ESOP (Employee Stock Option Plan)

What it means

An Employee Stock Option Plan (ESOP) gives employees the right, but not the obligation, to buy a fixed number of the company’s shares at a pre-decided price, called the exercise price. The right becomes usable only after a vesting period. ESOPs are popular with startups that want to reward and retain staff without paying high cash salaries.

How it works

Only companies can issue ESOPs; LLPs and partnership firms cannot. The plan is approved by shareholders through a special resolution.

• Grant: the company grants options at an exercise price. There is no tax at this stage.

• Vesting: the options vest after a minimum of one year from grant, often in stages over three to four years.

• Exercise: when the employee buys the shares, the difference between the fair market value (FMV) on the exercise date and the exercise price is taxed as a salary perquisite. The employer deducts TDS on it.

• Sale: when the shares are sold, the gain over the FMV on the exercise date is a capital gain. Listed shares held over 12 months, and unlisted shares held over 24 months, are long-term and taxed at 12.5% (listed equity gets an exemption of ₹1.25 lakh a year).

• Startup relief: employees of eligible DPIIT-recognised startups can defer the perquisite tax until the earliest of 48 months from the end of the tax year of allotment, leaving the company, or selling the shares.

Example

Ankit, who is in the 30% slab, is granted 1,000 options at ₹100 each by an unlisted company. He exercises them after vesting when the FMV is ₹400.

Perquisite = (₹400 - ₹100) x 1,000 = ₹3,00,000

Tax at 30% = ₹90,000, plus 4% cess of ₹3,600 = ₹93,600 (deducted by the employer)

Three years later he sells the shares at ₹700 each.

Capital gain = (₹700 - ₹400) x 1,000 = ₹3,00,000 (long-term, as held over 24 months)

Tax at 12.5% = ₹37,500, plus cess of ₹1,500 = ₹39,000

Ankit paid ₹1,00,000 to buy the shares and must arrange ₹93,600 of tax at exercise even though he has not sold anything yet.

Key points to remember

• Plan your cash before exercising; tax at exercise is due even if the shares cannot be sold.

• The cost of the shares for capital gains is the FMV used for the perquisite, not the exercise price. Using the exercise price leads to double taxation.

• Unvested options usually lapse when you leave; read the plan for the exercise window after resignation.

• Shares of a foreign parent company must be reported in Schedule FA of your return.