An Employee Stock Ownership Plan (ESOP) is a benefit plan that gives employees ownership interest in the company. In simple terms, it’s a way for a company to give its employees a piece of the business—like a reward for being part of the team.
It works by allocating company shares to employees, typically based on factors like salary or years of service. Over time, employees build up shares in the company, which can grow in value as the business grows.
Think of an ESOP as a retirement plan but instead of investing in mutual funds or stocks of other companies, it invests primarily in the employer’s own stock. By giving employees a stake in the company, it creates a culture of ownership that can propel business forward.
Types of ESOPs
1. Stock Options: Employees can purchase company stock at a specified price.
2. Restricted Stock Units (RSUs): Employees receive company stock after meeting vesting requirements.
3. Employee Stock Purchase Plans (ESPPs): Employees can purchase company stock at a discounted price.
How ESOPs Work?
- The company sets up a trust to hold its shares.
- Shares are allocated to individual employee accounts within the trust.
- Employees gain ownership of shares over time through a process called vesting.
- When an employee retires or leaves the company, the company buys back the shares at fair market value, and the employee receives the proceeds.
Common Misconceptions & Clarification about ESOPs
1. Misconception: Employees are required to purchase company shares.
Clarification: Typically, shares are allocated to employees by the company without any out-of-pocket expense.
2. Misconception: Employee ownership equates to control over company decisions.
Clarification: While employees hold beneficial ownership, decision-making authority usually remains with senior leadership or appointed trustees, except in significant corporate matters.
3. Misconception: Shares can be sold by employees at any time.
Clarification: Unlike publicly traded stocks, these shares are not listed on the stock market. Employees typically receive payouts upon retirement, departure, or under specific approved circumstances.
4. Misconception: Such plans are merely bonus schemes.
Clarification: They function more like retirement benefits, accruing value over time to support employees financially upon leaving the company or retiring.
5. Misconception: Only large or publicly traded companies offer employee ownership programs.
Clarification: Businesses of various sizes, including small and medium enterprises, can implement these plans to engage and reward their workforce.
Taxation of ESOPs for Employers in India
When a company grants or allots ESOPs to employees, no tax event is triggered for the company at that moment. When the employee exercises the ESOP (i.e., buys the shares at the exercise price), the difference between the Fair Market Value (FMV) and the exercise price is treated as a perquisite (salary income) for the employee.
- The company must deduct TDS on the perquisite amount at the time of exercise.
- This perquisite is considered a tax-deductible expense under Section 37(1) of the Income Tax Act.
- This means the company can claim it as a business expense while calculating its taxable income.
- Capital gains tax applies only to employees when they sell the shares. The employer has no tax liability when the employee sells their ESOP shares.
Taxation on ESOPs in India for Employees in India
When employee’s exercise the ESOP (buy the shares)
The employee has to pay tax on the “perquisite” — the difference between the fair market value (FMV) of the share on the exercise date and the exercise price (price paid to buy the share). Perquisite is taxed as per income tax slab of the employee.
When the employee sell the shares
Now the employee has to pay capital gains tax on the profit he/she make when the shares are sold.
Capital Gain = Sale Price – FMV on exercise date
The Tax rate on capital gains depends on how long the shares are held:
Compliance and Reporting Requirements for Employer
- ESOPs must be reported in the employee’s Form 16 (as part of salary).
- Companies may need to value shares (especially in unlisted companies) via a registered merchant banker for accurate FMV.
- ESOP-related deductions and benefits must be properly documented and disclosed during tax filings.
Compliance & Reporting Requirements for Employee
- The perquisite value is added to the salary income & reported in Form 16. This must be included in the personal Income Tax Return (ITR) under the “Salary” head by the employee.
2. When ESOP shares are sold, it must be reported as capital gain in the Income Tax Return.
3. Use the Correct ITR Form
- Use ITR-2 or ITR-3 if you have capital gains (from sale of ESOP shares).
- Use ITR-1 only if ESOP is not sold or only income is salary including ESOP perquisite
Maintain Supporting Documents
- Grant letter and vesting schedule
- Exercise confirmation
- FMV certificate (especially for unlisted shares)
- Sale transaction details and brokerage statement
- Proof of tax (TDS certificate, Form 16)
Foreign ESOPs (Additional Reporting)
If your ESOPs are in a foreign parent company, you also have to:
- Disclose foreign assets under Schedule FA in your ITR (if applicable)
- Report foreign income if shares are sold and gains are realized
Non-disclosure of foreign holdings can attract penalties under Black Money Act.
Summary
The tax implications of ESOPs can be complex, and employers or employees should seek professional advice to ensure compliance with tax laws and regulations.
