Employee compensation has gone beyond the basic pay package that employers offer. Nowadays, employees are offered much more than just their salary slips; one such benefit is the Employee Stock Ownership Plan (ESOP).
ESOP full form is Employee Stock Ownership Plan. Under this plan, employers offer their employees the stock of the company at a low or no additional cost that they can encash after a specified period at a specific price. ESOP examples in India include those offered by Flipkart, Myntra, and other companies when they were starting up.
How Do ESOPs Work?
Employers decide the number of shares to be offered under ESOPs, their price, and the beneficiary employees. ESOPs are, then, granted to employees and a grant date is provided.
Once ESOPs are offered, they remain in a trust fund for a specific period, called the vesting period. Employees should stay with the organization for the vesting period to avail the ownership of stock by exercising the ESOP.
Once the vesting period expires, employees get the right to exercise their ESOPs. The date on which the vesting period expires is called the vesting date. Employees can exercise their ESOPs and buy the company shares at allotted prices, which are lower than the market value. Employees can also sell the shares that they have bought through ESOPs and make a gain on their holdings.
If the employee leaves the organization or retires before the vesting period, the company is required to buy back the ESOP at a fair market value within 60 days.
ESOPs are beneficial for employees in the following ways:
Employees can enjoy ownership in the company that they work for as ESOPs give them the right to own a part of the company’s share capital.
A part of the profit earned by the company is distributed among the shareholders in the form of dividends. Employees can, therefore, earn additional dividend income and also get the direct benefit from the efforts that they put toward the company’s profitability.
At the time of exercising the ESOPs, employees usually pay a nominal amount to buy the shares allotted to them. This, therefore, allows them to invest in the company at a preferential rate.
ESOPs are favorable for employers too. Here’s how:
Since employees have to wait out the vesting period before they can exercise their ESOPs, it becomes easier to retain employees.
Since employees themselves stand to gain from the profits earned by the company, ESOPs can boost employee productivity and make the company more profitable.
ESOPs are additional compensation plans that help employers attract and retain talented employees. In fact, for start-ups, ESOPs help lure in good talent in the initial days when high pay packages are not feasible.
There are dual tax implications of ESOPs.
Let’s understand these instances in detail:
Employees can buy the shares after the vesting date at a rate lower than the Fair Market Value (FMV) of the share as of that date. As such, the difference between the FMV and the exercise price of the share is treated as a prerequisite in the hands of the employee and taxed at his income tax slab rate.
| Exercise date | January 1, 2021 |
| FMV | Rs. 150/share |
| Exercise price | Rs. 85/share |
| Taxable value of perquisite | 150 − 85 = Rs. 65/share |
| Number of shares exercised | 1,000 |
| Total taxable perquisite | 1,000*65 = Rs. 65,000 |
| Tax payable (assuming a tax slab of 30%) | 30% of 65,000 = Rs. 19,500 |
In the case of start-ups, however, the government has relaxed the tax implications on ESOPs. Start-up employees would not have to pay the tax on the perquisite in the year when they exercise the ESOP. For them, TDS on ESOPs would be deferred to the following dates, whichever is earlier:
If the employee sells the shares, the difference between the selling price of the share and the FMV on the date when the share was exercised, would be subject to capital gains tax.
If the gains are earned from selling the shares after 12 months of buying them, 10% tax would be applicable on gains exceeding Rs. 1 lakh. If, however, the shares are sold within 12 months, the gains would be taxed @15%.
In the above example, if the employee sells the shares, here’s how the tax would be calculated:
| Exercise date | January 1, 2021 |
| FMV as of January 1, 2021 | Rs. 150/share |
| Case 1: Shares sold on October 1, 2021 | |
| FMV on October 1, 2021 | Rs. 165/share |
| Difference between the FMVs | 165 − 150 = Rs. 10/share |
| Number of shares | 1,000 |
| The total amount of short-term capital gain | 1,000*10 = Rs. 10,000 |
| Short-term capital gains tax payable | 15% of 10,000 = Rs. 1500 |
| Case 2: Shares sold on February 2, 2022 | |
| FMV on February 2, 2022 | Rs. 180/share |
| Difference between the exercise FMV and sale FMV | 180 − 150= Rs. 30/share |
| Number of shares | 1,000 |
| The total amount of long-term capital gain | 1000*30 = Rs. 30,000 |
| Long-term capital gains tax payable | Nil as the gain is below Rs. 1 lakh |
Taxation of foreign ESOPs in India is also similar, and you would be taxed in India on the perquisites earned from a foreign company.
ESOP calculators in India also allow you to compute your tax liability instantly rather than indulging in complex calculations yourself.
For unlisted companies, selling shares bought through ESOPs is a challenge as there might be a few takers, and the FMV is determined by merchant bankers. Moreover, capital gains are taxed as per debt funds. This means that shares sold within 36 months of exercising them attract short-term capital gains wherein the gains are taxed at your income tax slab rates. Long-term gains, i.e., those earned from selling the stock after 36 months, are taxed @20% with indexation.
Once the company is listed, however, employees get more opportunities to cash out their shareholding. Moreover, the FMV is determined by market movements.
Therefore, understand what ESOPs are, how they work, their benefits, and tax implications. Remember what is the vesting period in ESOPs before you are allowed to exercise them. They might prove to be an attractive component of your pay package, but you should understand them completely to utilize the full potential that they have to offer. Further, use the ESOP tax calculator in India to find out your tax liability when you are exercising ESOPs or selling the shares so exercised.