Under an ESOP, 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 hope of further price appreciation.
The benefits derived from exercising the ESOPs at a discounted price are taxed as perquisites and form a part of the 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 to determine the FMV. An employer is required to deduct tax at source (TDS) in respect of any tax liability arising from perquisites.
In addition, if an employee decides to sell the shares, the difference between the sale consideration of the shares and the FMV on the date of exercise is chargeable to tax under the head, capital gains, in the hands of the employee. 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. If the shares are sold on a recognised stock exchange in India, the long-term capital gains will be exempt and the short-term capital gains will be subject to preferential rate of taxes at 15%.
The moot point, however, is whether we plan our investment in ESOPs, keeping in mind the above considerations. Most of us sell the shares immediately upon receipt to enjoy the gains and regard this money as a part of a bonus. This money is spent on luxury holidays, cars or pre-paying large home loan balances, among others. After having utilised the money gained from ESOPs, employees forget the potential tax liability arising out of the capital gains and end up facing the unforeseen tax burden at a later stage.
To sum it up, to optimise returns from ESOPs one must hold the shares for more than one year to avoid long-term capital gains tax, sell on a recognised stock exchange in India and if the shares are sold in less than one year, the employee has to pay short-term capital gains tax.
The writer is managing partner, Nangia & Co. Inputs from Neha Malhotra