Are you getting ESOPs as salary package? Know about taxability under Income tax Act, 1961
Background
ESOPs has gained popularity in last few decades and has been a factor to motivate, attract and retain the valuable employees in the organization by giving them a sense of ownership in the company by way of grant of ESOPs at pre-determined price or free of cost.
However, taxability of the ESOPs acts as roadblock. Thus , in this article, we have tried explaining the taxability of ESOPs in India.
Definitions
ESOP –Employee Stock Option Plan allows an employee to own equity shares of the employer company over a certain period of time.
Grant Date –The date of agreement between the employer and employee to give an option to own shares (at a later date).
Vesting Date –The date on which the employee is entitled to buy shares, after fulfilling all the conditions agreed upon. This date is also the agreed-on grant date.
Vesting Period – The time period between the grant date and vesting date which is agreed upon between the employer and employee .
Exercise Period – Once stocks options have ‘vested’ i.e vesting period is over, the employee now has a right to buy (but not an obligation) the shares within a period of time. This period is called exercise period.
Exercise Date – The date on which employee exercises the option.
Exercise Price – The price at which employee exercises the option at an agreed price.
Taxability under Income Tax Act, 2020
In the FY of allotment of ESOPs
As per Section 17(2)(vi) - The value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at concessional rate to the assessee.
Explanation.—For the purposes of this sub-clause,—
(a) "specified security" means the securities as defined in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and, where employees' stock option has been granted under any plan or scheme therefor, includes the securities offered under such plan or scheme;
(b) "sweat equity shares" means equity shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called;
(c) the value shall be the fair market value of the specified security or sweat equity shares, as the case may be, on the date on which the option is exercised by the assessee as reduced by the amount actually paid by, or recovered from, the assessee in respect of such security or shares;
(d) "fair market value" means the value determined in accordance with the method as may be prescribed;
(e) "option" means a right but not an obligation granted to an employee to apply for the specified security or sweat equity shares at a predetermined price;
Analysis
When the employee has exercised the option, basically agreed to buy; the difference between the FMV (on exercise date) and exercise price is taxed as perquisite when the shares are allotted to the employee as per section 17(2)(vi).
Value = FMV* on exercise date - Agreed pre-determined Price paid by employee
Tax Rate = Income tax slab rate will be applicable and taxed accordingly.
Illustration - On July 1, 2016 Mr. Ram an employee of ABC Pvt Ltd has been given an option under ESOP , to purchase 1000 shares of ABC Ltd. As per the policy, the option can be exercised at the end of 3 years(vesting period) i.e. July 1, 2019 at an exercise price of INR. 600.(pre-determined price).
On July 1, 2019, Mr. X exercised the his option. The fair market price of the shares of ABC Ltd at that time was INR 1000 and allotment made on August 1, 2019.
ESOPs would be taxed as perquisite:-
the value of which would be (on date of allotment) = (FMV per share – Exercise price per share) x number of shares allotted.
i.e (1000-600) x 1000 = 400,000
The amount calculated above as perquisite value of ESOP i.e. Rs. 4,00,000 shall form part of Ram’s salary and be taxable in the year of allotment of such shares i.e PY 19-20. Employer is liable to deduct TDS on such amount.
How to calculate FMV:- As per Rule 3(8) and (9) of the Income Tax Rules:-
(8)(i)The fair market value of any specified security or sweat equity share, being an equity share in a company, on the date on which the option is exercised by the employee, shall be determined in accordance with the provisions of below clause:-
The share in the company is listed on a recognized stock exchange:-
On the date of the exercising of the option, the fair market value shall be the average of the opening price and closing price of the share on that date on the said stock exchange.
The share is listed on more than one recognized stock exchanges:-