ESOP – Tax Implication and Practical Issue

In today’s world, many multinational companies offer ESOP benefits to employees in the home country as well as to employees based overseas in foreign branches, representative offices and subsidiaries. In the course of their duties, these employees are required to be deputed in different countries and hence taxation rules in the home as well as host country need to be examined to determine the taxability of stock options.

EMPLOYEE Stock Option Plan (ESOP) is an effective tool to attract and retain valuable human capital. Nowadays employers invest a lot of time, effort and money in recruiting and training employees and would definitely want to ensure that employees are retained over a longer time frame. ESOP schemes are in addition to the base pay of the employees and offer to high performing employees a reward accruing over a period of time by allowing them to share their employer’s rising market capitalization due to increase in share prices. ESOP schemes thus seem to be the perfect incentive for employees to ensure a long term alignment with the organization.

How it Works

Under an ESOP, top-performing employees are eligible to purchase a pre-determined number of shares (option granted) in the company at a pre-determined price (also called the exercise price). This is usually at a discount to the market price. Once this option vests with the employees, their decision to buy (or not) such shares has to be conveyed during the vesting period (generally a year or two). After the vesting period, the shares can be bought at the exercise price. At that time, an employee may sell the stock or hold on to it in hopes of further price appreciation. In some cases, companies provide for a specified lock-in period, during which the shares cannot be sold.

Tax Implications

At present, benefits derived from ESOP’s are taxed as perquisites and form part of salary income. The perquisite value is computed as the difference between the Fair Market Value (FMV) of the share on the date of exercise and the exercise price. There are specific valuation rules prescribed for listed and unlisted companies in order to determine the FMV. An employer is required to deduct tax (TDS) in respect of any tax liability arising from perquisites.

Tax implications on sale of such shares – Capital Gains

If the value of any share, debentures or warrants has been taken into account while computing perquisite value under section 17(2)(vi), the cost of acquisition of such shares, debentures or warrants shall be fair market value as considered while calculating perquisite amount under section 17(2)(vi).

In addition, the difference between the sale consideration of the shares and the FMV on the date of exercise (as referred above) is chargeable to tax under the head capital gains in the hands of an employee. In order to compute capital gains, the FMV on the date of exercise becomes the cost of acquiring such shares. Depending on whether they have been held for 12 months or more from the date of exercise, capital gains will qualify as long term or short term. Further, if the shares are sold on a recognized stock exchange in India, the long-term capital gains will be exempt and the short-term capital gains will be subject to the preferential rate of taxes at 15 per cent.

Most employees allotted ESOP’s sell the shares immediately to enjoy the gains and regard this money as a part of a bonus. Consequently, this money is spent on luxury holidays, cars or more productive matters such as pre-paying large home loan balances.

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