Understand the concept of the Taxability of Stock Options

If your company has granted you the Employee Stock Options as part of your CTC, then you must understand the process and the associated tax implications in order to understand your right to exercise the ESOP in a better way and this is why we have got you covered. So, let’s move further and understand the nuances of the ESOP in detail. 

Introduction to Employee Stock Option Plan 

As the name connotes, these types of securities are issued to an employee of the company under the scheme of the Employee Stock Option Plan, also known as the ESOP. 

This scheme allows the granting of the securities of the company to the employee at a concessional rate, which is taxable as a prerequisite in the year in which the securities have been allocated. With the ESOP, an employee gains an ownership interest in the company in the form of equity shares. 

However, the liability for the payment or the tax deduction on the prerequisite is allowed to be deferred in circumstances where the company is a start-up. The value of such a prerequisite is the market value on the date of the exercise of the ESOP, deducting the amount recovered from the employee. 

Eligibility Criteria for Issuing the ESOP 

Rule 12(1) of the Companies (Share Capital and Debenture) Rules, 2014 provides the eligibility criteria for the issue of ESOPs. The Rule states as: 

• The Director of the Company includes a director who is either part-time and full-time, but excludes an independent director. 

• Permanent Employee of the company who is working in India or outside of India. 

• A Permanent Employee or a Director of the Subsidary Company, an associate company or a holding company who is working in India or outside of India.

• If the company issuing the ESOP is a Private Company and it is an essential condition that the articles of the association of such a private company should authorise the issue of shares through ESOP. 

If in case the Articles of Association of such private company do not authorise the issue, then the company is required to hold an extraordinary general meeting in order to alter the Articles to include a provision to issue the shares through ESOP. Besides, a Board Meeting must be held to pass the resolution and obtain the approval from the shareholders. 

Ineligibility of Issuing the ESOP 

• In case the Director who by himself or through his relatives or any body corporate holds more than 10% either directly or indirectly of the outstanding equity shares of the company 

• If the employee belongs to the promoter group or is himself a promoter of the company. 

These two conditions are not applicable to start-up companies for a period of 10 years from the date of their incorporation. 

What is the reason behind issuing the ESOP?

• Offered by the Start-ups: As we have already discussed, the ESOP is issued by the start-ups to attract higher talent on board and for which a start-up is not able to match the higher compensation packages. This is why ESOP is preferred by start-ups.

• Ensuring Commitments: Some companies issue the ESOP, which is exercisable over a longer duration, thereby giving the company the right amount of assurance of commitment from their employees. 

• Ownership in the Company: The ESOP works in the direction of providing ownership to the employees in the company, which also acts as a motivating factor to work harder towards achieving the goals of the company. 

Benefits of the ESOP

• Employee Benefits: ESOP is an employee benefit program that allows the company to attract good employees on board and for the employees to stay motivated while working for the company. ESOPs are always used in combination with the employee savings plan, which enables the companies to match the savings of the employees through stocks instead of cash flows. 

• Borrow Money: With the help of the ESOPs, the companies can sell their shares, which allows the company to make contributions that are tax-deductible for buying out the shares, or alternatively company may use these ESOPs to borrow the money for buying the shares. 

The cash borrowed under the ESOPs is also used to buy the shares of the existing owners. Even both the amounts which includes principal and the interest are tax deductible. 

Disadvantages of the ESOP  

• Riskier: The Options can sometimes become an obligation on the company, as the ESOPs do not have a premium and the only option left for compensation with the company is through the increased liquidity and sometimes even through a tax advantage. This is the reason that options are considered riskier than normal stocks. 

• Not Clear Guidelines: Due to the non presence of clear guidelines, it becomes difficult for the procedures related to accounting and valuation for the ESOP in a company. 

• Uncertain Liquidity: As we have already discussed in the preceding sections of this Article that the options have a very low and uncertain level of the liquidity. 

Tax Implications of the ESOP & Taxation of stock options

Tax Implications at the Time of the Allotment of the ESOP 

Any organisation that is responsible for paying the salaries to its employees must deduct the taxes at the time of the payment of the salary at the average rate of the taxes. 

The definition of the salary under the Income Tax includes the perquisites provided by the employer to their employees and the value of the securities which are allotted to the employees either at a concessional rate or free of cost will be treated as the perquisite. The tax on the very first instance is accrued at the time of the allotment of such securities. 

Where an employee exercises the options, then the difference between the Fair Market Value of such securities as on the date of the exercise of the option and the amount which has been paid by the employee for the securities is taxable as perquisite. The point to be noted is that the Fair Market Value of the securities as on the date of the allotment is not relevant instead, the Fair Market Value of the securities at the time of the exercise of the option is taken into consideration. 

The Fair Market Value of the Securities, whether Quoted or Unquoted Equity Shares, is computed in accordance with the below-mentioned scenarios and formulas. So, let’s find out how this is calculated and arrived at!

Conditions and the Calculation of the Fair Market Value 

Conditions	Fair Market Value
In the case where the Shares are listed on only one stock exchange as of the date of the exercise of the ESOP	Its FMV is calculated by averaging the opening price and the closing price of the share as on the date on the stock exchange.
In the case where the shares are listed on more than one stock exchange on the date of exercising the ESOP	Its FMV is calculated by averaging the opening price and the closing price of the share on the stock exchange that records the highest volume of trading in the shares.
In the case where, on the date of exercising the ESOP, there is no trading in the shares on the stock exchange	The FMV will be the closing price of the share on the stock exchange on a date which is closest to the date of the exercising of the ESOP and immediately preceding such date; or The FMV will be the closing price of the share on the stock exchange which records the highest volume of the trading in such shares, but if the closing price as on the date closest to the date of the exercising of the option and immediately preceding such date is recorded on more than one recognised stock exchange.
In the case where the shares are not listed on a stock exchange	The value of the shares is determined by a Merchant Banker on: The date of exercising the ESOP or; Any date which is earlier than the date of the exercising of the option, not being a date which is more than 180 days earlier than the date of the exercising of the option.

Example Depicting the Calculation of the Perquisite 

If XYZ Ltd. issued the ESOP to Mr. M during the financial year 2023-2024, so the value of the perquisite based on the data will be:

Particulars	Amount
Date of Granting of the ESOP	01/04/2020
Period of Vesting	01/04/2020 – 31/03/2023
Date of Exercising the ESOP	10/05/2023
Fair Market Value as on March 31, 2023	6,000
Fair Market Value as on May 10, 2023	6,500
Number of the ESOP exercised	100
A pre-determined price that is to be paid by the employee to the employer	500
Value of Perquisite (Rs. 6,500 – Rs. 500) * 100]	Rs. 600 000

Tax Implications at the Time of the Shares by the Employee 

In the case when the securities are allotted under the ESOP and subsequently transferred by the employee, the gains which has been accrued from them must be taxable under the head of Capital Gains. The taxability of such capital gains depends upon the type of the security and the period of holding of such security. 

The period of the holding of the securities shall be taken into consideration, which is the period commencing from the date of the allotment of the securities, but not the date of exercising the options, which ends on the date when the employee transfers the securities. 

The fair market value of the securities as on the date of the exercise of the options is taken as the cost of the acquisition of such securities in order to compute the capital gains. 

For instance: If Mr. Apple exercised the ESOP on the date 01/04/2020 and the shares were allotted to them on 01/05/2020. Mr. Apple sold the shares on 01/04/2022 and the period of holding of the shares shall be computed from 01/05/2020 till 31/03/2022. Though, in order to compute the cost of the acquisition, the fair market value of the shares as on 01/04/2020, being the date of exercising the ESOP, will be considered. 

Tax Implications in the case of Start-ups 

The taxability of the ESOPs occurs in the hands of the employee at two stages. On the very first instance, when the securities are allotted to the employee and secondly, when such securities are sold. At the time of the allotment of the securities, the difference between the fair market value of the shares as on the date of exercising the option and the amount which has been actually paid by the employee for the securities is taxed as the perquisite and is charged as tax under the head Salary. 

At the same time, the employer is required to include such amount of the perquisite in the salary of the employee and the tax has to be deducted under Section 192 in the year when the securities are allotted. The employees do not get any benefit from the securities allotted under the ESOPs, so to reduce the burden of the taxes on the employees some provisions of the Income Tax Act, has been amended to defer the deduction and make the payment of the tax on income in the nature of the perquisite arising from the ESOP. 

It is pertinent to note that only an eligible start-up under Section 80-IAC and its employees get the benefit of the deferment of the taxes and the TDS payment on the perquisite arising from the ESOPs. 

Particularly, Section 192 of the Income Tax Act provides for the tax deduction by the employer from the salary of the employee. This Section further provides for the eligibility of the start-ups, which shall deduct the tax from the income arising in the nature of the perquisites from the ESOPs within 14 days from the occurrence of any of the following events:

• On the expiry of 48 months from the end of the assessment year in which the securities were allotted under the ESOPs.  
• From the date of the assesse ceases to be an employee of the company 
• From the date of the sale of the securities allotted under the ESOPs. 

The tax is required to be deducted on the basis of the rates of tax in force for the financial year in which the securities are transferred or allotted under the ESOPs. An employee is required to disclose the value of the perquisite from ESOPs in their return of income for the year in which the securities are allotted. 

Though due to the deferment in the payment of the taxes, the employee will not be required to pay the taxes on the perquisites accrued from the ESOPs in the year. 

ESOP Tax Calculator India

The tax is calculated:

Tax Payable on Salary Income, excluding the ESOPs perquisite = 

Tax on Total Income including the ESOPs perquisites * Total Income excluding ESOPs perquisites/ Total Income including ESOPs perquisites 

Conclusion 

Employee Stock Option Plan is an employee benefit program that brings twofold advantage to the employer as well as the employees. Apart from the two-fold advantage of the scheme, the ESOPs also bring a step tax liability on the account of the employee. 

Frequently Asked Questions 

Q1. Are stock options Taxable Income?

Ans1. Yes, stock options are taxable income or a deductible loss in case a person sells the stock. 

Q2. Are stock options taxed twice?

Ans2. Yes, the taxability of the stock options comes into play twice, as firstly it is applicable when the stock option is exercised and secondly during the time of selling of these shares. 

Q3. How are restricted stock options taxed?

Ans3. Restricted stock options are taxed by using the value of the vesting date. 

Q4. Is ESOP taxed twice in India?

Ans4. Yes, ESOPs are taxed twice in India. 

Q5. How to disclose ESOP in ITR?

Ans5. An Indian Resident is required to mandatorily file the Schedule FA and Schedule FSI while filing the ITR to report the ESOP. 

Q6. Is ESOP part of CTC?

Ans6. Yes, ESOPs are part of an employee’s CTC and a CTC typically includes the Salary, Variable Components and other benefits. 

Q7. Is there Income Tax on options trading?

Ans7. The tax on the options trade is treated as the income of the business. The STT on these option transactions is 0.1% of the premium amount. 

Q8. Is ESOP valid after resignation?

Ans8. In the case of the resignation, an employee may lose their unvested share but can retain their vested share in the ESOP. 

Q9. What is the lock-in period for ESOP?

Ans9. Usually, the lock-in period for the ESOP ranges from 1 year to 5 years. 

Q10. Do ESOPs have expiry?

Ans10. Yes, if an employee does not exercise their ESOP before the expiration date, then in such a circumstance, the ESOP will expire and become worthless. 

Q11. What are the taxes on stock options in India? 

Ans11. In India, taxes on stock options are applicable at two stages: first, as a perquisite tax when the employee exercises the stock options, and second, as capital gains tax when the employee sells the shares. The perquisite is taxed under the head “Salary,” and the capital gain is based on the holding period.

Q12. How is ESOP tax calculated for employees?

Ans12. The employee stock options tax is calculated as the difference between the Fair Market Value (FMV) of the shares on the exercise date and the exercise price paid by the employee. This value is treated as a perquisite and taxed as salary income. Use an ESOP tax calculator India to estimate your tax liability accurately.

Q13. Is there a way to schedule tax-deferred on ESOP in India?

Ans13. Yes, eligible startups under Section 80-IAC can defer the schedule of tax on ESOPs. Employees of such startups can defer the tax on share options until the earliest of the following: 48 months after the end of the relevant assessment year, sale of the shares, or termination of employment.

Q14. What is the taxation of stock options at the time of sale?

Ans14. At the time of sale, the taxation of stock options falls under capital gains tax. The gain is the difference between the sale price and the FMV on the date of exercise, which is considered the cost of acquisition. The holding period from the date of allotment determines whether it’s short-term or long-term capital gain.

Q15. How is ESOP valuation done for tax purposes?

Ans15. ESOP valuation for tax purposes depends on whether the shares are listed or unlisted. For listed shares, FMV is the average of opening and closing prices. For unlisted shares, a Merchant Banker must determine the FMV either on the exercise date or within 180 days prior. This valuation is crucial for accurate tax reporting.

Q16. Do employees have to pay tax on share options even if they don’t sell them? 

Ans16. Yes, employees pay tax on share options at the time of exercising the ESOPs, regardless of whether they sell the shares. This is because the exercise itself triggers a taxable perquisite based on the FMV of the shares.

Q17. How do I report ESOPs in my ITR?

Ans17. To report employee stock options tax in your Income Tax Return (ITR), include the perquisite value under Salary income. If shares were sold, report the capital gains separately. Indian residents must also fill out Schedule FA and Schedule FSI if the ESOPs involve foreign assets.