Are you getting ESOPs as salary package? Know about taxability under Income tax Act, 1961

Background

ESOPs has gained popularity in last few decades and has been a factor to motivate, attract and retain the valuable employees in the organization by giving them a sense of ownership in the company by way of grant of ESOPs at pre-determined price or free of cost.

However, taxability of the ESOPs acts as roadblock. Thus , in this article, we have tried explaining the taxability of ESOPs in India.

Definitions

ESOP –Employee Stock Option Plan allows an employee to own equity shares of the employer company over a certain period of time.

Grant Date –The date of agreement between the employer and employee to give an option to own shares (at a later date).

Vesting Date –The date on which the employee is entitled to buy shares, after fulfilling all the conditions agreed upon. This date is also the agreed-on grant date.

Vesting Period – The time period between the grant date and vesting date which is agreed upon between the employer and employee .

Exercise Period – Once stocks options have ‘vested’ i.e vesting period is over, the employee now has a right to buy (but not an obligation) the shares within a period of time. This period is called exercise period.

Exercise Date – The date on which employee exercises the option.

Exercise Price – The price at which employee exercises the option at an agreed price.

Taxability under Income Tax Act, 2020

• In the FY of allotment of ESOPs

As per Section 17(2)(vi) - The value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at concessional rate to the assessee.

Explanation.—For the purposes of this sub-clause,—

(a) "specified security" means the securities as defined in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and, where employees' stock option has been granted under any plan or scheme therefor, includes the securities offered under such plan or scheme;

(b) "sweat equity shares" means equity shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called;

(c) the value shall be the fair market value of the specified security or sweat equity shares, as the case may be, on the date on which the option is exercised by the assessee as reduced by the amount actually paid by, or recovered from, the assessee in respect of such security or shares;

(d) "fair market value" means the value determined in accordance with the method as may be prescribed;

(e) "option" means a right but not an obligation granted to an employee to apply for the specified security or sweat equity shares at a predetermined price;

Analysis

When the employee has exercised the option, basically agreed to buy; the difference between the FMV (on exercise date) and exercise price is taxed as perquisite when the shares are allotted to the employee as per section 17(2)(vi).

Value = FMV* on exercise date - Agreed pre-determined Price paid by employee

Tax Rate = Income tax slab rate will be applicable and taxed accordingly.

Illustration - On July 1, 2016 Mr. Ram an employee of ABC Pvt Ltd  has been given an option under ESOP , to purchase 1000 shares of ABC Ltd. As per the policy, the option can be exercised at the end of 3 years(vesting period) i.e. July 1, 2019 at an exercise price of INR. 600.(pre-determined price).

On July 1, 2019, Mr. X exercised the his option. The fair market price of the shares of ABC Ltd at that time was INR 1000 and allotment made on August 1, 2019.

ESOPs would be taxed as perquisite:-

the value of which would be (on date of allotment) = (FMV per share – Exercise price per share) x number of shares allotted.

i.e (1000-600) x 1000 = 400,000

The amount calculated above as perquisite value of ESOP i.e. Rs. 4,00,000 shall form part of Ram’s salary and be taxable in the year of allotment of such shares i.e PY 19-20. Employer is liable to deduct TDS on such amount.

How to calculate FMV:- As per Rule 3(8) and (9) of the Income Tax Rules:-

(8)(i)The fair market value of any specified security or sweat equity share, being an equity share in a company, on the date on which the option is exercised by the employee, shall be determined in accordance with the provisions of below clause:-

The share in the company is listed on a recognized stock exchange:-

On the date of the exercising of the option, the fair market value shall be the average of the opening price and closing price of the share on that date on the said stock exchange.

The share is listed on more than one recognized stock exchanges:-

On the date of exercising of the option, the fair market value shall be the average of opening price and closing price of the share on the recognized stock exchange which records the highest volume of trading in the share.

There is no trading in the share on any recognized stock exchange

On the date of exercising of the option, , the fair market value shall be—

(a)the closing price of the share on any recognised stock exchange on a date closest to the date of exercising of the option and immediately preceding such date; or

(b)the closing price of the share on a recognised stock exchange, which records the highest volume of trading in such share, if the closing price, as on the date closest to the date of exercising of the option and immediately preceding such date, is recorded on more than one recognized stock exchange.

The share in the company is not listed on a recognised stock exchange

On the date of exercising of the option,, the fair market value shall be such value of the share in the company as determined by a merchant banker on the specified date.

Click here for full text of Rule 3(8) & (9)

• At the time of sale of ESOPs by employee

Once the shares bought by the employee, the employee may want to sell the shares after holding the share for certain period (i.e Holding period).

When employee sells these shares, another tax event gets trigger i.e. Capital gain tax

Capital Gain = Sale price and FMV on the exercise date.

Capital gain can be long term or short term, depending upon the period of holding of such shares. The period of holding shall be computed from the date of allotment of such shares as per section 2(42A).

Note - As per section 49(2AA), the FMV as per Rule 3(8) considered for determining the perquisite value u/s 17(2)(vi) shall be taken as cost of acquisition. This ensures that the employee does not suffer double taxation on the perquisite value already taxed as salaries.

Tax rate on capital gain will be decided on the basis of holding period.

1. In case of short term capital gain

In respect of shares (equity or preference) which are listed in a recognised stock exchange in India, units of equity oriented mutual funds, listed securities like debentures and Government securities, Units of UTI and Zero Coupon Bonds, the period of holding to be considered is 12 months.

Tax rate = 15% on short term capital gains.

2. In case of long- term capital gain

In respect of shares (equity or preference) which are listed in a recognised stock exchange in India, units of equity oriented mutual funds, listed securities like debentures and Government securities, Units of UTI and Zero Coupon Bonds, the period of holding to be considered is more than 12 months.

Tax rate

The Finance Act, 2018 inserts a new Section 112A with effect from Assessment Year 2019-20.

As per the new section capital gains arising from transfer of a long term capital asset being an equity share in a company or a unit of an equity oriented fund or a unit of a business trust shall be taxed at the rate of 10 per cent of such capital gains exceeding Rs. 1,00,000.

This concessional rate of 10 per cent will be applicable if:

a) in a case of an equity share in a company, securities transaction tax has been paid on both acquisition and transfer of such capital asset; and

b) in a case a unit of an equity oriented fund or a unit of a business trust, STT has been paid on transfer of such capital asset.

The cost of acquisitions of a listed equity share acquired by the taxpayer before February 1, 2018, shall be deemed to be the higher of following:

a) The actual cost of acquisition of such asset; or

b) Lower of following:

(i) Fair market value of such shares as on January 31, 2018; or

(ii) Actual sales consideration accruing on its transfer.

Hence, the benefit of grandfathering of cost will be available.

Illustration( In continuation of above illustration)

Mr Ram decides to sell the share on January 01, 2020 @ Rs. 1200 each.

In that case, he would be liable to pay capital gain tax , which shall be calculated as follows:

Capital gains = Sale proceeds – FMV of shares at the time of allotment of shares

(1200 – 1000) x 1000 = Rs. 200,000

Long-term or short term ?

Since the holding period of shares in the hands of X is more than 12 months (will be counted from the date of allotment), gains will be classified as Long-term Capital Gains and will be taxable as per the section 112A i.e Rs. 100000 is not taaxable and balance Rs. 100,000 @10% as per grandfathering provision since allotment of the shares is done prior to 31.1.2018 and the Company was listed as on 31.1.2018.

Amendment by Budget 2020

From the PY 2020-21, an employee receiving ESOPs from an "eligible start-up" need not pay tax in the year of exercising the option and the TDS on the ‘perquisite’ may be deducted under section 192 within 14 days -

• after expiry of five years from the end of assessment year of allotment of ESOPs

• from date of sale of the ESOPs by the employee

• from date of termination of employment

Tax shall be calculated based on rates in force for the previous year in which said ESOPs is allotted to the employee.

CONCLUSION

To conclude, ESOP is one of the way to build the corpus for retirement which have some risk since investment is in equity shares of company. However, it acts as a motivational tool for employees to be retained, be motivated, and be enthusiastic for the company and work towards the goal of the company serving dual objectives i.e. company success along with employee wealth creation. Besides this, company get an opportunity to retain the desirable candidates by framing such plan for them.