Is ESOP Taxable?

An Employee Stock Option Plan (ESOP) is a scheme for employee compensation provided by listed companies. Under the scheme, a portion of the salary due to be received by the employee is settled by means of making an allotment of shares to the employee. The concept of ESOP shares and sweat equity shares are related. Taxpayers should note that the value of any ESOP or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at a concessional rate will be taxable as per the Income Tax Act. The Income Tax Act mentions that when an employer makes an allotment of sweat equity shares to the employee, the allotment will be considered as a perquisite in the income tax assessment of the employee. Perquisites which are provided by the employer to an employee are taxable under the Act. In the Budget 2020 announced on 01.02.2020, the Finance Minister announced a new method for the treatment of ESOP under the Income Tax Act. As per the announcement, tax payment on ESOP is deferred to five years or till the time of leaving the company of employment or at the time of sale of the shares, whichever is the earliest.

ESOPs vs Sweat Equity

ESOPs and sweat equity are both ownership rights provided to an employee as a reward for performance or tenure of employment with the company. ESOP is when the employee receives a right to purchase a certain number of shares in the company at a predetermined price after a predetermined period. Know more about ESOPs.
Sweat equity shares are equity shares issued by a company to its directors or employees at a discount for consideration, other than cash, for providing know-how or making available intellectual property rights like copyright, patent or trademark or other value additions. Know more about sweat equity.

ESOP Valuation for Income Tax

The value of ESOP or sweat equity shares will be the fair market value, on the date on which the option is exercised by the assessee as reduced by the amount actually paid or recovered for the ESOP or sweat equity. The fair market value of an ESOP can be determined under one of the two methods mentioned below:

Fair Market Value where Shares are Listed on a Stock Exchange

If on the date of exercising of the option, the share in the company is listed on a recognised stock exchange, the fair market value will be the average of the opening price and closing price of the share on that date on the stock exchange. If the stock of the company is traded in multiple stock exchanges, then the fair market value of the shares will be average of opening price and closing price of the share on the recognised stock exchange which records the highest volume in trading. If there was no trading in the shares on any recognised stock exchange on the date of exercising of the option, the fair market value will be:

The closing price of the share on any recognised stock exchange on a date closest to the date of exercising of the option and immediately preceding such date, or
The closing price of the share on a recognised stock exchange, which records the highest volume of trading in such share, if the closing price, as on the date closest to the date of exercising of the option and immediately preceding such date, is recorded on more than one recognised stock exchange.

Fair Market Value where Shares are NOT Listed on a Stock Exchange

If on the date of exercising the option, the share in the company is not listed on any recognised stock exchange, the fair market value will be the value of the shares in the company as determined by a merchant banker on the specified date. Merchant banker means any Category I merchant banker registered with SEBI.

Taxability of ESOP

ESOPs received by an employee are taxable under the Income Tax Act. ESOPs are taxed at two different times:

Allotment of ESOP

First, as per Finance Act, 2009, the value of ESOP in excess of Rs.1 lakh would be added as a perquisite under the head Salaries and taxed when received by an employee. The difference between the fair market value of the ESOP as calculated above and any subscription paid by the employee (if any), would be taxed as perquisite under the head "income from salary" on the date of allotment of shares. The income tax rate at which the perquisite would be taxable will be based on the applicable income slab in the financial year, in which the ESOP was allotted.

Sale of ESOP Shares

When the employee sells the shares or warrants received under an ESOP plan, the employee would be required to pay capital gains. The capital gain could be a short-term gain or a long-term gain depending on the period of holding of shares.

Section 73 of the Finance Act, 2020

Section 73 of the Finance Act amends the law relating to the taxability of ESOPs. The text of the section is provided below for reference:

(1C) For the purposes of deducting or paying tax under sub-section (1) or sub-section (1A), as the case may be, a person, 

being an eligible start-up referred to in section 80-IAC, responsible for paying any income to the assessee 

being perquisite of the nature specified in clause (vi) of sub-section (2) of section 17 

in any previous year relevant to the assessment year, beginning on or after the 1st day of April, 2021, 

shall deduct or pay, as the case may be, tax on such income within fourteen days– 

(i) after the expiry of forty-eight months from the end of the relevant assessment year; or 

(ii) from the date of the sale of such specified security or sweat equity share by the assessee; or 

(iii) from the date of the assessee ceasing to be the employee of the person, whichever is the earliest, 

on the basis of rates in force for the financial year in which the said specified security or sweat equity share is allotted or transferred.