BackRead the terms, know tax rules before signing up for Esops
If your employer is offering you Esops, ensure that you get the contract to understand what it entailsAlso consider the risk: the returns depend on the company’s market value in the future, which is uncertain
PremiumNot all startups went under due to the covid-19 setback. There were some that not only were able to tide over the crisis but have started recovering. Some of these startups are now rewarding their employees by buying back employee stock option plans (Esops) issued earlier. Recently, fintech startup Niyo and logistics company Shadowfax rolled out Esop buyback plans for their employees. According to Niyo, its business has crossed the pre-covid-19 level and “operating profit is in sight". Shadowfax, too, has seen a recovery in business like Niyo.
Companies use Esops to retain talent and to let employees benefit from the growth in business. Employees looking forward to it should know that Esops are taxed twice, unlike other benefits that employers provide. First, when employees receive stocks and then, when they sell the securities.
Also read: Why your health plan premium is suddenly spiking
They should also read the fine print. There have been cases where employees were not aware of the fine print and felt let down when their expectations were not met. In new startups, sometimes founders discuss Esops orally when hiring employees as they don’t have a framework in place. When the paperwork is done, the employee may or may not be satisfied with the offering. “Employees should always ask for the paperwork before joining a company, and not go by oral assurance," said Aarti Raote, partner, Deloitte India, a company that offers taxation and audit-related services, besides business advisory and consultancy.
Here’s how Esops are taxed when the company buys it back, and the paperwork employees need to keep in mind.
the basics
To understand the taxation of Esops, there are a few jargons that employees need to know.
The quantity of stocks that an employee would get is usually decided at the start of the financial year but the day a company offers stocks to its employees is called the grant date. On this date, the company shares the details of the Esops with the employees. This includes information such as the number of stocks the firm will offer the employee, when will they be issued, the terms and conditions of allotment and so on.
There is also a vesting date, when an employee is entitled to buy the stocks of a company. When an employee buys the shares, it’s called vesting of options.
Then, there’s exercise date, when stocks are purchased. The price at which an employee purchases the stock is called the exercise price, which depends on the fair market value (FMV) of the firm.
the tax brunt
Most companies offer options at a price lower than the FMV of the company. The difference between the FMV and the purchase price is the gain for the employees, who need to pay tax on this gain in the financial year in which they receive the shares. So, if the stocks are worth ₹1,000 apiece (the FMV) and the company offers them at ₹600 apiece, the employee will need to pay tax on ₹400 ( ₹1,000 – ₹600).
“This difference between the FMV on the date of allotment and the buying price is taxed as a perquisite, which comes under the head ‘income from salaries’. The employer will deduct the applicable tax," said Naveen Wadhwa, deputy general manager, Taxmann.com, a platform that provides tax research-related services.
When employees sell the stock either in a buyback or on the stock exchange (in case of listed companies), they will need to pay tax once more. “Here, the gains are the difference between the selling price and the perquisite value that was considered on acquisition," said Raote.
Say, the FMV of the company went up from ₹1,000 to ₹2,500. However, the value at which the employee paid the perquisite tax was ₹1,000. The difference of ₹1,500 ( ₹2,500 – ₹1,000) will be taxed as capital gains.
If it’s a listed company, and the holding period is over one year, profits will be taxed as long-term capital gains (LTCG). There’s no tax if the gains are up to ₹1 lakh. Any gains above ₹1 lakh are taxed at 10%. Short-term capital gains for listed firms are taxed at 15%.
In the case of unlisted companies, LTCG arises when the holding period is over two years. It is taxed at 20% but with indexation benefit. “In the case of a foreign company, the taxation is the same as an unlisted company in India. It doesn’t matter whether the firm is listed abroad or not," said Wadhwa.
THE FINE PRINT
If your employer is offering you Esops, ensure that you get the contract to understand what it entails. The contract, typically, lays down the details of when Esops would be vested (will be available to purchase), in what quantity, and other terms and conditions.
An employee can get a fixed number of stock options annually for a few years. For example, an employer can offer 25% of the total quantity every year for four years. Alternatively, the number of units can increase year-on-year by, say, 10%, 20%, 30% and 40% in year one, two, three and four, respectively. The vesting period is, typically, spread over a few years in order to retain the employees.
Many times, Esops are also linked to performance. The vesting conditions may require the employee to achieve a specific performance target. Such details must also be clearly discussed and agreed upon to avoid disappointment later.
There’s one significant caveat that many unlisted companies include in the Esop contract. When an employee wants to sell the shares, the promoters will have the first right of refusal. In other words, an employee cannot sell the stocks to an outsider unless the promoters agree. In such a case, an employee must wait until the employer announces a buyback. Usually, companies buy back the Esops when an employee quits.
Once the details are agreed upon, keep a copy of the contract. You can also get it checked by a lawyer to ensure it includes everything you wanted.
Employees receiving Esops must also keep in mind the risk factors for the returns while setting expectations. The returns depend on the company’s market value in the future, which is uncertain. It also depends on the price investors are willing to pay to acquire the stocks of a company, which is highly subjective and varies at different stages of investment.
Mohini Varshneya, partner and head, Esop services, Corporate Professionals Capital Pvt. Ltd, a Sebi-registered (category-I) merchant banker, gave a quick checklist of things that employees need to keep in mind when going for Esops. According to her, employee must read the conditions of Esop as elaborated in the grant letter. An employee must also go through the stock option plan that is approved by the company’s Board. The vesting conditions may require employee to achieve specific performance target and these should be discussed and agreed upon beforehand.
Finally, an employee must also understand the nature of the Esop plan as different plans may have different objective and benefits.
Further, employees must understand that mergers and acquisitions may not offer a clear exit option like in the case of an IPO. When there is an acquisition or merger of the company, the treatment of Esops depends on the deal that promoters, existing investors, and the acquiring company decides upon.
Employees can feel disgruntled if the exit price for the stocks offered is low or the acquiring company acquires a part of the vested Esops for existing employees and choose not to buy back the vested options of past employees. If the acquirer doesn’t buy back stocks of former employees, there’s nothing much you can do. If the acquirer is only acquiring Esops partially, the existing employees will need to wait for some more time until the firm goes for a buyback.
Look into the details to understand what the Esops really offer you and how much you will lose to taxation.
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