ESOP – Employee Stock Option Plans
Last week, we had a fresh college graduate visit our office to learn about Employee Stock Option Plans (ESOPs). She had a vague understanding on a theoretical level about ESOPs but wanted a more solid explanation. We had a productive discussion, using examples of our clients who received ESOPs from both Indian companies like Mahindra and multinational corporations like Microsoft and Accenture.
By the end of our meeting, she had a clear grasp of what ESOPs are, how they function, their tax implications, and the potential benefits they offer employees.
This blog post is inspired by our conversation with this inquisitive young professional.
Employee Stock Option Plans (ESOPs) are a way for companies to offer employees ownership in the business. Here’s how they work, how they are taxed, and specific considerations for ESOPs in foreign-listed companies:
1. What are ESOPs and How Do They Work? ESOPs are a type of employee benefit plan that allows employees to purchase company shares at a predetermined price, often lower than the market rate.
Grant: The company gives an option to employees to buy a certain number of shares after a specified period (vesting period).
Vesting Period: This is the time an employee must wait before they can exercise the option and purchase shares.
Exercise: After the vesting period, the employee can exercise the option to buy shares at the predetermined price.
Sale: The employee can then sell these shares, typically after a lock-in period.
2. Taxation of ESOPs in India:
ESOPs are taxed at two points:
At the time of exercise: The difference between the fair market value (FMV) of the shares on the date of exercise and the exercise price paid by the employee is considered as a perquisite (income from salary) and is subject to income tax.
At the time of sale: When the employee sells the shares, the profit made (i.e., the difference between the sale price and the FMV on the exercise date) is subject to capital gains tax.
3. ESOPs in Foreign-Listed Companies:
If the ESOPs are granted by a foreign company listed in another country, there are additional considerations:
Exercise and Perquisite Taxation: The employee will still be taxed on the FMV of the shares on the exercise date minus the exercise price. This amount will be added to their salary income and taxed in India.
Foreign Exchange Fluctuation: If the shares are denominated in a foreign currency, appreciation or depreciation of the foreign currency may affect the capital gains when the shares are sold.
Taxation on Foreign Currency Appreciation: The gain from foreign currency appreciation is part of the overall capital gain and will be taxed as capital gains in India.
Double Taxation Avoidance: If taxes are paid on the sale of ESOPs in the foreign country, employees can use the Double Taxation Avoidance Agreement (DTAA) between India and the foreign country to avoid paying tax twice.
4. Benefits of ESOPs to Employees:
Wealth Creation: Employees gain an ownership stake in the company and benefit from the increase in share value over time.
Alignment with Company Goals: By owning shares, employees are more likely to work toward the company’s growth and success, benefiting both the company and themselves.
Deferred Compensation: ESOPs often serve as a form of deferred compensation, helping companies retain talent over longer periods.
5. Tax Benefits for Employees:
Long-Term Capital Gains: If shares are held for a long period, the tax rate on capital gains is lower, especially if the gains qualify for LTCG rates.
Tax Deferral: The tax on ESOPs is generally only due upon exercise and sale, allowing employees to defer tax liability until they receive actual cash benefits.
To sum up, ESOPs provide employees with ownership and potential financial gains through capital appreciation. They are taxed when exercised and when sold, with additional considerations for foreign-listed companies regarding currency fluctuations and tax treaties.
The content made available in this article is for general informational purposes only. While every effort has been made to ensure the accuracy and completeness of the content, it should not be considered as a substitute for professional consultation.
