Tax Talk: Know how tax on ESOPs is calculated for employees of eligible startups

By Shailesh Kumar

Employee stock option plans (ESOPs) have become popular amongst corporates, especially in the IT industry, to attract and retain talent. Different schemes are introduced by the employers; however, the complete benefit accrues to the employees when the lock-in conditions are met; or vesting period is completed by the employees.

Tax implications in the hands of employees
The taxability of ESOP in the hands of employees involves two stages. First, you need to pay tax by considering the benefit derived from ESOP as a part of your salary and second levy occurs when the employee sells the shares granted under ESOP. We have discussed each stage briefly as below

I. Taxed under head salary as perquisites: The difference between fair market value of share vis-à-vis actual price, at which such ESOPs are allotted to the employee, on date of exercise of ESOP option, is considered as perquisite / salary incentives in the hands of employee and the same is chargeable to tax under the head ‘income from salary’.

II. Taxed as capital gains: When an employee sells such shares, the gain arising  i.e., actual sale price minus the fair market value on date of exercise of ESOP option, is taxed under the head ‘Capital Gains’.

In general, the taxability under stage one results in an additional tax burden on the employees as by then they only get the shares but no actual inflow of funds. The tax payment on such an incentive goes out of their pocket as additional taxes are withheld by their employers, if they don’t sell the shares immediately.

Relief for employees of eligible startups
Considering that India is the third largest startup ecosystem in India, the government  recently relaxed the taxability of ESOPs exclusively for Indian startupsunder the first stage; i.e., the employee does not need to pay taxes as soon the shares are allotted to him under an ESOP granted by an eligible startup. A scheme of late/ delayed taxation of such benefit has been made applicable from ESOPs allotted on/ after  April 1, 2020 (i.e. financial year 2020-21 onwards). With this, now the taxes will need to be withheld by the employers on such ESOP benefits after a period of four years.

However, the tax deduction may also trigger early; i.e., in the year when the employee sells such shares or leaves the employer who had granted the ESOPs.

What constitutes an eligible startup
As this delayed taxation is only applicable for the employees of eligible startups, it becomes important to analyse whether a startup is eligible under income tax laws or not. Eligible startup has been defined to include a company or a limited liability partnership engaged in eligible business— innovation, development or improvement of products or processes or services or a scalable business model with a high potential of employment generation or wealth creation which fulfils the following conditions, namely (a) it is incorporated between 1.04.2016 and 1.04.2022; (b) its turnover does not exceed Rs 100 crore; and (c) it holds a certificate from the Inter-Ministerial Board of Certification of India

Conclusion
Accordingly, in case an employee has received ESOPs from his employer, for determining his income tax liability on such ESOPs, he would need to ascertain, whether the employer is an eligible startup, whether conditions for claiming deferred tax payment on such ESOPs granted by an eligible start are fulfilled or not. Further, for determining the tax liability, employees must know the fair market value of such ESOPs on the date of exercise. Such details would be quite important for determining his income tax liability.

The writer is partner, Nangia & Co LLP. Inputs from Mayank Khaneja