Taxation of ESOPs: Recent Changes
Allotment of ownership stake or shares to the important employees of an organization has become a significant part of corporate human resources culture in India. This is institutionalised through Employee Stock Options Plan (ESOPs) wherein the company offers shares at a discounted price, employee stock purchase plans meaning the employees can purchase shares with a lock-in period and stock appreciation rights where employees are rewarded with pay-outs at better valuation of company’s shares. These are also used as substitutes for remuneration owed to the employees helping the companies to conserve on cash or tide over financially challenging times. The latter strategy has been tested very well in the start-up ecosystem of India who are short of cash but want sharp-skilled manpower. In fact, for this ecosystem, it has been proved as a win-win situation.
Since the ESOPs are basically the remuneration paid to employees instead of cash pay-outs, they attract income tax in the hands of employees and in turn employers are required to deduct TDS on such income. This part of ESOP process was preventing it from being a completely pay-out neutral mechanism and in the end 30% of cash was anyways going out of the system. This cause of anxiety amongst start ups in India was picked up by the Government in last Budget and redressed by deferring the payment of such tax.
How do ESOPs work?
Based on the different criteria and parameters, the company announces that it is offering ESOP to employees and they may exercise the option at a definite price which is generally lesser than the fair value of the company’s shares. After this declaration, the employee exercises the option for a finite number of shares. Upon such exercise, the employees are allotted number of shares by the company with or without certain conditions. The declaration, exercise of option and allotment may happen in different periods and may also transcend two or three financial years. After some time, the employee may sell those shares for a price in open market. This is the process of ESOP.
How are the ESOPs taxed till Budget 2020-21?
ESOPs are basically the components of salary package given to the employees. So, these are taxed as income from salary. The Income tax Act through Section 17(2) has categorised the ESOPs compensation as ‘perquisites’ and the value of such perquisites is taxed as income from salary in the hands of employees. The value of such ESOPs is computed as per the Rule 3(8)(ii) of Income tax Rules. The value of ESOPs is determined as on the date of exercise of options and not on the date of allotment. However, the tax payment liability is relevant to the date of allotment shares. For instance, Shri Satish was eligible for ESOP by his employer for allotment of 1000 shares at ₹50 apiece. He exercised the option in March-2021 (F Y 2020-21), however, the company allotted the shares to him in December 2021 (F Y 2021-22). The fair value of shares of company in March 2021 was Rs. 100 and that in December 2021 was ₹150. The value of perquisites of Shri Satish is determined at ₹ 50000/- [(100-50) x 1000]. The employer is required to include this amount of ₹ 50000/- in his Form 16 as valuation of perquisites and deduct TDS. However, the employer is required to do this in next financial year 2021-22 when the shares were finally allotted and not in the year of exercise of option.
The second incidence of tax on ESOP arises when the allottee sells those shares. From the above example, suppose that Shri Satish sold 500 shares for a total amount of ₹200,000/- in February 2025. Then in F Y 2024-25, he will have to pay tax on capital gains income on sale of such shares. This shall be computed by deducting the cost of such shares from the sale value. And such cost shall be the amount determined as perquisites plus the amount he paid. Shri Satish will accrue capital gains income of ₹150000 (₹200000-50000) in F Y 2024-25.
Thus, ESOPs give rise to tax outgo at two times, one at the time of allotment as income from salary and at the time of sale as income from capital gains.
What is the relief from F Y 2020-21?
This Budget has touched the first incidence of tax i.e. income from salary with TDS thereon and did not disturb the second incidence of tax i.e. income from capital gains. The changes brought in by Budget have implications for the employee as well as the employer company/LLP.
What are the impacts on employee and employer?
The employees are required to include the amount of taxable ESOP in their Income tax return (ITR) to be filed for assessment year 2021-22 and thereafter. This means they must plan their transactions in the current financial year. The tax amount on the income component related to ESOPs need not be paid by them while filing ITR nor the TDS needs to be deducted by the employer on this component. This Budget has deferred the payment of tax on such income. This has effectively eased the anxiety related to cash outgo on the unrealised income of the employees. So, from financial year 2020-21, the TDS shall not be deducted nor the tax on the said income be paid while filing ITR next year. However, relevant amount of tax needs to be paid within 14 days from any of the following events, whichever is earliest:
- after the expiry of 48 months from the end of the relevant assessment year; or
- from the date of the sale of such ESOP shares by the assessee; or
- from the date of the taxpayer ceasing to be the employee of the ESOP allotting employer,
In case the employer did not deduct TDS and pay to the Government as per above deadlines, then the employee himself must pay the tax according to the same dates. The rates of tax and TDS in such cases shall be the one applicable for the year in which ESOP was allotted.
Shri Satish in the example cited above does not sell his shares nor leaves the employment. In such case, for assessment year 2021-22, Shri Satish has to include the amount of ₹50,000/- in his ITR as income from salary but not pay the tax on the same. Since he is in continuous employment with his employer, he will have to pay tax in assessment year 2025-26. He does not need to include the said amount in his ITR but only in computation of tax and pay the tax as per the rates applicable for assessment year 2021-22. So, for assessment year 2025-26, his tax liability will be increased by the tax on ₹50,000/- which was deferred from assessment year 2021-22. This tax needs to be paid either by Shri Satish on or before 14/04/2026 or his employer must deposit his TDS on or before this date.
How are this to be disclosed in ITR?
The tax and TDS on the ESOPs have been deferred but the accrual of income has not been deferred. The income belongs to the year in which ESOPs are allotted. This means the income must be considered for computation in ITR and disclosed properly. The present ITR forms do not facilitate such a disclosure of income on which tax is to be computed but not paid. The ITR forms need to have separate columns for this income. Since this is relevant for assessment year 2021-22, we expect that the ITR forms of that year may come with relevant columns.
Who are impacted by this tax deferment benefits?
Not all the enterprises and companies giving out ESOPs are benefited by this move is beneficial to those start-ups which fulfil certain conditions-
- the start-up must be incorporated between 01/04/2016 and 31/03/2021
- the total turnover of the start-up must be less than ₹100 crores for the year in which benefit is sought
- it must be certified as eligible start-up by the Inter-Ministerial Board of the Government of India.
The data in the public domain suggests that there are around 250 odd start-up companies which hold the certificate from Inter-Ministerial Board. The number of employees impacted by this and the amount of cash that such employees will be able to conserve or the amount of revenue deferment for the Government is not in public domain yet.