Reforms in Taxability of ESOP’s (Equity Stock Option Plans)

What is an Employee Stock Option Plan (ESOP)?

An employee stock ownership plan (ESOP) is basically a plan given to employee’s wherein subscription to the same gives employee(s) ownership interest in the company. ESOPs give the sponsoring company, the selling shareholder, and participants receive various tax benefits, making them qualified plans. Companies often use ESOPs as a corporate-finance strategy to align the interests of their employees with those of their shareholders. ESOP are generally issued at a discounted price than the fair value of the shares.

Head of Taxability

As ESOPs are generally issued in lieu of Remuneration/ Salary and thus can be categorized as a part of Salary, they are taxed under the head ‘Income from Salary’.

Prior taxation of ESOP

The Income tax Act through Section 17(2) has categorized the ESOPs compensation as ‘perquisites’ and the value of such perquisites is taxed as income from salary in the hands of employees. The value of such ESOPs is computed as per the Rule 3(8)(ii) of Income tax Rules. The value of ESOPs is determined as on the date of exercise of options and not on the date of allotment. However, the tax payment liability is relevant to the date of allotment of shares. For instance, Mr. Shinde was eligible for ESOP by his employer for allotment of 1000 shares at ₹50 apiece. He exercised the option in March-2021 (F.Y. 2020-21), however, the company allotted the shares to him in December 2021 (F.Y. 2021-22). The fair value of shares of company in March 2021 was Rs.100 and that in December 2021 was ₹150. The value of perquisites of Mr. Shinde is determined at ₹ 50000/- [(100-50) x 1000]. The employer is required to include this amount of ₹ 50000/- in his Form 16 as valuation of perquisites and deduct TDS. However, the employer is required to do this in next financial year 2021-22 when the shares were finally allotted and not in the year of exercise of option.

The second incidence of tax on ESOP arises when the allottee sells those shares. From the above example, suppose that Mr. Shinde sold 500 shares for a total amount of ₹200,000/- in February 2025. Then in FY 2024-25, he will have to pay tax on capital gains income on sale of such shares. This shall be computed by deducting the cost of such shares from the sale value. And such cost shall be the amount determined as perquisites plus the amount he paid. Mr. Shinde will accrue capital gains income of ₹150000 (₹200000-50000) in F Y 2024-25.

Thus, ESOPs give rise to tax outgo at two times, one at the time of allotment as income from salary and at the time of sale as income from capital gains.

What is the relief from F Y 2020-21?

This Budget has touched the first incidence of tax i.e. income from salary with TDS thereon and did not disturb the second incidence of tax i.e. income from capital gains. The changes brought in by Budget have implications for the employee as well as the employer company/LLP.

What are the impacts on employee and employer?

The employees are required to include the amount of taxable ESOP in their Income tax return (ITR) to be filed for assessment year 2021-22 and thereafter. This means they must plan their transactions in the current financial year. The tax amount on the income component related to ESOPs need not be paid by them while filing ITR nor the TDS needs to be deducted by the employer on this component. This Budget has deferred the payment of tax on such income. This has effectively eased the anxiety related to cash outgo on the unrealized income of the employees. So, from financial year 2020-21, the TDS shall not be deducted nor the tax on the said income be paid while filing ITR next year. However, relevant amount of tax needs to be paid within 14 days from any of the following events, whichever is earliest:

1. after the expiry of 60 months (5 years) from the end of the relevant assessment year; or
2. from the date of the sale of such ESOP shares by the assessee; or
3. from the date of the taxpayer ceasing to be the employee of the ESOP allotting employer,

In case the employer did not deduct TDS and pay to the Government as per above deadlines, then the employee himself must pay the tax according to the same dates. The rates of tax and TDS in such cases shall be the one applicable for the year in which ESOP was allotted.

Illustration

Mr. Shinde in the example cited above does not sell his shares nor leaves the employment. In such case, for assessment year 2021-22, Mr. Shinde has to include the amount of ₹50,000/- in his ITR as income from salary but not pay the tax on the same. Since he is in continuous employment with his employer, he will have to pay tax in assessment year 2025-26. He does not need to include the said amount in his ITR but only in computation of tax and pay the tax as per the rates applicable for assessment year 2021-22. So, for assessment year 2025-26, his tax liability will be increased by the tax on ₹50,000/- which was deferred from assessment year 2021-22. This tax needs to be paid either by Mr. Shinde on or before 14/04/2026 or his employer must deposit his TDS on or before this date.

Who are benefited by this tax deferment ?

Not all the enterprises and companies giving out ESOPs are benefited by this move is beneficial to those start-ups which fulfill certain conditions-

1. the start-up must be incorporated between 01/04/2016 and 31/03/2022
2. the total turnover of the start-up must be less than ₹100 crores for the year in which benefit is sought
3. It must be certified as eligible start-up by the Inter-Ministerial Board of the Government of India.

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