Published by Vinay Pandya Compiled by Chandni Shah
ESOP stands for Employee Stock Ownership Plan. Under this plan, employers offer their employees the stock of the company at a predetermined fixed price or discounted price that they can encash after a specified period at the specified price. In the event of significant growth of the corporation, the ESOP will have tremendous value of encashment in the market if the company is so listed. Examples in India include Infosys, Wipro, HCL, Mind Tree, Nykaa, Zomato, Policybazaar, Flipkart, Byjus, Ola.
ESOPs are designed so that employees’ motivations and interests are aligned with those of the company’s shareholders and employee’s retention.
How do ESOPs work?
Employers decide the number of shares to be offered under ESOPs, their price, and the beneficiary employees. ESOPs are then granted to employees and a grant date is provided.
First, an ESOP is set up as a trust fund. Here, companies may place newly issued shares, borrow money to buy company shares, or fund the trust with cash to purchase company shares. Once ESOPs are offered they remain in trust fund for a specified period, called the vesting period. Employees should stay with the organization for the vesting period to avail the ownership of stock by exercising the ESOP.
Once the vesting period is over, employees get the right to exercise their ESOPs. The date on which the vesting period expires is called the vesting date.
Employees can exercise their ESOPs and buy the company shares at allotted prices, which are lower than the market value. Employees can also sell the shares that they have bought through ESOPs and make gain on their holding.
If the employees leaves the organization or retires before the vesting period, the company is required to buy back the ESOP at a fair market value within 60 days.
Benefits of ESOPs for Employees:
- Stock ownership
Employees can enjoy ownership in the company that they work for as Esops give them sense of belongingness as they get right to own part of company’s share capital.
- Dividend Income
A profit earned by the company is distributed among the shareholders in the form of dividend. Employees can therefore earn additional income and get direct benefit from the efforts that they put in company profitability.
- Buy shares at Discounted rate
At the time of exercising the ESOPs, employees usually pay a nominal amount to buy the shares allotted to them. This allows them to invest in the company at a preferential rate.
Benefits of ESOPs for Employers:
- Employee Retention
Since the employees have to wait out the vesting period before they can exercise their ESOPs, it becomes easier to retain the employees.
- Better Productivity
Since employees themselves can earn from the profit earned by the companies, ESOPs encourage employee productivity and make them work more efficiently.
Example
Consider an employee who has worked at a large tech firm for five years. Under the company’s ESOP, they have the right to receive 20 shares after the first year, and 100 shares total after five years. When the employee retires, they will receive the share value in cash. Stock ownership plans may include stock options, restricted shares, and stock appreciation rights, among others.
Tax implication of ESOPs
There are dual tax implications of ESOPs
- When employee exercises his/her rights and buys the shares of the company.
- When employee sells the shares after buying them.
Tax implication at the Time of exercising the right
Employees can buy the shares after the vesting date at a lower rate than the fair market value (FMV)of the shares as of that date. As such, the difference between the FMV and the exercise price of the share is treated as a prerequisite in the hands of the employees and taxed at income tax slab rate.
Example:
| Exercise date | Jan 1, 2021 |
| FMV | 200/ share |
| Exercise price | 100/share |
| Taxable value of perquisite | 200-100 Rs.100/share |
| Number of shares to be exercised | 1000 |
| Total taxable perquisite | 1000*100= Rs. 100,000 |
| Tax payable (assuming slab rate at 30%) | 30% of 100,000= Rs.30,000 |
In case of start –ups however the government has relaxed the tax implications on ESOPs. Start –ups employees would not have to pay tax on the perquisite in the year when the exercise the ESOP. For them TDS on ESOPs would be deferred to following dates, whichever is earlier:
- Completion of five years from the ESOP grant date
- Date when the employees sells the ESOP
- Date of leaving the company
Tax implication at the Time of selling the shares
If the employee sells the shares, the difference between selling price and the FMV on the date when the share was exercised, would be subject to capital gain tax.
If the gains are earned after selling shares after 12 months of buying them, 10% tax would be applicable on gains exceeding Rs 1 lakh. If however sold in less than 12 months the gains would be taxed @ 15%
Example:
| Exercise date | Jan 1, 2021 |
| FMV as on January | RS 150/share |
| Case 1 :Shares sold on October 1, 2021 | |
| FMV on October 1,2021 | Rs 175/share |
| Difference between Fmv and selling price | 175 -150 =Rs 25/ share |
| Number of shares | 750 |
| Total amount of short term capital gain | 750*25= Rs 18,750 |
| Short term capital tax payable | 15% of Rs 18750 = Rs 2,813 |
| Case 2 : Shares sold on March 1, 2022 | |
| FMV as on 1 March 2022 | Rs 200 |
| Difference between Fmv and selling price | 200 – 150 = Rs 50/ share |
| Number of shares | 750 |
| Total amount of Long term capital gain | 750*50 = Rs 37,500 |
| Long term capital tax payable | Nil as gain is <1 lakh |
Conclusion:
ESOPs are generally a win-win for employers and employees, encouraging greater effort and commitment in exchange for bigger financial rewards. However, they are not always straightforward and can be frustrating if the participant doesn’t fully understand the terms of their particular plan.
Not all ESOPs are the same. Rules on actions such as vesting and withdrawals can vary, and it’s important to be aware of them to make the most of this benefit.
