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ESOP Distribution & Taxation : Ultimate Guide

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ESOP Distribution & Taxation : Ultimate Guide

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So you’ve been offered Employee Stock Option Plan (ESOP) as part of your package and, naturally, are excited about the income likely to come your way in a few years' time. But, like all good things, ESOPs are taxed too. Let’s find out more about ESOP taxation and how it happens.

How Are ESOPs Taxed?

ESOPs are liable to be taxed in two instances. First, when the shares are assigned as a consequence of executing the vested options (which is when the income is taxed as salary), and then again when the shares are sold in the market (taxed as capital gains).

In the first case, ESOPs are taxed as perquisites. To begin with, the exercise price per share needs to be deduced from the fair market value of the shares (as on the date of exercising the selling option). The total (difference) amount of the perquisite is considered a part of your income by salary, hence, it is subject to tax deductions (TDS) by your employer. 

For example, as part of the firm's stock option plan, the employer grants Mr. Walter White 10,000 shares. If the Fair Market Value of the shares on the day of exercise is ₹200 per share and the exercise price is ₹10, the taxable perquisite value for Mr. White equals (200 – 10) *10,000 = ₹ 19,00,000. Assuming Mr. White is in the highest tax slab of 30% (with a 10% surcharge), the tax would be deducted at 34.32% (including a 4% cess). This results in a TDS deduction of ₹6,52,080 more. To fulfill this obligation, Mr. White must either sell a small number of shares or pay it from his own pocket.

Moving on to the second kind of taxation—on sale, ESOP tax is levied on the capital gains made by selling the shares. This may be long-term capital gains tax (LTCG) or short-term (STCG), depending on the actual holding period. Holdings less than 12 months qualify for STCG. The calculation of capital gains is fairly simple, total money received from sales of shares minus the Fair Market Value on the day of allotment of the shares. Tax is levied on the differential amount. 

Budget Amendments Related to ESOP Taxation

When it came time to tax ESOPs as perquisites, many startups ran into practical difficulties. Startups depend significantly on ESOPs to retain employees. Since the total amount (on paper) is high, it comes with a TDS obligation as well, which can cause a heavy dent in the employee’s monthly budget. Furthermore, it is likely to be challenging to find buyers for startup shares due to the fact that these shares are often not listed, and there may not be an active market for them.

Keeping this dilemma in mind, the Income Tax Act was amended in order to provide financial help to "qualified startups." This decision was arrived at after an analysis of the many remarks made, as well as an understanding of the real challenges that are faced by new businesses and their employees.

So, what kind of startups are eligible?

In layman's terms, an eligible startup is a corporation or a limited liability partnership (LLP) formed after April 1, 2016, but before April 1, 2022. Furthermore, it must fulfill the turnover requirement (no more than Rs 100 crores) and conduct qualifying activities as recommended.

One of the key benefits of this amendment is that an employee would, now, not be required to pay taxes on perquisite income for at least the next five years unless he resigns or sells his shares earlier. It gives the employee the option of retaining the shares without requiring to sell any part of them in order to simply satisfy the tax obligations. 

The proportion of start-up companies that meet the requirements relative to the total number of businesses is negligible. While it is definitely a boost to help new businesses get off the ground, several appeals have been made in this regard to expand the definition of eligibility so that more organizations (and employees) can benefit from the amendment. 

Perquisite Tax And Capital Losses

ESOP tax in the year of allocation may result in a possible additional tax loss if the share value falls enough after paying tax on fair value. In the situation described earlier, if Mr. Walter White decides to keep the shares by paying a tax of Rs 6,52,080 from his resources (presuming that his employer is not an eligible start-up), then he would have a capital loss of Rs 18,00,000 (10,000 * (200-20)).

Capital loss cannot be deducted from pay income. So, if Mr. White does not have enough capital gains to balance the loss, he may end up carrying the loss forward for the allowed term and then need to write it off. It is worth noting here that although it is possible to set off short-term capital losses against either short or long-term gains, long-term losses can only be set off against long-term capital gains.

ESOPs Issued By Foreign Firms

If your employer (or its parent firm) is registered overseas, then the manner in which allocation is taxed is unaffected. It is nevertheless subject to taxation as a benefit, and the employer is obligated to withhold TDS from the employee's pay. It makes it more difficult to comply with regulations since these shares have to be recorded in the ITR as foreign assets, but you cannot file the usual ITR 1 form for salaried employees.

The dilemma that emerges when you sell these shares is whether the capital gains are taxed in India or the foreign nation in which they are registered. The answer is determined by your residency status; a resident is taxed on their international income. As a result, if you are a resident, you may end up paying taxes in both nations. However, you could be entitled to relief under the Double Taxation Avoidance Agreement (if India has such an agreement with the foreign country in which the shares are registered). This needs to be ascertained on a case-to-case basis.

Wrapping Up

To summarise, ESOPs are an optional component in the overall design of an employee's compensation plan, somewhat akin to profit sharing. ESOP taxation in India occurs in 2 stages. They are, first, taxed as perks by the employer and then again upon the actual sale in the stock market. While certain benefits and relief have been provided to emerging companies that qualify under the criteria, it is only fair to expand and extend this umbrella to cover the larger workforce. 

Frequently Asked Questions (FAQs)

Are ESOPs heavily taxed?

There are two situations in which an employee's ESOP is taxed. The first is when they are exercised, and the second is when the shares are sold. In the first case, it is considered a perk and is taxed as income under the head wages. When sold on the market, it is recognised as a capital gain.

Does an ESOP incur income taxes?

ESOPs are considered perquisites and part of your salary. Hence, they are liable for tax deducted at source (TDS) by the employer, as per your prevalent tax slab. Other than that, there are no unique tax rates that apply to ESOPs.

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