Although Union Finance Minister Nirmala Sitharaman will be presenting the Interim Budget ahead of the scheduled Lok Sabha elections in May, startups and experts feel that the government should offer clarity on ESOP taxation to benefit start-up employees.
ESOPs (Employee Stock Ownership Plans) are employee incentives that companies use to attract, reward, and retain talent. ESOPs enable employees to become shareholders and benefit from the company’s growth.
Under the Income Tax Act of 1961, ESOPs are taxed twice — first when employees exercise their stock options, and again when they sell their shares. Startups have asked to change this to a single point of taxation – when shares are sold – rather than the current two-stage approach.
“For ESOPs, an individual is liable to tax at the time of exercising the stock option, on the amount of fair market value of the share as reduced by the amount recovered from the employees. At this point, there is no cash inflow in the hands of the taxpayer, but he is subjected to tax outflow. Subsequently, the taxpayer receives income on the sale of stock options, wherein the capital gain is chargeable to tax. The Government may rationalise the mismatch in the accrual of tax liability at the time of exercise of stock options by deferring the tax liability at the time of sale of shares/ stocks,” said Rahul Charkha, Partner, Economic Laws Practice.
Last year, FM Sitharaman extended the tax holiday by a year and loss carry forward to 10-year period. But kept ESOP taxation untouched.
How are ESOPs taxed?
Taxing ESOPs is quite complex, especially when they are earned over multiple years and when employees work in different countries during the vesting period.
With the increasing popularity of ESOPs as part of employee compensation, it is important to simplify and clarify the tax regulations surrounding them to ensure easy compliance for individual taxpayers.
At present, ESOPs or any profit made from selling shares that were given to an individual through ESOPs are subject to taxation under the category of ‘Capital Gains’.
When an employee is granted shares at a price lower than their fair market value, the employee is required to pay taxes on the difference between the fair market value and the price paid. This difference is considered a taxable perquisite for the employee.
As per the provisions of the Income Tax Act, 1961, the fair market value (FMV) of shares allotted under an ESOP as reduced by the exercise price is taxed as ‘salary’ in the hands of the employee in India at the point of allotment or transfer of the shares.
Double taxation
ESOPs are subject to double taxation. First, they get taxed when the employee uses the ESOPs to acquire company shares. Second, the employee incurs capital gains tax when he sells those shares.
The tax saving opportunities for them are comparable to the tax saving opportunities available for salaried individuals, such as the 80C deduction and the 80D deduction.
If the shares of an Unlisted Company/ Foreign Company are held for more than 24 months, they will be classified as long-term assets. Any profits made from selling these shares will be regarded as long-term capital gains.
Long-term capital gains are subject to a fixed 20% tax rate after indexation. If the shares are sold within 24 months, the profits will be taxed as short-term capital gains. Short-term capital gains are treated as regular income and are subject to taxation based on the applicable slab rate.
Also read: Interim Budget 2024: Here’s how the Budget document is compiled and presented in Lok Sabha