that have vested. The exercise price is Rs 10, while the startup’s FMV is Rs 1,000 per share. The employee exercises 100 ESOPs and pays the business Rs 1,000. In this case, the employee is required to pay tax on Rs 99,000 (100 ESOPs X Rs 1,000 (FMV) — Rs 1,000 paid for exercising). Depending on the employee’s tax bracket, this tax might be as high as Rs 42,273.

In addition to those mentioned earlier, there might be three other scenarios:

Scenario 1a: The employee promptly sells it as part of the company-arranged repurchase. The buyback occurs at the exact FMV. The employee is not subject to any additional taxation.

Scenario 1b: The repurchase occurs at Rs 1,500 since the firm’s second round was priced higher due to high demand. In this case, the employee must pay an extra tax of Rs 21,350. (due to an additional gain of Rs 50,000).

(Note: If the startup described above is one of the 0.5 percent allowed under Section 80 of the Income Tax Act, this employee must pay a one-time tax of Rs 63,623 if they continue to work for that firm)

Scenario 1c: The employee does not participate in the buyback or secondary following exercising and paying taxes but instead decides to gain from the startup’s increased worth. They maintain the exercised shares in a Demat account for two years. After two years, there was a repurchase event, and the startup’s share price rose to Rs 3,000.

The proposed amendment in Budget 2022 takes effect now, and the tax will appear like this: The employee receives Rs 300,000 in cash (100 ESOPs X Rs 3,000 per share). The tax due is Rs 71,700. (23.9 percent). The employee paid Rs 42,273 in tax at the time of exercising. Thus, they must now reimburse Rs 29,427. In this scenario, the employee ESOP benefits from the LTCG and is paid significantly less tax overall.

Scenario 1c is unusual in today’s world when both companies and workers are focused on the present.

So, to make ESOPs a true success in India, we must:

ESOPs are only taxed when they are exercised, and

ESOPs should be taxed at the same rate as listed shares, which is 15% if sold within one year and 10% beyond that. Until then, ESOPs will be both tax and employee unfriendly. Budget 2023, one hopes, will usher in the actual improvements we have all been waiting for.

Final Takeaway

While point one would include many startups, including most newly-minted unicorns, point two would exclude most unicorns, except a handful that were overvalued based on their future potential rather than their present traction. This places revenue-generating large startup workers at a significant disadvantage because they are penalized for establishing a viable firm. However, this is not even the main issue with this half-baked ESOP change. Other factors make implementation considerably more difficult: 

Section 80 of the Act required eligible startups to be authorized separately by an inter-ministerial body, followed by permission from the IT department. As a result, just 0.5 percent of companies are qualified, rendering this change ineffective.

Another condition that made it unappealing is that tax would be levied if employees left the firm. This is a major irritant because employees have not yet received any money but must pay considerable tax.