ESOPs (Employee stock option plans) are a component of compensation packages, especially in startups and technology companies. They give employees the right to acquire equity shares of the company after meeting certain vesting conditions, allowing them to benefit from the firm’s future growth.
The stock benefit is treated as a part of salary for tax purposes. However, the tax liability does not arise at just one stage. Employees may have to pay tax when they exercise their options and again when they sell the shares. Some employees of eligible startups can also defer the tax payable at the time of exercise, providing relief from an immediate.
How are ESOPs taxed?
ESOPs are generally taxed at two stages:
- At the time of exercise (taxed as a perquisite under salary income)
When an employee exercises the option, they basically agree to buy the company’s shares. At this stage, the difference between the fair market value (FMV) of the shares on exercise date and the exercise price is taxed as perquisite.
The employer the deducts TDS on this perquisite value. The amount is shown in the employee’s Form 16 and must be included under salary income while filing the income tax return (ITR) in the relevant financial year.
- At the time of sale by the employee (taxed as capital gains)
If the employee later sells the shares acquired through , a second tax liability arises. In this case, the difference between the sale price and the FMV considered on the exercise date is taxed as capital gains.
The applicable capital gains tax depends on factors such as the type of shares and the holding period before sale.
Who does not have to pay taxes while exercising the option?
An employee receiving ESOPs from an “eligible startup” under Section 80-IAC of the Income Tax Act, 1961, does not have to pay tax in the year of exercising the option, meaning the tax deducted at source (TDS) on the ‘perquisite’ can be deferred. The tax only becomes payable on the earliest of the following events:
- Expiry of five years from the year in which the ESOP shares are allotted
- Date of sale of the ESOPs by the employee
- Date of termination of employment
This benefit is only available to companies who are recognised as a startup by the Department for Promotion of Industry and Internal Trade (DPIIT). In addition to DPIIT recognition, the startup must also obtain a separate certification as an “eligible startup” under Section 80-IAC.
How to determine the tax rate on ESOPs?
When an employee sells shares acquired through ESOPs, the gains are taxed as capital gains. For listed equity shares, gain are treated as long-term capital gains (LTCG) if the shares are held for more than 12 months.
For listed shares, gains are treated as long-term capital gains (LTCG) if the shares are held for more than 12 months. is taxed at 12.5% on gains exceeding ₹1.25 lakh. If the shares are sold within 12 months, the gains are treated as short-term capital gains (STCG) and taxed at flat 20%.
If the case of unlisted shares, long term capital gains are taxed at 12.5% and short term is taxed according to the slab rates, Cleartax said in a report.
When an employee incurred a loss on the sale of these shares, they are allowed to carry forward these capital losses in their tax return and set them off against gains in future years. These losses can be carried forward for up to eight assessment years.
People must also note that LTCG can only be set off against long-term gains, whereas short-term loss can be set off against both STCG and LTCG.