Share Based Payments to employees: Know about ESOP Taxation

Purpose of ESOPs: -

Employee Stock Option Plan (ESOP) or Share based payments to employees is a well-established mechanism for corporates to retain employees and keep employees motivated at the same time. It enhances the value of the company, as every employee feels that he is owner. Employee stock options provide benefit or right to the employees of a Company to purchase or subscribe at a future date, the securities offered by the company at a pre-determined price. ESOPs is one of the ways by which shares are issued to employees as benefits, other variations are Share Appreciation rights (SARs), which are granted only if share prices go up in the market and Sweat equity shares for developing intellectual properties.

History of Taxation of ESOPs: -

ESOPs, where first taxed in India through introduction of Fringe Benefit Tax (FBT) Act in 2005, which was imposed on the employers. However, in 2009, through amendment to the Income Tax Act, 1961, FBT was suspended and ESOPs were included as perquisites under section 17(2)(vi), taxable in the hands of employees.

Methodology of Taxation of ESOPs

Under the current regime, ESOPs are taxed at 2 stages in the hands of employees
Stage 1 – Under the head Salary at the time of allotment of shares
Stage 2 – Under the head Capital Gains at the time of sale of shares

ESOPs Timeline (For unlisted Companies) before 1st April 2020

Stage 1: Income Tax Applicability at The Time of Exercise of Options: -

Allotment of shares to employees on exercising of their option will be treated as perquisites and will be made taxable in the hands of employees under section 17 of Income Tax Act, 1961.

Valuation: -

At the time of exercise of the options by the employees, the difference in fair market value (FMV) of the shares allotted and the exercise price is treated as perquisite.

Stage 2: Income Tax Applicability at The Time of Sale of Shares by The Employees: -

Upon the sale of shares by the employee the income will be treated as a capital gain and the net gain amount will be taxed in the hands of employees. The capital gain tax would be calculated as a difference between the sale consideration and the fair market value as on the date of exercise of the options. As per section 2(42A) of IT Act, the period of holding such shares should be considered from the date of allotment of such shares.

The period of holding of the shares are taken into consideration to check whether the gain classifies as short term or long-term capital gain.

1. Shares held for a period less than or equal to 12 months to be considered Short term.
2. Shares held for a period of more than 12 months are to be considered long term.

In case of shares of unlisted companies: -

1. Shares held for a period of less than or equal to 24 months are to be considered short term.
2. Shares held for a period of more than 24 months are to be considered long term.

Amended ESOPs Timeline for eligible start-ups (from 1st April 2020)

Since ESOPs are taxable in the hands of employees at stage 1, i.e. when shares are allotted, it created a disadvantage for the employee to pay tax on unrealized gains which were not even assured, hence made ESOPs unattractive. The Finance Bill, 2020 has considered the challenges faced both by employees and startups and has sought to offer some relief in the form of deferring the taxation of ESOPs through insertion of clause to section 192.

Section 192, which provides for deduction of tax by the employer from salary of an employee, is amended to provide that an eligible start-up as referred to in section 80-IAC shall deduct tax from perquisites income arising from ESOPs within 14 days of following (whichever is earlier):

Note: This benefit is only applicable to eligible startups registered under section 80 IAC of Income tax act.

Tax deduction for Employers

Now another question that arises is, can the employer who is providing ESOPs Claim deduction under Income Tax Act. In case of ESOPs, as shares are issued at a discount compared to the market price of the shares, the discount offered to employees to purchase shares shall be treated as employee benefit expenses. Such expenses are allowed under section 31 (1) of Income Tax Act in the hands of employers, this has been endorsed in the instant case of Biocon Limited, Bangalore vs Department Of Income Tax on 16 July, 2013, ITAT, Bangalore.

Tips for Start ups

As you can see ESOPs are a very good employee engagement initiative, however the drafting of scheme and executing the process of allotment and the tax complication both in the hands of Employee and Employer as not encouraging. For startups which are on Boot strap, can look for an altered version of this scheme where a common pool of Shares for employees can be created and held in custody of a shareholder or a trust and then transferred as per the terms of share-based payment agreement. Similar result can be achieved through this mechanism with comparative ease.

Disclaimer:“The information contained herein is only for informational purpose and should not be considered for any particular instance or individual or entity. We have obtained information from publicly available sources, there can be no guarantee that such information is accurate as of the date it is received or it will continue to be accurate in future. No one should act on such information without obtaining professional advice after thorough examination of particular situation.”

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Prepared By

Ankit Shetty


Date: 08/09/2020