It is important to understand the tax implications of ESOPs in India before the employer considers implementing an ESOP scheme and the employee decides to participate in the same
Over the years, equity-based compensation has gained momentum among corporates to incentivise employees as the same is considered an effective way to reward past service and to retain the best talent in the marketplace. It serves as a catalyst for an organisation’s growth by giving employees a sense of ownership. Moreover, it enables employees to align their personal investment goals with that of the overall performance of their organisations.
Rewarding with stock options
In India, historically, the most commonly used equity-based compensation has been the Employee Stock Option Plan (‘ESOP’). In simple terms, an ESOP is an option granted to an eligible employee to purchase/subscribe to a specified number of shares on a future date, at a predetermined exercise price, upon fulfilment of the vesting period and other criteria defined by the organisation. Once vested, an employee has the option of exercising such ESOPs at a pre-agreed exercise price, which is generally marked at or lower than the prevalent Fair Market Value (FMV) of the organisation’s shares on the date of the grant of the options. In case the ESOPs are underwater, i.e., the FMV as on the date of the exercise falls lower than the exercise price, then exercising the option may not be feasible for an employee.
Hence, it is important to understand the tax implications of ESOPs in India before the employer considers implementing an ESOP scheme and the employee decides to participate in the same.
In the case of ESOPs, the tax incidence in the hands of employees occurs at two stages. First, upon allotment of shares pursuant to exercise of options – taxable as a perquisite that is part of employees’ salary income. Second, at the time of subsequent sale of such shares – taxable as income from capital gains. At the first stage, the perquisite value is computed as the difference between the FMV of the share on the date of exercise and the exercise price. There are specific valuation rules prescribed for listed and unlisted entities. Unlisted entities (including foreign companies) need to determine the FMV by obtaining a valuation certificate from a Category I merchant banker registered with the Securities and Exchange Board of India (SEBI). The employer is required to withhold tax at source (TDS) in respect of such a perquisite.
Second-stage taxation, i.e. income from capital gains, is triggered at the time of subsequent sale of shares by an employee. This sale may be categorised as long-term or short-term in nature depending upon the period of holding from the date of allotment and tradability in a recognised stock exchange. Capital gains are computed as a difference between the sale consideration and the FMV as on the date of allotment of shares (which was already considered for the first stage of taxation). In the case of listed equity shares and units of equity-oriented mutual funds subject to Securities Transaction Tax (STT), if the holding period is less than 12 months, the gains would be categorised as short-term and taxed at a concessional rate of 15 per cent. If the period of holding exceeds 12 months, then the gains would be categorised as long-term and taxed at 10 per cent for value in excess of Rs 1 lakh without indexation benefit. Such long-term gains were exempt from taxation prior to Financial Year (‘FY’)2018-19. However, such exemption was withdrawn in the Union Budget of 2018 and the gains were grandfathered up to January 31, 2018.
Treatment of unlisted securities
In the case of unlisted securities (including shares issued by foreign companies), the period of holding for categorising short-term and long-term gains is 24 months and such gains are taxable at the applicable slab rates, and 20 per cent with the indexation benefit (10 per cent without the indexation benefit), respectively. In case such a sale transaction results in capital loss, then it may be set off against other current year capital gains wherein short-term losses can be set off against short-term or long-term gains. Long-term losses, however, can be set off against long-term gains only. Unabsorbed capital losses, if any, may be carried forward to eight subsequent FYs for set-off as above.
In the case of migrating employees, the taxation of ESOPs poses its own unique challenges. Such employees are generally recipients of home-country ESOP plans and they may be rendering services in different jurisdictions at various stages of the ESOP life cycle. There are no direct provisions in the Income Tax Act, 1961, with respect to taxability of such an incentive – as to whether the taxable amount can be pro-rated to exclude the portion of value that is attributable to the period of services rendered by the expatriate employee outside India during the vesting period (i.e., from the date of grant to the date of vesting). Based on the general principles of taxation, a proportionate amount relating to service rendered in India is income accrued in India and, hence, taxable irrespective of the residential status of the individual employee.
In other cases wherein the entire stock income is taxable in India, the benefit available, if any, under the relevant Double Taxation Avoidance Agreement (DTAA) to mitigate the impact of double taxation may be explored further subject to fulfilment of the prescribed conditions. Hence, a lot of factors, such as the detailed terms and conditions of the plan and rendering of services, must be examined to conclude the taxability. This also impacts the resultant withholding tax/TDS obligation of the employer.
Historically, ESOP taxation in India has undergone very limited change. Certain aspects, such as proportionate taxation in the case of migrating employees and replacement of the FMV on sale, if expressly clarified, would help bring more certainty on taxation of this important element of the compensation structure. Also, all other potential regulatory aspects should be evaluated (e.g., company law, accounting and FEMA) before organisations consider implementing an ESOP plan for their employees.(The writer is Partner and Head, Global Mobility Services – Tax, KPMG in India)Get access to India's fastest growing financial subscriptions service Moneycontrol Pro for as little as Rs 599 for first year. Use the code "GETPRO". Moneycontrol Pro offers you all the information you need for wealth creation including actionable investment ideas, independent research and insights & analysis For more information, check out the Moneycontrol website or mobile app.