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ESOPs, or Employee Stock Ownership Plans, are benefit schemes where companies grant their staff an ownership stake.
ESOPs are employee benefit schemes where companies grant their employees a stake in ownership. (Pic for representation)
Employee Stock Ownership Plans (ESOPs) have become a popular means for companies to reward their workforce. It ensures there’s a sense of ownership and also aligns employees’ interests with business growth. These plans, offering various types of stock-based compensation, provide employees with opportunities to participate in the company’s financial success. As such, understanding the different ESOPs and their taxation is crucial for both employees and employers.
ESOPs are employee benefit schemes where companies grant their employees a stake in ownership. Through these plans, organisations aim to incentivise employees by linking their performance to the company’s growth. Usually, ESOPs are offered with specific terms, such as vesting periods or performance targets, making them a strategic tool for talent retention.
A look at 4 types of ESOPs
- Employee Stock Option Plan (ESOP): This is a right provided by the company that allows employees to acquire its equity shares at a discounted price, providing an opportunity to share in the company’s growth.
- Employee Stock Purchase Plan (ESPP): Through this plan, employees can purchase the company’s shares, often at a discount from the Fair Market Value (FMV) determined at the end of a specific quarter.
- Restricted Stock Units (RSUs): These are shares granted to employees subject to the fulfilment of certain conditions, such as achieving specific targets, revenue milestones, or performance benchmarks.
- Stock Appreciation Rights (SARs): SARs provide employees with financial benefits equivalent to the difference between the stock price at the time of grant and the price at the time of exercise. These can be settled either in cash or equity.
Tax implications
Taxation of ESOPs in India occurs in two stages:
Taxation at the time of share allotment
When companies offer employees the option to buy shares at a discounted price or for free, it creates a taxable benefit. This benefit, treated as part of your salary, is subject to tax deduction by the employer at the time of the transaction. The first instance of tax liability occurs when the employee exercises the option to acquire these shares.
The taxation process involves calculating the difference between the Fair Market Value (FMV) of the shares on the date the option is exercised and the actual amount paid by the employee to purchase the shares. This difference, referred to as a “perquisite,” is added to the employee’s taxable salary. The FMV is determined according to specific rules outlined under Rule 3 of the Income Tax Act.
The FMV used for calculating the taxable value is not the value on the date of allotment but the value on the date the option is exercised. This difference ensures that the tax liability reflects the actual market value of the shares at the time the employee gains ownership.
Taxation when the employee transfers their shares
When an employee transfers shares received through an ESOP, the profits made from the transfer will be taxed under ‘capital gains.’ The tax treatment depends on the type of security and how long it has been held. The holding period of the securities begins from the date they are allotted to the employee, not from when the option to buy the shares is exercised. It ends when the employee transfers the shares.
For calculating the capital gain, the fair market value of the shares on the date the employee exercises the option will be considered the purchase cost of those shares.
For example, X exercised their ESOP on April 1, 2022, and the shares were allotted on May 1, 2022. On April 1, 2024, X sold the shares. Here, the holding period for the shares will be from May 1, 2022, to March 31, 2024. But while calculating the cost of acquisition, the fair market value on April 1, 2024, or the date when X exercised the option, will be considered.
Overall, it’s often recommended to hold the shares for more than 24 months, or 2 years, to benefit from long-term capital gain exemptions and reduced tax rates. This can maximise the financial benefits of participating in an ESOP.
