Personal Finance

All about ESOP taxation

Vishal Balabhadruni |BL Research Bureau | Updated on: Feb 19, 2022

Returns from this avenue can be phenomenal; here’s how it is taxed

Employee stock option plan (ESOP) is as one of the most popular methods to incentivise employees by offering them a chance at part ownership of the company It allows employees to own the shares of the company in future at a pre-determined price (exercise price) which is generally lower than the market price.

ESOPS have a lock-in period (vesting period) after which the employee can buy the shares. The returns from ESOPs can be phenomenal especially when the markets are bullish, however these returns do not come without the tax.

ESOPs are taxed twice - first as a perquisite when the options are exercised and as capital gains when the shares are sold. In the year of exercising, ESOPs are treated as perquisite and under “Income from Salaries”, the difference between Acquisition cost and Fair Market Value (FMV) is the taxable amount. The FMV of listed companies will be the average of opening and closing prices on the day of exercise. In case of unlisted shares, the FMV will be decided by a merchant banker.

Capital gains tax is levied when the shares are sold. Here the tax would be applied on the difference between the sale proceeds and the FMV at the time of exercising the ESOP. ; the period of holding will determine whether it is long term capital gain (LTCG) or short-term capital gain (STCG).

Let us take an example : Employee X of ABC company which is listed, received ESOPs of 1000 shares at ₹100 ; on the date of exercise the lowest price was ₹102 and highest was ₹112 so the FMV will be ₹107 ;the taxable amount will be (107-100) X 1000 i.e., ₹7000, to be taxed under income from salaries.

Now assuming the shares have been held for more than 12 months, it would be considered as long term capital gains and taxed at 10 percent (Short term capital gains rate would be 15 percent) on gains over ₹1 lakh (shares acquired after February 1, 2018).

Assuming Mr. X held the shares for more than 12 months and then sells at the price of 220. Then LTCG would arise and the gain here will be ₹113000 (1000 *(220-107) therefore, the taxable amount will be ₹13,000 and tax payable will be ₹1300 (10 per cent of ₹13000).

Recent developments

In Budget 2020 , it was announced that employees of certain eligible start-ups u/s 80IAC can defer their tax liability on allotment of shares to 48 months from the applicable assessment year after exercising the right. If the employee quits the job before 48 months or sells the shares, then the tax will be due in the year of quitting or sale of shares.

Also, in the latest budget, the government announced that it is going to cap the surcharge on LTCG to 15 per cent across all forms of capital gains, Until now, the surcharge is 15 percent on LTCG from listed securities and goes up to 37 percent in a graded manner on LTCG from other assets including unlisted equities Thus, the Budget announcement implies that long-term gains on unlisted equities will also benefit from lower surcharge. However, one should keep in mind that this change will benefit only high-income earners and in that, those earning LTCG of ₹2 crore and above on ESOPs.

Let us understand with a simple example: Mr. Raj is holding ESOPs an unlisted company and sells his holding. As the shares are of an unlisted company, as per existing laws, the surcharge would be 25 percent for LTCG in the range of ₹2-5 crore which will now come down to 15 per cent. This means the effective tax rate of 26 percent will come down to 23.92 percent post budget.

Assuming Mr. Raj made gains of more than ₹5 crore, the surcharge would be 37 percent now. Based on the budget announcement, this would come down to 15 percent now. This means the effective tax rate would come down from 28.50 percent to 23.92 percent.

This move is expected to benefit Startup founders, investors and employees having ESOPs as the effective tax rate has come down quite well and savings are significant amount in absolute terms.

Published on February 19, 2022

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