Employee Stock Option Plan: All you need to know about ESOP and its tax implications
You must have heard the stories of many drivers, office assistants and secretaries working with Infosys becoming millionaires. This could become possible owing to a system of making such stakeholders as stockholders of the company by granting them what is generally known as ESOP (Employee Stock Option Plan or Employee Stock Ownership Plan). Here we are talking about the various aspects related with ESOP.
What is ESOP?
ESOP is a system under which the employees of a company are generally given the right to acquire the shares of the company for which they are working. In some of the cases, the foreign holding/subsidiary company also grants such options to the employees of the Indian subsidiary/ holding company. Under such a scheme, the employees are granted some rights, called as stock options, to get the shares of the company for free or at a concessional rate, at a predetermined price or the price to be determined on the prefixed method, as compared to the potential market rate.
Why are ESOPs given?
There are various reasons for which the employees of a company are given such stock options. The phenomena of stock options is more prevalent in start-up companies which can not afford to pay huge salaries to its employees but are willing to share the future prosperity of the company. In such cases the employees are given the stock options as part of the compensation package. Moreover in some cases, the employee is given such stock options which he can exercise in future date/s, in order to ensure long-term commitment of the employee. So apart from rewarding the employees with monetary gains, ESOP also help create a sense of belonging and ownership amongst the employees.
Understanding the vesting date and grant price
Under the ESOP schemes, the stock option is free when it is given to an employee. The terms and conditions on which employee can exercise his rights are spelt in the ESOP scheme. The option given to the employee can be exercised after a certain lock in period, which is generally more than one year.
The right to exercise the option may get vested in the employee in the next future date/s. The dates on which the employee becomes entitled to exercise the right to acquire the shares is called as “vesting date.” The rights may vest fully or partially over the vesting period. For example, an employee is given 1000 options on 31st March, 2016 which can be exercised in phases like 20% on completion of one year, 30% on completion of second year and the balance on completion of the third year from the date of such grant. So in the instant case, the vesting dates for 200 options is 1st April, 2017, for 300 shares it is 31st March 2018 and for balance 500 shares it is 31st March 2019. The plan may stipulate same or different grant price or exercise price for such vesting. The grant price or the price at which the employee can buy the share from the company is generally fixed and is generally substantially lower than the prevailing market price of the shares in case the shares are listed.
Since the employee is given just an option without any obligation attached to it, it is not mandatory for the employee to exercise the option. The employee may decide to exercise the option or may decide to let the option lapse in case the prevailing price of the shares is lower than the exercise price. The employee is given a time period during which the he has to exercise the option failing which the vested rights may lapse. The date on which the employees exercise their option to buy the shares is known as ‘exercise date’.
There are no cash outflows or taxation implications when the options are granted as well as when the options are vested in the employee.
When to exercise options
It is not necessary for an employee to exercise the option once it vests with him. The employee can exercise the right within the stipulated time period. When the employee should exercise the options is a very important question from financial and taxation angle as well. Once the employee exercises the option, he has to pay for the shares at the price predetermined and thus causing cash outflow. In case the shares are not listed on a stock exchange, the same can not be liquidated and thus the money gets locked till the shares get listed or the promoters offer you an exit option. Moreover there is taxation implication if you delay your exercise date because the holding period for capital gain purpose will start from the exercise date. So the decision has to be taken after having considered cash flow and taxation implications of such decision.
Tax implications when exercising the option
The taxation of ESOP has a typical structure. It is taxed in two stages. First stage is when the employee exercises the option to buy the shares at the exercise price. The second stage is when the shares are ultimately sold.
Let us first discuss the first stage. As and when the options under the ESOPs are exercised, the difference between the exercise price and the value of the security is treated as perquisite in the hand of the employee. The employer is required to deduct tax at source on the employee exercising the option, treating the same as perquisite. The value of the shares allotted to the employee shall be the average of market price (average of highest and lowest price) on the date the option is exercised in case the shares are listed on any stock exchange in India. In case the shares are not listed the fair market value of the same shall be as per the valuation certificate obtained from merchant banker. The certificate of valuation of shares should not be older than 180 days from the date of exercise of the option. Even if the shares are listed outside India, the company will have to obtain the certificate from the Merchant Banker as such shares are treated as unlisted shares for ESOP purposes.
Tax implications when the shares acquired under ESOP are disposed off
Now let us understand the second leg of the taxation of the ESOP shares, i.e. when the employee actually sells the shares. The incidence of sale will attract capital gains tax. The gains can be either long term or short term, depending on the period for which the employee has held the shares. The holding period requirement is different for listed shares as well as for unlisted shares. Listed shares shall become long term if held for more than one year. Unlisted shares become long term after three years. The period of three years has been proposed to be reduced to two years in the current budget.
The rate at which the short term or long term gains shall be taxed will depend on whether the shares have been traded on the platform of stock exchange on which the Security Transaction Tax has been paid. In case shares are traded through a broker, the long term capital gains are taxed under Section 112A at 10% over Rs 1 lakh of capital gains. However, such short-term capital gains shall be taxed at a flat rate of 15% under Section 111A.
However, in case the shares are not sold through the platform of the stock exchange, the long term capital gains shall be calculated after applying the indexation to the original cost of purchase. Indexed gains so calculated shall be taxed at a flat rate of 20% plus applicable surcharge and education cess. You have the option to pay tax @ 10% on capital gains without applying indexation benefits. Such short-term capital gains are be treated like any other income and added to other income and taxed at the slab rate applicable.
For the purpose of computing the capital gains the fair market value as on the date of exercise, taken into account for the purpose of perquisites of the options, is treated as the cost of acquisition and not the price actually paid by the employee.
The tax implications would be different in case the ESOPs are allotted to a person who is not an employee either by the holding or subsidiary company or the any non-executive director or any other eligible person. The question of it being taxed as perquisite does not arise when the option is exercised by such persons. However, the capital gains tax will have to be paid as and when such shares are sold.
Taxation of Foreign ESOPs
In case the ESOPs are granted by foreign companies to the Indian resident, the same would be taxable in India. Moreover, the taxation provisions of the country of the company which grants the option as well as the double taxation avoidance agreement shall have to be looked into for understanding the exact tax implication. Moreover concessional tax on long term capital gains under Section 112A or concessional rate of 15% tax on short term capital gain in respect of such shares would not be available as these shares would not be sold on Indian stock exchanges as these are not likely to be listed in India.
When should you sell the shares?
The decision to sell the shares acquired under ESOP is like any other investment decision. You need to take into account the capital gains implication as well as the need for liquidity for arriving at the decision. Moreover, whether and when to sell will also depend on the future prospects of the company. It may also happen that the shares which you have acquired under ESOP are not listed. So, in such a situation you can not sell the shares until the shares are listed or the promoters offer you an exit, which may not be at very attractive terms. In such a situation, it will make sense for you to wait a little till the shares are listed on a stock exchange.
Should you accept ESOPs in lieu of cash as part of salary?
An old saying goes, “One bird in hand is better than two in bush.” Common sense would demand that one should opt for cash in lieu of ESOPs, but here such a comparison may not be so easy to make because generally the projected price of shares under the ESOP plan may be significantly higher than the cash component being offered. Moreover, the option to chose cash in lieu of the ESOP may not always be available.