Taxation on ESOPs Uncovered!

Remunerating employees with Employee stock options (ESOP) is becoming common in this new start-up world to retain their workforce. ESOPs is a representation of the ownership in the company. It is given to the employees at a lower price than the fair market value (FMV). In other words, shares are given at a discounted rate. However, the delight of earning ESOPs may fade quickly when employees are required to pay tax in accordance with the Income Tax Act in India.

It is very important to know the tax rules applicable on ESOP before accepting the offer. There might be chances that you have to pay taxes even before the value is realised. They are taxed in two ways one as a perquisite forming the part of salary and the other is in the form of capital gains at the time of selling the shares.

The entire global income from any sources of a tax resident of India is taxable in India. Any individual qualifies as a resident if he/she has stayed in India for more than 182 or meets any other conditions of stay in the 4 preceding years.

The tax treatment for ESOP given by foreign entities is not very different from how ESOPs are given in Indian companies. The period of holding foreign shares is 24 months. Short term capital gains are taxed at slab rates, while 20% is charged on long term capital gains with indexation benefits.

If you are working remotely for a company based out of India you are liable to pay taxes in India. This can be taxed in two ways. First, when you sell those shares as capital gains. Second, the difference between the fair market value and selling price will be recorded under the head income from salary as a perquisite and will be taxed at normal tax rates.

Some important terminologies that you should know.

• Grant Date - The agreement between the employer and employee to give an option to own the share.

• Vesting Date - The date when the employee is entitled to buy the shares.

• Vesting Period - The interval between the grant date and the vesting date.

• Exercise period - The employee has the right to buy but not an obligation the shares for a time period.

• Exercise date - The date when the employee exercises the option.

• Exercise price - The price at which the employee sells the option.

To summarise, ESOPs play an important part in the design of an employee's compensation plan. The advantage of tax deferral should not be limited to "qualified startups." Even if the assistance given to 'qualified startups' is not as appealing, a scaled-down version of the same may still be required.

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Writer - Mayank Choudhary