What is ESOP?

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).

What is ESOP Meaning

ESOP full form stands for 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 taxation in India is done as a prerequisite and is subject to tax at the time of exercise or transfer of shares to the employee.

Some popular ESOP example in India includes those offered by L&T, ICICI Bank, Infosys and many other companies when they were starting up.

How Does an Employee Stock Ownership Plan (ESOP) 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.

ESOP Initial Costs and Distributions

In India, the initial costs of an Employee Stock Ownership Plan (ESOP) can include legal fees, accounting fees, and administrative costs.

The cost of creating and maintaining an ESOP varies based on the size and complexity of the plan.

Furthermore, ESOP distributions in India might take place in various methods.

When an employee exercises their stock option to acquire shares, they have the choice to sell the shares right away or store them for prospective appreciation.

If the employee decides to sell the shares, the proceeds will be sent to them, less any taxes owing on the gain. If the employee decides to keep the shares, they will have a stake in the firm and may receive dividends or capital gains if the stock price rises.

Benefits of ESOPs for Employees

Here we have listed ESOP benefits that are advantageous for employees in the following ways-

• Stock Ownership

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.

• Dividend Income

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.

• Buy Shares at a Discounted Rate

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.

Benefits of ESOPs for Employers

ESOPs are favourable for employers too. Here’s how:

• Employee Retention 

Since employees have to wait out the vesting period before they can exercise their ESOPs, it becomes easier to retain employees.

• Better Productivity

Since employees themselves stand to gain from the profits earned by the company, ESOPs can boost employee productivity and make the company more profitable.

• A Tool for Attracting Talent

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.

Tax Implication of ESOPs

There are dual tax implications of ESOPs. 

1. When the employee exercises his/her rights and buys the shares of the company
   
2. When the employee sells the shares after buying them

Let’s understand these instances in detail:

• Tax Treatment at the Time of Buying the Shares

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.

ESOP Example

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:

• Completion of five years from the ESOP grant date
• Date when the employee sells the ESOP
• Date of leaving the company

• Tax Treatment at the Time of Selling the Shares

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:

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.

What Happens to ESOPs when the Company is Listed?

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 Capital 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.