Taxation of ESOPs – A tricky tale
These days when acquiring good talent is becoming increasingly difficult, founders are coming up with creative ways to hire and retain employees. Many start-ups are offering hefty salaries along with perks such as insurance, flexible working hours, work from home, sponsorship for education etc. to compensate for the perceived job insecurity at start-ups. Another emerging trend in the start-up ecosystem is the Employee Stock Options Plan (ESOP) which offers employees an option to have actual ownership in the company. Along with building a sense of ownership, it also helps increase the offered CTC to the employees.
ESOP offers employees the right to acquire certain number of shares in the company at a pre-determined rate price after a pre-determined period(s). Before looking at its taxation, let us understand terms specific to ESOP and how exactly it works.
Grant: Generally, options are granted at the time of the employee joining the company through a Grant letter. Granting of stock options means one is entitled to shares in the Company under the ESOP subject to certain conditions. These terms and conditions of options such as number of shares, vesting period, exercise price, etc. is mentioned in the grant letter.
Vesting Period: Vesting can happen only after a cliff period of minimum one year. Vesting means right to convert options to equity. Options get vested as per the schedule mentioned in the grant letter.
Exercise Price: The options, when granted, have an exercise price. Exercising the options by paying the exercise price converts the options to equity shares. This is the point when one becomes a stakeholder in the company and owns a portion of it.
e.g. a Company grants 100 options to an employee on joining with a vesting period 2 years and exercise period of 5 years at an exercise price of Rs.10 per share. In such a case:
| Time | Event | Meaning |
|---|---|---|
| On joining | Granting of 100 options | Right to buy shares but cannot be exercised |
| End of Year 1 | Vesting of 50 options | 50 options can be converted to equity anytime by Year 6 i.e. end of exercise period for these 50 options |
| End of Year 2 | Vesting of remaining 50 options | 50 options can be converted to equity anytime by Year 7 i.e. end of exercise period for these 50 options |
| End of Year 1 to End of Year 7 | Exercise Period | Period in which options can be converted to shares by paying exercise price of Rs.10 per share |
| End of Year 1 to End of Year 6 | Exercising 50 options | Period in which first tranche of 50 options can be converted to shares by paying exercise value of Rs.500 (Rs.10 per share) |
| End of Year 2 to End of Year 7 | Exercising remaining 50 options | Period in which remaining 50 options can be converted to shares by paying exercise value of Rs.500 (Rs.10 per share) |
| After End of Year 7 | Lapse of Options | Options get lapsed if not exercised within exercise period |
Owning options lead to certain tax implications for the employees even though they are mere rights without any obligation to purchase shares.
| Event | Tax Implication |
|---|---|
| Receiving Grant | No tax |
| Vesting of Options | No tax |
| Exercising of Options | Difference between market value and exercise price is treated as perquisites and taxed at normal tax slab rate under salary income |
| Sale of Equity Shares | Difference between sale price and market value on exercise, shall be taxed as capital gains (refer below table for further tax rules). |
Taxation on sale of equity shares differs depending on the type of company in which one is holding shares. Equity shares in Indian Listed Companies, Indian Unlisted Companies (like start-ups) and Foreign Companies (Non-Indian Entity) have different tax treatment as per below table:
| Company | Period of Holding for Short-Term Gains | Short-Term Capital Gain | Long-Term Capital Gain |
|---|---|---|---|
| Listed Company Shares | Less than 12months | Taxed at 15% | Tax-free |
| Unlisted Company Shares (Start-ups) | Less than 24months | Taxed at normal slab rate | Taxed at 20% with indexation |
| Foreign Company (Non-Indian Entity) | Less than 36months | Taxed at normal slab rate | Taxed at 20% with indexation |
Taxation of ESOPs is a tricky task and could go wrong. Therefore, one should be careful before exercising options and/or selling shares as its tax effect is calculated by multiple factors illustrated above.