All you need to know about ESOPs

With recent changes in its taxability, the importance of ESOP as a compensation component and retention strategy may undergo change.

All you need to know about ESOPs

Employee Stock Ownership Plan (ESOP) is an ownership option provided by employers to employees, through which the latter get a preferential right to purchase the shares of the company they work for. By becoming shareholders, employees gain a sense of ownership and greater affinity to their workplace. They get voting rights and their goals become more aligned with those of the company. 

On the other hand, companies often use the ESOP scheme as a tool to retain their valued employees; that is, they offer ESOPs as an incentive. Companies that are unable to offer best-in-market salaries try to compensate by offering an ESOP scheme as an add-on. In fact, ESOPs are often part of the long-term strategy of the company offering it.

Taxability of ESOPs

Prominent among the companies that offer ESOPs as a tool to attract talents are startups, the proverbial ‘Young Turks’ of the industry. As their name suggests, startups are beginners that are often not in a position to offer competitive pay packages to acquire the best talent in the market. It makes more financial sense for them to offer ESOPs to their employees instead.

However, the taxation on ESOPs has hindered startups from using it as an effective tool. To understand the taxability of ESOPs, we have to understand some of the key terms that are relevant in this scheme. 

  • Grant date is the date on which the agreement between the employer and the employee bestows on the latter the option of owning the employer’s shares in the near future.
  • Vesting date is the future date on which the employee is entitled to buy the shares.
  • Exercise date is the date on which the employee exercises the option to buy the shares.
  • Vesting period is the time between the grant date and the vesting date.
  • Exercise period is the period during which the employee has a right to buy the shares.
  • Exercise price is the share price at which the employee buys the ESOP.

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Notably, under Section 17(2) of the Income Tax Act 1961, ESOPs have been categorised as a perquisite that is to be included in the total income of the recipient and therefore liable to tax. For calculating tax, the perquisite is calculated as the difference between the fair market value (FMV) of the share on the date of exercise and the exercise price of the share. In case of unlisted shares, the FMV is determined by a merchant banker. In case of listed shares, the FMV is the average of the opening and closing price on the exercise date, or the closing price on the date before the exercise date.

Apart from being taxed as a perquisite, ESOPs are also taxed as capital gains at the time of sale of the shares by the employee. Here, the difference between the sale price and the FMV of the share on the exercise date is considered as capital gains for tax calculation. Thus, ESOP taxation has been applicable in a two-pronged manner, and ESOP in India has been subject to double taxation. 

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The premise for change 

Companies, particularly startups, have been critical of this double taxation of ESOP in India. Although the Income Tax Act identified ESOP as a part of the incentive, its benefit didn’t always arise in the year of incidence. Companies have long demanded a relook at the taxation imposed on the point of exercise. The justification was that the difference between the FMV and the exercise price was a notional earning and not a cash inflow for those who didn’t sell immediately. This reduced the popularity of ESOPs among employees and as a result startups haven’t been able to harness it as the tool it is defined to be.

Ultimately, ESOPs are an important driver in empowering employees and increasing the wealth of the workforce. It also decentralises the shareholding pattern in a company by including this key stakeholder in the list of shareholders. 

ESOP taxation in Union Budget 2020

In this year’s Union Budget, Finance Minister Nirmala Sitharaman proposed that tax on ESOPs be deferred for five years or till the departure of the employee from the company, whichever was earlier. She noted that due to the taxation of ESOPs, employees were facing a cashflow problem if they didn’t sell them immediately and instead held on to them over the long term. 

Sitharaman acknowledged that ESOPs are used by startups to attract and retain talented employees and that they form a significant component in the compensation offered to these employees. Startups have been requesting this decision for some time now; they don’t want their employees to be taxed at the time of allotment of shares.

Renewed interest in ESOPs

Understandably, the government’s decision to withdraw tax on the point of exercise of ESOPs has renewed the interest of employees and their employers in this scheme. Startups generally begin their operations on a tight budget and ESOPs can be the perfect tool for them to acquire the desired quality of manpower without compromising on their cashflow situation. They can compensate what they lack in terms of financial might (when compared to industry heavyweights) by offering their employees a ride in their growth trajectory through shareholding. 

This is a win-win situation for both employees and employers, as quality manpower will also positively impact the growth of the startup companies. The presence of ESOPs in a typical startup salary structure is only likely to increase in the future. Various startups have admitted considering an increase in the proportion of ESOPs in their employee compensation packages.

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Last words

Taxation of ESOPs at the point of exercise has not been completely done away with in the recent budget. The budget proposal only defers the tax liability for a maximum of five years. Employers and industry experts point out that double taxation of ESOP is still present in the tax structure and this will hinder it from being a fully effective retention and compensation tool. 

However, if and when later budgets choose to bring in a more liberal view on ESOP taxability, the logical step would be to do away with the deferred taxation of ESOP at the point of exercise. Understand what is budgeting, bootstrapping and bartering tips for startups.


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