Employee Stock Options Plans (ESOPs) are gaining a lot of importance these days. ESOP typically means an option given to employees of a company to purchase shares of the company at a future date at a pre-determined price.
Tax on ESOP
The Income Tax Act, 1961 has laid down the following two stages of taxation for employees in respect of shares allotted to them under an ESOP.
– Upon allotment of shares after the employee exercises his option on the completion of the vesting period; and
– When the shares allotted to the employee are sold by him.
In the first stage, the difference between the Fair Market Value (“FMV”) of the shares on the date of exercise and the exercise / subscription price paid by the employee, if any, is taxable as perquisite under the head ‘Income from salary’ on the date of allotment of shares. It can be illustrated as follows:
Perquisite value of ESOP (on date of allotment) = (FMV per share – Exercise price per share) x number of shares allotted.
Upon allotment of shares, the employer will have to compute the perquisite value of ESOP taxable in the hands of the employee and deduct tax on such ESOP. The perquisite value and the tax deducted thereon by the company would be reflected in Form 16 and Form 12BA of the employee.
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When he sells the shares, the employee will be taxed for capital gains. The capital gains is computed as the difference between the sale proceeds and FMV of the shares that were already considered by the employer while computing the perquisite value. The employee can claim the expenditure that he may have incurred wholly in connection with the sale. It can be illustrated as follows:
Capital gains = Sale proceeds – FMV of ESOP – expenses incurred by employee.
Capital gains tax
Earlier, capital gains tax would depend upon the period of holding of shares by the employee from the date of allotment, and whether securities transaction tax (STT) has been paid on the sale. As per a recent circular issued by the income tax department, the condition that STT should be paid on the acquisition of shares to qualify for the exemption from long-term capital gains (LTCG) tax is not applicable to shares allotted through ESOP, so long-term capital gain arising on sale of shares acquired under SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999, shall be exempt under Section 10(38).
Let us take an example to understand this. X has been granted 10,000 shares of ABC Ltd under ESOP on July 1, 2014. The vesting period is for three years and the exercise price is `60 per share. He has exercised all the shares on July 1, 2017 (exercise date). The FMV on the date of exercise was `100 per share and X decided to sell the shares on a recognised stock exchange at `120 per share on January 31, 2018.
The taxability of the shares will be:
At the time of exercise of options: The difference between the FMV and the exercise price shall be treated as perquisite in the hands of X. Perquisite value would be calculated as under:
(FMV of share of ABC Ltd – exercise price paid by X per share) x number of shares
(Rs 100 – Rs 60) x 10,000 = Rs 400,000
The employer would be required to deduct tax on Rs 400,000 and to issue a Form 16 and Form 12BA to X reflecting such perquisite value under ‘Income from salary’ and the taxes paid on the same. Employee will then have to report such ESOP income and tax deducted thereon in his personal income tax return.
At the time of sale of shares by X: The capital gain would be calculated as under:
(Selling price of share – FMV considered by employer while calculating perquisite income) x number of shares
(Rs 120 – Rs 100) x 10,000 = Rs 2,00,000
Since X held the shares for not more than 12 months, the above will be taxed as short-term capital gain. He would be required to pay advance tax on the capital gain.
Since many companies have now made ESOPs as part of the compensation for key employees, it is very important for an employee to be aware of the taxability of ESOPs.
The writer is partner, Deloitte Haskins and Sells LLP