Tax calculation on ESOPs

ESOPs can provide significant gains in the long run, but they are also taxed twice. Once at the option exercise stage, and the other when you sell the shares. Know your exact tax amount with the formula given, and take measures to reduce your tax liability.

How to calculate your tax liability on ESOPs

How ESOPs benefit both – employer and employee

ESOPs stands for Employment Stock Option Plans. It is an ownership investment strategy that employers use to retain talented employees by having them invest in the company. The company offers its stock to certain employees at a discounted rate, enabling these employees to cash in on the upward movement of the stock at a later period.

This benefits the employees by helping them create long-term wealth. Moreover, there is a sense of ownership, and greater commitment to the organisation’s goals as it stands to financially benefit the invested employees. Thus, ESOPs are very effective as they help employers restrict attrition, and reduce cash outflow in the immediate future.

While it presents a lucrative wealth-creation opportunity for in-demand employees, there is also an element of taxation that needs to be considered.

Also read: Is Income from Shares Brought Under an ESOP taxable?

Let’s look at how ESOP taxation in India works.

ESOPs are taxed twice:

  1. At the time of exercise

The employer offers an employee the option to buy a specified number of shares at a discounted rate (exercise price) over a certain period of time (in order to keep the employee in the company). This period is called the vesting period. Once this period is over, the options are said to have vested, and then the employee can purchase the shares during the defined exercise period. The employee can purchase the shares whenever he/she chooses within this exercise period.

In order to make the offer attractive, the exercise price is usually lower than the fair market value (FMV) of the stock. The price is set taking into account the company's performance during the vesting period. The difference between the FMV and the exercise price is taxed as perquisite, under the ‘salary’ section of Form 16. The employer deducts TDS on this perquisite.

Tax = Income tax slab rate x no. of shares x (FMV-Exercise price) + Health and Education cess

    2. At the time of sale

  •      Listed company

Once the employee has acquired shares through ESOPs, they can choose to sell the shares to realise profit.

If the shares of a listed company are sold within a year of having acquired ESOPs, the employee will be subject to short-term capital gains tax of 15%.
Tax = STCG tax per cent (15%) x no. of shares sold x (Selling price of share – FMV on the date of exercise) + Health and Education cess

If the shares are sold after a year, and the profit on sale is over Rs. 1 lakh, then a long-term capital gains tax of 10% is applicable. If the gains are below Rs. 1 lakh, then no tax is applicable.

  •          Unlisted company

For an unlisted company, selling shares also attracts ESOPs tax.

On selling the shares within a year of having bought them, the tax amount is as follows:
Tax = Income tax slab rate x no. of shares sold x (Selling price of share – FMV on the date of exercise) + Health and Education cess

If the shares are sold after a year of having bought them, the tax is calculated as given below:
Tax amount = LTCG percent (20%) x no. of shares sold x [Selling price – FMV on date of exercise x (CII for year of sale / CII for year of exercise)

The CII (cost inflation index) aims to increase the cost of acquisition by factoring in inflation, and therefore reduces the capital gains, and the taxable amount.

Also read: Your Guide To Understanding Capital Gains In India [Part 1]

Now that we know tax is inevitable, how can we reduce tax on capital gains from equity?

The strategy is - ‘Harvesting’ your gains at just under Rs. 1 lakh, and reinvesting the proceeds. You can buy back the  same shares or a different one altogether, and it will reset the price and date of acquisition to the new values.

For example, say you buy 1,000 shares of your company at a share price of Rs. 100 per share on 1 April 2020. On 3 April 2021, you sell all the shares at Rs. 150 each. That is a long-term gain of Rs. 50,000, which is well under the Rs. 1 lakh limit, and therefore exempt from taxation. If you buy back the shares at say, Rs. 160, your date of acquisition and purchase price will be reset. Now in another year, say the stock rises to Rs. 230, your gains will be Rs. 70,000 – still under the limit.

But if you keep your initial holdings, your gains would be Rs. 1,30,000 of which Rs. 30,000 would be subject to taxation at 10%.

Another way to save on tax is to book capital losses as well. Losses that you’ve incurred in the short or long-term on selling shares, can be set against the gains to lower your overall capital gains.

Conclusion

ESOPs are a great long-term investment for employees but they come with the caveat of double taxation that needs to be managed carefully. The best way to save on tax is to either forgo your ESOPs entirely (no tax), or harvest your gains (and losses) after a year.

Also read: Looking For Ways To Save Tax On Long-Term Capital Gains? Here Are Some Solutions

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