Esops are great, but they come with taxes too

It is important to know the tax rules applicable for Esops before accepting the offer. Because, it may require paying taxes on notional benefits even before the value from the offer is realised in cash.

Tax relief

ESOPs are taxed in two forms. One, as a perquisite forming part of the salary, at the time of allotment of shares and two—as capital gains on sale of the shares.

The startup industry for long have been demanding relief of taxing Esop as perquisite. The point here is that the employee do not receive any cash when shares are allotted but requires them to pay taxes on it that year.

This problem becomes more significant in case of unlisted shares as there may not be any avenue to sell shares, to pay taxes.

However, Budget 2020 deferred the tax liability for some startups for 4 years. The tax payable on the allotment of shares was deferred by 48 months from the end of the assessment year in which the shares are allotted.

 

Say, you were given an Esop in November 2021. The applicable assessment year (AY) in this case is 2022-2023. Instead of being taxed in the AY23, the Esops will now be taxed in AY27 but using the slab rates applicable for AY23.

This relaxation is applicable only for eligible startups, which include:

1) Incorporated between 1 April 2016 and 1 April 2022

2) Has a turnover of less than ₹100 crore

3) Holds a certificate of eligible business from the government.

Budget 2022 amended the definition of eligible startups to include those incorporated till 31 March 2023. “This would mean Esops that will be given by startups incorporated till March 2023 will also be eligible for deferring of tax on perquisite," said Gidwani.

While this is another positive news, the demand for extending the relief to all startups is not proposed in the Budget. Aarti Raote, partner, Deloitte India said “It’s ideal if the 4-year tax relaxation available for startups is extended to employees of unlisted companies as well."

Perquisite tax

The value of shares received as perquisite will be added as part of salary and will be taxed at applicable tax rates.

The value of the perquisite will be fair market value (FMV) of shares on the day you exercise your option minus amount paid for Esop to the company. Say, you exercised 100 Esops in the company which are valued ₹1 lakh in the market ( ₹1000 per share), which were offered to you at ₹50,000 ( ₹500 per share). The difference of ₹50,000 will be considered as perquisite for taxation purpose.

If the share is listed as on the date of exercising option, FMV is the average of the opening price and closing price of the share on that day. In case of an unlisted share, the FMV will be what is determined by a merchant banker on the specified date.

Perquisite becomes chargeable to tax in the year of allotment of shares. As mentioned above, for eligible startups, tax is charged after four years from end of the AY in which shares are allotted. But there are some conditions.

If the employee quits the job or sell the shares before the said 48 months, the perquisite value will be taxed in the hands of employee in the year of exit or sale.

For instance, based on above example, if you leave the organisation in May 2022, the perquisite becomes taxable in the FY 23 (AY 23-24) itself.

The company will also deduct TDS (tax deducted from source) in the year in which the perquisite value becomes taxable in the hands of the employee. Thus, employees must be ready for lower take-home salary in the year the Esops are taxed.

Capital gains on sale

The capital gains taxation in case of Esop is no different to capital gains computation on sale of shares. Except that the cost of acquisition of shares in this case is the FMV of shares considered for calculating value of perquisite.

In the above example where you were allotted 100 Esops, the cost of acquisition is the FMV of ₹1 lakh and not ₹50,000 paid by you to the company, as the difference would have been already taxed as perquisite.

If the shares are listed and sale of shares is done after 12 months, the long-term gains exceeding ₹1 lakh will be taxed at 10%. Otherwise, the gains will be taxed as short-term capital gains at 15%.

If shares are unlisted, the period of holding for capital gains calculation is 24 months. The short-term gains are taxed at slab rates, while long-term gains are taxed at 20% with indexation benefit (revising the cost of acquisition after considering inflation).

However, this LTCG for higher earners is also subject to surcharge. The budget 2022 proposal for capping the surcharge to 15 % on sale of long-term capital assets including unlisted equity shares is a positive news for those holding Esops of higher value (above ₹2 crore).

“Earlier the effective tax rate including highest surcharge of 37% on LTCG could go up to 28.5%, now with 15% surcharge, the effective tax would be 23.9%," Sunil Gidwani, partner at Nangia Andersen. On the other hand to save tax, one can make use of section 54F, which provides for exemption in respect of long-term capital gains if the money is deployed in purchasing or constructing a house property.