ESOPs, or Employee Stock Ownership Plans, are benefit schemes where companies give their employees a share of ownership.
ESOPs are employee benefit schemes where companies give ownership shares to their employees. (Image for representation)
Employee Stock Ownership Plans (ESOPs) have become a popular way for companies to reward their workforce. It ensures that there is a sense of ownership and aligns employee interests with business growth. These plans, offering a variety of stock-based compensation, provide opportunities for employees to share in the company’s financial success. Thus, understanding the various ESOPs and their taxation is crucial for both employees and employers.
ESOPs are employee benefit schemes where companies give ownership shares to their employees. Through these plans, organizations aim to motivate employees by linking their performance to company growth. Typically, ESOPs are offered with specific terms, such as a vesting period or performance goals, making them a strategic tool for retaining talent.
A look at the 4 types of ESOPs
- Employee Stock Option Plan (ESOP): It is a right granted by the company that allows employees to acquire its equity shares at a discounted price, providing an opportunity to participate in the company’s growth.
- Employee Stock Purchase Plan (ESPP): Through this plan, employees can buy company shares, often at a discount to the fair market value (FMV) determined at the end of a certain quarter.
- Restricted Stock Units (RSUs): These are shares granted to employees subject to the fulfillment of certain conditions, such as the achievement of certain goals, revenue milestones, or performance standards.
- Stock Appreciation Rights (SARs): SARs provide employees with financial benefits equal to the difference between the stock price at the time of grant and the price at the time of exercise. These can either be settled in cash or equity.
Tax implications
ESOPs are taxed in India in two stages:
Tax at the time of allotment of shares
When companies offer employees the option to buy shares at a discounted price or for free, it creates a taxable benefit. This benefit, which is treated as part of your salary, is subject to tax deduction by the employer at the time of transaction. The first instance of tax liability occurs when the employee exercises the option to acquire these shares.
The tax process involves calculating the difference between the fair market value (FMV) of the shares on the date the option is exercised and the actual amount paid by the employee to purchase the shares. This difference, referred to as an “assignment,” is added to the employee’s taxable pay.
The FMV used to calculate the taxable value is not the value on the date of allotment but the value on the date the option is exercised. This difference ensures that the employee’s tax liability reflects the actual market value of the shares at the time of ownership.
Tax when the employee transfers his shares
When an employee transfers the shares received through the ESOP, the profit from the transfer will be taxed under ‘Capital Gains’. The tax treatment depends on the type of security and how long it has been held. The holding period of the securities starts from the date they are allotted to the employee, not from the time the option to purchase the shares is exercised. It ends when the employee transfers the shares.
For calculation of capital gain, the fair market value of the shares on the date on which the employee exercises the option will be treated as the purchase price of the shares.
For example, X exercised his ESOP on April 1, 2022, and the shares were allotted on May 1, 2022. On 1 April 2024, X sold the shares. Here, the share holding period will be from 1st May 2022 to 31st March 2024. But while calculating the acquisition cost, the fair market value on April 1, 2024, or the date when X exercised the option, should be considered.
Overall, holding shares for more than 24 months or 2 years is often recommended to take advantage of long-term capital gains exemptions and lower tax rates. This can maximize the financial benefits of participating in an ESOP.