ESOP, or Employee Stock Ownership Plans, are unique employee benefit programs that provide employees with an opportunity to own a stake in the organization they work for. By offering eligible employees the right or option to purchase equity shares of the company at a predetermined rate within a specified timeframe, ESOP creates a sense of ownership and aligns the interests of employees with the long-term success of the organization.

Understanding ESOP Terminology

Grant Date

The grant date marks the agreement between the employer and the employee, granting the latter the option to own shares of the company at a later date. It serves as the starting point for the employee’s journey towards ownership.

Vesting Date

The vesting date signifies the point at which the employee becomes entitled to purchase the shares, subject to the fulfillment of previously agreed-upon conditions. It represents the culmination of the vesting period.

Vesting Period

The vesting period is the duration between the grant date and the vesting date. During this period, the employee must satisfy certain conditions, such as continued employment or achieving specific performance milestones, to become eligible to exercise the option to buy shares.

Exercise Date

The exercise date refers to the moment when the employee decides to exercise their option and purchase the shares. It typically occurs after the shares have vested, and the employee chooses to take advantage of the ownership opportunity.

Exercise Period

Once the shares have vested, the exercise period commences. This period provides the employee with a window of time to exercise their right to buy the shares, usually at a price lower than the fair market value.

Exercise Price

The exercise price is the predetermined price at which the employee can buy the shares when exercising their option. This price is often set below the fair market value of the shares, making it an attractive opportunity for employees to acquire ownership.

Taxation of ESOP’s

Tax is levied at two points in ESOP

• First Trigger of ESOP taxation will be at the event of exercising ESOP
• Second trigger will be at the time of sale of shares

First Tax Trigger – When ESOP’s are Exercised – It will be taxable as part of Salary (Perquisite)

First Trigger – When ESOPs Are Exercised

At the time of exercising ESOPs, the difference between the fair market value (FMV) on the exercise date and the exercise price is taxable as perquisite, which is treated as part of the employee’s salary. The employer deducts TDS (tax deducted at source) on this perquisite, and it is reflected in the employee’s Form 16 and included as part of the total income from salary in the tax return.

Important Note for Eligible Startups

An amendment in the Budget 2020 stated that from FY 2020-21, employees receiving ESOPs from eligible startups are not required to pay tax in the year of exercising the option. The TDS on the perquisite is deferred to the earlier of the following events: 1) expiry of five years from the year of ESOP allotment, 2) date of sale of the ESOP by the employee, or 3) date of termination of employment.

How to Calculate Fair Market Value (FMV) of Shares

If the shares are traded on a recognized stock exchange on the exercise date, the FMV of the shares is the average of the opening and closing rates.

If the shares are not traded on a recognized stock exchange on the exercise date, the FMV of the shares is the closing price on the day preceding the exercise date.

If the shares are unlisted, the FMV of the shares is determined by a merchant banker

Second Tax Trigger – When ESOP’s Are Sold – Capital Gains Tax will Apply

Taxability on Short-term or long-term capital gains

Capital gains tax applies when ESOPs are sold. The taxability of capital gains depends on the period of holding the shares, which is calculated from the exercise date up to the date of sale.

For Listed Shares: Equity shares listed on a recognized stock exchange, where Securities Transaction Tax (STT) is paid on sale, are considered long-term gains if held for more than one year. If sold within one year, they are considered short-term gains.

For Unlisted Shares: Unlisted equity shares are considered long-term if held for more than two years. If sold within two years, they are considered short-term gains.

Taxation of Capital Gains

Taxation of Loss on sale of Shares under ESOP

Long-term capital losses on the sale of listed or unlisted shares can be set off against long-term capital gains and carried forward for up to eight years.

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Short-term capital losses on the sale of listed or unlisted shares can be set off against both long-term and short-term capital gains and carried forward for up to eight years.

Disclosures under Income Tax Return

Income tax return forms now include several disclosures for foreign assets held. If an individual owns ESOPs of a foreign company, they may need to disclose their foreign holdings under Schedule FA of their income tax return. These disclosure requirements apply to resident taxpayers.

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