What are ESOPs?
Employee Stock Option Plans (ESOPs) are employee benefit plans that give employees the right to purchase company shares at a predetermined price (exercise price) after a specified vesting period. ESOPs are widely used by startups and established companies to attract, retain, and reward employees.
Key ESOP Terminology
- • Grant: When company offers ESOPs to employee
- • Vesting: Process of earning the right to exercise options
- • Exercise: Converting options into actual shares by paying exercise price
- • Exercise Price: Price at which employee can buy shares
- • Fair Market Value (FMV): Market value of shares on exercise/sale date
- • Spread/Perquisite Value: Difference between FMV and exercise price
ESOPs align employee interests with company performance and provide an opportunity for wealth creation when the company grows in value.
Two Stages of ESOP Taxation
ESOPs are taxed at two distinct stages under Indian tax laws:
Stage 1: At Exercise (Perquisite Tax)
Taxed as "Income from Salaries"
- • Taxable in the year of exercise
- • TDS deducted by employer
- • Taxed at slab rates
- • Added to Form 16
Stage 2: At Sale (Capital Gains)
Taxed as "Capital Gains"
- • Taxable in the year of sale
- • No TDS (unless NRI)
- • Separate tax rates apply
- • Reported in ITR Schedule CG
Perquisite Tax on Exercise
When an employee exercises ESOPs (converts options into shares), the difference between the Fair Market Value (FMV) on the exercise date and the exercise price is treated as a perquisite and taxed as salary income.
Perquisite Value Calculation
Perquisite Value = (FMV per share - Exercise Price per share) × Number of shares exercised
Example Calculation
Employee Details:
- • ESOPs granted: 1,000 shares
- • Exercise price: ₹100 per share
- • FMV on exercise date: ₹500 per share
Perquisite Value:
(₹500 - ₹100) × 1,000 = ₹4,00,000
This ₹4,00,000 is added to salary income and taxed at applicable slab rates.
TDS by Employer
- • Employer must deduct TDS on the perquisite value
- • TDS deducted at the time of exercise
- • Reflected in Form 16 Part B
- • Employee receives Form 12BA detailing perquisites
Capital Gains on Sale
When the employee sells the ESOP shares, any gain over the FMV at exercise is treated as capital gains. The tax treatment depends on whether the shares are of a listed or unlisted company and the holding period.
Holding Period and Tax Rates
| Company Type | Short-term | Long-term | STCG Rate | LTCG Rate |
|---|---|---|---|---|
| Listed (STT paid) | ≤ 12 months | > 12 months | 15% | 10% above ₹1 lakh |
| Listed (STT not paid) | ≤ 12 months | > 12 months | Slab rates | 20% with indexation |
| Unlisted | ≤ 24 months | > 24 months | Slab rates | 20% with indexation |
Cost of Acquisition
For capital gains calculation, the cost of acquisition is the Fair Market Value (FMV) on the date of exercise (not the exercise price paid). This is because tax was already paid on the difference as perquisite.
Example Calculation
Sale Details:
- • Shares sold: 1,000
- • FMV at exercise: ₹500 per share
- • Sale price: ₹800 per share
- • Holding period: 3 years (unlisted company)
Capital Gains Calculation:
- • Sale consideration: ₹800 × 1,000 = ₹8,00,000
- • Cost of acquisition: ₹500 × 1,000 = ₹5,00,000
- • Indexed cost of acquisition: ₹5,00,000 × (Cost Inflation Index of sale year / CII of exercise year)
- • Long-term Capital Gain = Sale price - Indexed cost
ESOP Valuation Methods
Fair Market Value (FMV) determination is crucial for ESOP taxation. Different methods apply based on whether the company is listed or unlisted.
Listed Companies
- • FMV = Average of opening and closing price on the exercise date on the recognized stock exchange
- • If traded on multiple exchanges, consider the exchange with highest trading volume
- • If no trading on exercise date, consider the closing price of the immediately preceding trading day
Unlisted Companies
- • FMV determined by Merchant Banker registered with SEBI
- • Valuation report required as per Rule 3(8) of IT Rules
- • Valuation valid for 180 days from the date of the report
- • Methods: DCF, NAV, comparable company analysis
Valuation Importance
Incorrect valuation can lead to tax disputes. The tax authorities may challenge undervaluation, leading to additional tax, interest, and penalties. Always obtain a proper valuation report from a registered valuer.
Startup Benefits under Section 80-IAC
To ease the cash flow burden on employees of eligible startups, the government has provided a tax deferment benefit. Under Section 80-IAC, employees of DPIIT-recognized startups can defer the perquisite tax on ESOPs.
Deferment Conditions
- • Deferment period: Up to 5 years from the date of exercise, OR
- • Until the employee sells the ESOP shares, OR
- • Until the employee ceases to be an employee of the startup
- • Whichever is earlier
Eligible Startups
- • DPIIT-recognized startups under Startup India scheme
- • Incorporated between April 1, 2016 and March 31, 2024
- • Turnover not exceeded ₹100 crores in any previous year
- • Working towards innovation, development, or improvement of products/processes
Important Note
The benefit is only for deferment of perquisite tax, not exemption. The tax will eventually have to be paid when the deferment period ends or shares are sold. Interest may apply on deferred tax.
Reporting ESOPs in ITR
Stage 1: Perquisite Reporting
- • Report in Schedule Salary under "Value of perquisites"
- • Amount as per Form 16/12BA
- • TDS credit available in Schedule TDS
Stage 2: Capital Gains Reporting
- • Report in Schedule CG (Capital Gains)
- • Select "Shares" as type of asset
- • Provide ISIN if listed, "Others" if unlisted
- • Enter full value of consideration, cost of acquisition, and holding period
- • Claim exemption under Section 54F if applicable (residential property investment)
Schedule Foreign Assets (if applicable)
If ESOPs are of a foreign company, report in Schedule FA (Foreign Assets) including:
- • Equity shareholding details
- • Income accrued from foreign assets
- • Sale consideration if sold
ESOP Tax Planning Tips
Timing of Exercise
- • Exercise in years with lower taxable income
- • Consider vesting schedule and tax brackets
- • Exercise in tranches to spread tax liability
Timing of Sale
- • Hold for 12/24 months to get LTCG benefits
- • Plan sale across financial years if gains are large
- • Consider basic exemption limit utilization
Startup Benefits
- • Claim deferment if eligible startup employee
- • Understand when deferment ends
- • Plan for eventual tax payment
Other Strategies
- • Invest LTCG in Section 54F bonds/property
- • Set off capital losses against gains
- • Claim Section 80C deductions to reduce overall tax
Frequently Asked Questions
Q: Is there any tax at the time of ESOP grant?
No, there is no tax liability when ESOPs are granted. Tax liability arises only at the time of exercise (perquisite tax) and at the time of sale (capital gains).
Q: Can I claim exemption on capital gains from ESOP sale?
Yes, you can claim exemption under Section 54F by investing the net sale consideration in a residential house property in India, subject to conditions and timelines.
Q: What if I exercise ESOPs but don't sell the shares immediately?
You will pay perquisite tax in the year of exercise based on FMV at that time. Capital gains tax will apply only when you eventually sell the shares, based on the difference between sale price and FMV at exercise.
Q: Are ESOPs of foreign companies taxed differently?
The tax structure is similar, but foreign ESOPs must be reported in Schedule FA of ITR. Additionally, if tax is deducted abroad, you may claim Foreign Tax Credit under DTAA provisions.
Q: Can I offset capital losses from ESOPs against other gains?
Yes, short-term capital losses can be set off against both short-term and long-term capital gains. Long-term capital losses can only be set off against long-term capital gains. Unadjusted losses can be carried forward for 8 years.
Q: What documents should I maintain for ESOP taxation?
Maintain: ESOP grant letter, vesting schedule, exercise confirmation, FMV certificate/valuation report, sale contract/statements, Form 16/12BA, and bank statements showing exercise price payment and sale proceeds.
Q: Does the employer always deduct TDS on ESOP perquisite?
Yes, the employer is obligated to deduct TDS on the perquisite value at the time of exercise. The TDS is added to your overall TDS and reflected in Form 16 and Form 26AS.
Q: What happens to ESOPs if I leave the company?
Unvested options typically lapse. Vested options can usually be exercised within a specified period (often 90 days) after resignation. Tax treatment remains the same based on exercise and sale dates.