Taxability of ESOPs

INTRODUCTION

Employees Stock Option Plan (“ESOP”) has gained enough popularity after young start ups struggle to attract suitable human capital. This becomes more relevant as the start ups are not able to offer them hefty pay packages.

In such situations ESOPs have been proved to be useful tool for employee retention by giving them a sense of ownership. However, taxability of the ESOPs acts as roadblock. Thus , in this article, we have tried explaining the taxability of ESOPs in India and have also discussed about  Inter Country ESOPs.

EMPLOYEE STOCK OPTION PLAN

Employee Stock Option Plan or ESOP is an option which is given to the employees to purchase company’s shares at pre-determined price at a future date. It provides unique rewards to employees where they can receive significant retirement benefits at no monetary cost. It motivates the employees of the company through equity ownership and thereby retaining the employees of the company and reducing the employee turnover rate. The stocks are provided to the employees at the end of the financial year as an incentive for the work done throughout the year and in order to ensure they remain in the respective company or organisation. Many times, startups and companies that cannot provide high pay package provide stocks of the company to their employees.

TAXABILITY OF ESOP IN INDIA

Upon expiry of a certain time period from the date of grant, shares are vested with the employees(vesting) when employee gets unconditional right to receive the shares. Once such options are vested with the employee, he gets right to exercise the options(exercise). Company allots the shares to the employees (allotment) upon exercise of the shares by the employee. In India, ESOPs are granted as per SEBI Guidelines 1999. Companies grant ESOPs not only to employees but also to directors of the company, linked on their performances.

Tax on ESOPs is calculated at two stages-

• First levy occurs when shares are allotted to the employee after he has exercised his option on completion of the vesting period and
• Second levy occurs when the employee opts to sell the allotted shares under the ESOP.

At the time of allotment of shares on the exercise date, the difference between fair market value of the shares as on exercise date and the amount that employee have paid for the exercise or subscription to the shares is calculated and taxed accordingly. This taxable value is called Perquisite value. When employee sells the shares which were allotted to him under ESOP, tax is levied on any amount of profits or gains arising from such transaction. Such profit is taxable under the head ‘Capital Gains’. Capital gains can further be classified as ‘Short Term Capital Gains’ and ‘Long Term Capital Gains’ depending upon the period of holding of such shares.

EXAMPLE: On July 1, 2014 Mr. X an employee of ABC Pvt Ltd  has been given an option under ESOP , to purchase 10,000 shares of ABC Ltd. As per the policy, the option can be exercised at the end of 3 years i.e. July 1, 2017 at an exercise price of INR. 60.

On July 1, 2017, Mr. X exercised the his option. The fair market price of the shares of ABC Ltd at that time was INR 100. Further, on January 31, 2018, he decides to sell the shares @ 120 each.

Now, we will see how the ESOP Taxation will work:

First level of taxation (when the option is exercised):

ESOPs would be taxed as perquisite, the value of which would be (on date of allotment) = (FMV per share – Exercise price per share) x number of shares allotted.

(100-60) x 10,000 = 400,000

The amount calculated above as perquisite value of ESOP i.e. Rs. 4,00,000 shall form part of X’s salary and be taxable in the year of allotment of such shares. Employer is liable to deduct TDS on such amount.

Second level of taxation (when ESOPs are sold):

When Mr X decides to sell the share on January 01, 2018, he would be liable to pay capital gain tax , which shall be calculated as follows:

Capital gains = Sale proceeds – FMV of shares at the time of allotment of shares

(120 – 100) x 10,000 = Rs. 200,000

Since the holding period of shares in the hands of X is less than 12 months (will be counted from the date of allotment), gains will be classified as Short-term Capital Gains and will be taxable as per the normal slab rates applicable on X. 

INTER COUNTRY ESOPs:

Normally ESOPs are granted by parent entity to the employees of the group. But taxation challenges surface when such employee migrates from the parent organization in one country to a subsidiaries in another country by way of deputation. Typically the country of service at the time of grant of ESOP may be different from country where the vesting and exercise happens thereby giving rise to conflict for apportionment of taxing rights between the countries.

How are ESOPs taxed in this case

The first step is to ascertain the residential status of an employee for a particular year. In case the employees becomes resident of more than one country in a particular year, then the ultimate residential status needs to be examined by applying tie-breaker test as per tax treaty. ESOP perquisites is taxable in a country on the basis of number of days services rendered in the country.

Example on how ESOPs are taxed between two countries:

A Ltd (Indian Parent) grants 150 ESOP options @ Rs.100 to the employee on 1st May 2013 at Rs.100, with a condition that such options would vest with the employee over three years i.e. 1st May 2014,1st May 2015,1st May 2016 (per year 50 options) provided the employee is in service with any entity in the group.

Employee gets deputed to a foreign subsidiary on 1 Jan 2015. The taxability of ESOP perquisites in respect of the second vesting i.e. 1st May 2015 (assume date of exercise: 1st May 2015). FMV of the shares on the 1st May 2015 is Rs.1100. Perquisite amounts to Rs.1000 (i.e. FMV Rs.1100 minus Option price Rs.100).

Tax in India will be from date of grant 1st May 13 to date of departure 1st Jan 15, i.e., 610 days and tax in foreign country will be from date of arrival 1st Jan 15 to date of vesting/exercise i.e., 120 days.

Key points covered in Inter Country ESOPs transactions:

1.  Divergence in tax treatment :

ESOP granted in country A and exercised in country B: Perquisite is apportioned on the basis of the no of days service rendered in respective countries during the period of grant and vesting. However, country B does not tax its portion on premise that ESOP is not granted in contemplation of duties in country B if sufficient time has elapsed between the date of departure from country A and date of exercise in country B.

2. Double Taxation :

In a situation where an employee of an Indian parent exercises shares while in India, pays perquisites tax in India on the difference between Fair Market value and option price. Subsequently, the employee gets deputed to the subsidiary abroad and then sells such shares while serving abroad in the subsidiary. The employee would have become a tax resident in the foreign company in the year of sale of share and is liable to offer tax on the global income including capital gain on sale of shares. While calculating such capital gain, ideally the FMV should be adopted as cost of shares. However, foreign states normally recognize option price paid as cost and not FMV due to the fact that perquisite tax is remitted in India. Foreign tax authorities need to be convinced about the FMV as appropriate cost for calculating capital gain. Otherwise employee would end up paying tax twice on the portion of difference between FMV and option price paid.

3. Cash Flow :

Sometimes employee of parent company goes on deputation to the foreign subsidiary. Upon allotment of the shares, employee pays perquisite tax partly in India and partly abroad depending on the number of days service rendered in respective countries. But in this case, liability arises while the employee is abroad. He faces substantial challenge for remitting Indian tax liability in INR to the parent company since he would ceased to get INR salary and also would have closed his bank account in India.

ISSUES WITH ESOPs

ESOPs come with complex rules and regulations. Companies that provide it to the employees must have a proper administration system that works towards providing stock ownership to the employees. If a company does not have staff or help to look into the administration of ESOPs then it may invite certain risk issues. Upon establishing ESOPs the company must have proper administration, staff, including third-party administration, legal costs, and trustees. It must be aware of the costs that will be incurred while providing this facility.

CONCLUSION

To conclude, ESOP is a great way to build the foundation of financial freedom and retirement. It acts as a motivational tool for employees to stay in the company and work towards the goal of the company. Employees feel pride in the ownership of the company and measure the success of the company as their success. On the other hand, a company gets an opportunity to retain the desirable candidates by framing Employee Stock Option Programme for them.

This article is also published in Taxguru : https://taxguru.in/income-tax/taxability-esops.html