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Employee Stock Option Plan or Employee Stock Ownership Plan, abbreviated as ESOP, under the Indian system, enables employees of a company to purchase a certain number of shares of that company. The price of the stock, referred to as Exercise Price, is either pre-decided at a lower rate than their existing market value or an employee is offered a certain percentage of his/her monthly stipend in the form of company’s stocks. It is an efficient tool that improves remuneration mechanism and employee retention.
Grant Date: The day on which the employer and employee decides to enter into an agreement on owing shares at a future date
Vesting Date: The day on which an employee is entitled to purchase shares of the company that has employed him/her basis mutually agreeable terms and conditions
Vesting Period: The duration between the Grant Date and the Vesting Date
Exercise Period: The period, after shares having been vested, when an employee is eligible for buying the same shares
Exercise Date: The day on which an employee exercises the option
Exercise Price: This is the price at which an employee may exercise the option. Exercise price is usually lower than the existing Fair Market Value (FMV) of the share.
It is an effective scheme for companies, especially start-ups, that would take some time to break-even and is usually not in the position of offering large remuneration packages to their employees
Offering an ESOP acts as an incentive for employees to invest in the company’s growth
It creates a sense of ownership in the employee for the company, encouraging greater productivity
A company that allows its employees to buy ESOPs on a future date at pre-determined prices, garners a long-term commitment towards the company from the employees
According to the Income tax Act 1961, taxations for shares allotted under ESOP can be carried out during two different instances.
When an employee decided to buy a certain number of shares of his/her company, the difference between Fair Market Value and Exercise Price is taxed as Perquisite. TDS is deducted by the employer on this perquisite value, gets reflected in the employee’s Form 16 and is considered as a part of the total income from salary in the tax return.
If and when an employee decides to sell the shares of his/her company, the difference between Sale Price and Fair Market Value on the exercise date is taxed as Capital Gains, as per the tax bracket that he/she belongs to.
If an employee sells the shares within one year, the tax levied against capital gains is 15%. If an employee sells the shares after a year, they are not taxable as they are considered to be long-term assets. For long-term capital gains, the tax levied without the benefit of indexation is 10%, while the tax levied with the benefit of indexation is 20%.
In case an employee has ESOPs in a foreign company, the shares sold by him/her are short-term capital gains. This will be included as a part of his/her income and will be taxable as per the relevant tax bracket.
Advance Taxes on capital gains demand that an employee pays his/her tax dues for the annual year in advance through instalments. An employee may have to deposit advance tax on earning capital gains, despite the employer being eligible for deducting TDS after the employee exercising his/her options. Delayed payment or non-payment of advance tax leads to penal interest under Section 234B and 234C. During the time period in which an employee pays advance tax instalments, no penal interest is charged when the instalment is short as a result of capital gains. This is because it is difficult to estimate the tax on capital gains and deposit advance taxes during the first few instalments, in case the sale occurs later in the year. However, the remaining instalment of advance tax, post the sale of shares, has to include tax on capital gains.
Residential location : The residential status of an employee decides on whether his/her income will be taxable in India. When an employee is a resident of India, all his/her income for across geographical locations in India, will be taxable in the country. If an employee is a non-resident or is not an ordinary resident who has exercised the options or sold company shares, the employee may have to pay tax outside India. However, in such a situation, the employee may avail the benefit of double tax avoidance treaty or DTAA.
On opting against exercising the option or buying stocks : An employee has the right to opt out of exercising his option or buy company stocks on the vesting date. In such a case, there will be zero tax implications for the employee.
Disclosures : When an employee owns ESOPs in a country abroad, he or she may have to disclose the foreign holdings under Schedule FA of income tax return, if he or she is a resident taxpayer.
ESOP is a two-way street for the employer and the employee. However, both the parties need to be transparent about taxation, documentation, exit policies, etc. to avoid roadblocks in the future.
The amended provisions of Section 17(2)(vi) and 49(2AA) of the Income Tax Act 1961 defines that stock options that have been offered under ESOP and exercised on or after 1st April 2009, will be taxable by the employee.
Shares are exercised as a perquisite during its allotment and are taxable under the ‘Income from Salaries’. Employees are liable to pay taxes only while exercising the options. These options are calculated and paid on the difference amount between Fair Market Value on the date of exercise and the Exercise Price. This amount is taxable according to a perquisite under Section 17 of the Income Tax Act 1961 in the hands of the employee.
Employees are liable to pay tax under Income from Capital Gains during transfer of shares under Section 49 of the Income Tax Act 1961. This tax is calculated on the difference amount between the Fair Market Value of the shares during the time of transfer and the pre-determined Exercise Price.
Section 37(1) of the income Tax Act 1961 grants deduction for expenses that have not been specifically mentioned in Sections 30 and 36 are not personal expenses or capital expenditures of the assessee. These are taxable under the profits and Gains of business or profession. As discount on ESOP is a general expense, it is considered as a general provision under Section 37 of the Income Tax Act 1961.
ESOP expenses are offered by employers to their employees as an incentive for their services and improve the retention rate. Also referred to as Compensation Cost, it is a share-based payment that includes the grant of shares at a concession from the prevailing market price of the stocks or in the form of cash at a future date. The Compensation Cost is the difference amount between Fair Market Value on Grant and Exercise Price at which the stocks have been offered to the employee.
Compensation Cost is offered through two types of schemes
Equity-settled Schemes: Under this scheme, the employee receives the equity shares against exercise of options. The total expense is calculated during the grant of options, following which it is divided equally over a duration within which the options will vest with the employees.
Cash-settled Schemes: Under this scheme, the employee is eligible for the incremental value of the shares of the company over a time period. The employer makes an offer that is of the same value as the amount expected from the employees in a year, within which the payment has to be made.
Cash borrowed under ESOP can be invested in buying company shares and shares of outgoing owners of the company. Both principal and interest paid for ESOP are tax deductible because they help in repaying the loan amount.
ESOPs are often combined with employee savings plan in public companies. In such cases, an employer contributes a certain number of stocks from an ESOP that is equivalent to an employee’s savings as opposed to matching the savings of the employee through cash.
ESOP can be used by outgoing owners of private companies to sell their shares. ESOPs can be bought by companies through tax deductible contributions or can use ESOPs to borrow money for buying the shares.
What if I incur a short-term or long-term capital loss?
In case of a short-term capital loss, you can carry it forward in your tax return and adjust them against gains in the future. For long-term losses on equity shares, it is a dead loss and cannot be balanced out in the future because capital gains are not taxable.
Shares of Indian companies or foreign companies – which one is better?
The tax treatment for shares of foreign companies, that is, companies that are unlisted in India or listed out of India, is different from shares of listed companies, that is, listed shares. Until FY 2016-17, shares held for a period less than 3 years were short-term unlisted shares, while long-term unlisted share were those that were sold after 3 years. However, since FY 2016-17, unlisted shares have the same holding period as unlisted shares – short-term shares being those that are sold within 1 year and long-term shares when sold after 1 year.
If a considerable number of ESOPs have been allotted to me, can I exercise them in parts?
When you receive the option to exercise your ESOPs, you will be informed about the maximum time period within which you can exercise them. You can spread out exercising the option within the mentioned time frame. In case their FMV substantially varies, enabling you to spread your cost, you can go exercise them in parts. This is mostly helpful for listed shares (long-term shares that are sold after 1 year), and does not make a significant difference for unlisted shares (short-term shares that are sold within 1 year).
Is investing in ESOPs safe? Do I get a certificate as a proof? Are there any other rights that I should be aware of?
Yes, you will get a written proof if you exercise ESOP, usually in the form of a paper certificate. Exercising ESOP does not necessarily make you eligible for voting rights. You may be considered for voting if you occupy a senior position in the company in which you are employed and you have a significant number of ESOPs – at least 5% of the total – among other considerations. Besides, your employer may have to make disclosures and other relevant formalities unique to your company.
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