Employees Stock Option Scheme or ESOPs as they are commonly referred to, are options given by the employer companies to their employees to buy shares at a future date at a pre-determined price. It is an option to the employee and not an obligation to buy.
Generally, there are three terminologies used in ESOP scheme:
Grant date ——-> vesting date ———-> exercise date
The date when the employee is given the option to buy the shares at a future date
The date when employee actually gets the right (though not the obligation) to buy the shares after certain conditions are fulfilled.
Vesting period :
This is the actual period between grant date and vesting date.
The date when employee actually purchases the shares.
Once the options are vested, they can be generally exercised anytime by the employee. The period between vesting date and exercise date is called exercise period.
Types of plans:
- Employee Stock Option Scheme
- Employee Stock Purchase Plan
- Phantom Stocks / Stock Appreciation Rights
- Restricted Share Purchase Units
Employee Stock Option Scheme (‘ESOS’)
Under ESOS, the employee has a right but not an obligation to purchase certain number of shares at a future date at a pre-determined price. Normally, there are certain conditions to be fulfilled before the ESOPs get vested on the employee. These conditions can be like being in employment with the company for certain period of time or achieving a particular milestone etc. Once the ESOPs get vested, the employee can purchase the shares, or in other words, exercise the options.
Employee Stock Purchase Plan:
Under this plan, the employees are offered shares at a certain discount on market price. The shares are issued generally with certain lock-in period or conditions.
Phantom Stocks / Stock Appreciation Rights (SAR):
Under these plans, as the name suggests, the employees are provided with notional shares. They have an option to exit at a future date at a price to be derived at based on a pre-determined formula. On exercise of the phantom stocks / SAR, the Company will be obligated to pay cash based on the valuation formula specified therein.
Restricted Share Purchase Units (RSUs):
Under RSUs, shares are granted to the employees as and when vesting rights accrue. Vesting is generally subject to fulfilment of certain conditions. Generally, the employees do not have to pay any price for the shares so granted.
Income tax implications in India:
- In this para, we will discuss the tax treatment applicable where ESOPs or other plans are given by Indian employer company to its Indian employees:
- Employee Stock Option Scheme:
On exercise of ESOPs, the difference between the Fair Market Value (‘FMV’) and the exercise price is considered as perquisite and is taxed under the head ‘salaries’. The tax deduction at source (‘TDS’) is also done accordingly.
Later on, when these shares are sold, the resultant profit is considered as capital gains and taxed as long term or short term capital gains depending on the period of holding. While calculating the amount of capital gains, the cost of acquisition will be equal to the fair market value on exercise date which was considered for valuation of perquisite.
Valuation [Rule 3(8) and 3(9) of Income tax Rules]:
In case of listed shares, the FMV will be the price as on the date of exercise. In case of unlisted shares, the FMV will be as per the valuation done by Category – I Merchant Banker registered with SEBI.
Employee Stock Purchase Plan (‘ESPS’):
Generally, ESOPs have a vesting period before they can be exercised. Under ESPS, the employees are given the option to buy the shares at a discount. The difference between the market value and the actual purchase price will be treated as perquisite. On subsequent sale, the gain or loss will be treated as capital gains.
- Phantom stocks or Stock Appreciation Rights:
As already discussed, under these plans, employees are not allotted actual shares. On exercise of phantom stocks or SAR, the employees are paid cash based on pre-determined formula. This cash compensation will be taxable as salary.
In some cases, the employees are also allotted shares. In that case, the fair market value of shares will be treated as salary.
- Cross border ESOPs:
- ESOPs of foreign holding company:
Under this arrangement, the employees of Indian company are given ESOPs of its holding company abroad. The basic tax treatment remains the same. The point of taxation is the date when ESOPs are exercised. The difference between the fair market value and exercise price is taxed as salary and the Indian employer company would deduct tax at source accordingly.
On sale of shares, the resultant profits or gains will be taxed as capital gains.
Complexities arise when the country of the holding company also levies tax at the time of exercise of the option. Under such cases, one needs to refer to the provisions of Double Taxation Avoidance Agreement (DTAA) between India and the other country.
Also, any dividends arising out of such shares may be taxed in the foreign country and the tax payer may have to claim credit of taxes paid abroad. Much of this would depend on the facts of each case and the provisions of each DTAA.
Once the options are exercised, they are like any other shares. On sale, the resultant gain will be taxed as long term / short term capital gains. Here, one needs to take care, that there may be tax payable in the foreign country where the shares are held. Further, under the Foreign Exchange Management Act (‘FEMA’) in India, the sale proceeds on sale of shares by a person resident in India needs to repatriated back to India within 90 days of sale.
- ESOPs issued by Indian parent company to employees of foreign subsidiary:
Generally, in such cases, the value of shares can be taxed as salary. One can take benefit of DTAA provisions and claim that the ESOP value should not be taxed in India since there were no services rendered or employment exercised in India.
The other view can be that since there is no employer-employee relationship between the Indian company and the foreign employee, this should be categorised as ‘income from other sources’ in India. Since there was no economic activity being carried on in India, whether the income should be really taxed in India, has always remained a subject matter of controversy.
However, these are very fact specific issues and it is advisable to seek a professional opinion before reaching any conclusion.
Further, when the shares are sold in India, the foreign employee will also be liable to capital gains tax subject to treaty provisions. Also, any dividend earned from these shares will be taxable in India subject to the provisions of DTAA.
- In case of mobile employees:
In these times when it is very normal for employees to be mobile and on deputation to different countries, complexities may arise when ESOPs are vested while in one country, they are exercised while in another country and sold when in third country.
Different countries may tax depending upon the time the individual might have served in these countries. This may also give rise to double taxation.
- ESOPs by start-ups:
Vide Finance Act, 2020, the Indian government has provided some relaxations to start-ups by deferring the payment of tax on ESOPs issued by such start-ups to its employees. With effect from previous year 2020-21 (assessment year 2021-22), the employer company which an eligible start-up shall deduct tax at source from the value of ESOPs considered as perquisite after passage of four years of exercise of option or on sale of such shares by employee or on his ceasing the employment with such start-up whichever is earlier.
For a start-up to be eligible for this benefit, it should be satisfying certain conditions and holds certificate as mentioned in section 80-IAC of the Income tax Act.