Tax Implications of Employee Stock Purchase Plans (ESPPs)

What is an Employee Stock Purchase Plan (ESPP)?

Employee Stock Purchase Programs (ESPPs) offer employees the opportunity to receive company shares at a discounted rate, fostering a sense of ownership and commitment. These programs enable workers to allocate a portion of their paycheck toward stock purchases, aligning their interests with the company’s success.

By participating in an ESPP, employees can benefit financially through stock appreciation, dividends, and overall corporate growth. The discount on stock purchases is typically set below the market price, making it an attractive investment option.

Enrollment periods allow employees to contribute a designated percentage of their salary toward stock purchases. Even after the offering period, they can continue acquiring shares at a reduced cost, leveraging market gains while strengthening their connection to the company.

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Types of ESOP's

There are four types of Employee stock options as follows:

• Employee Stock Option Plan (ESOP) – A company grants employees the right to purchase its shares at a discounted price, offering ownership incentives.
• Employee Stock Purchase Plan (ESPP) – Employees can buy company shares, often at a discounted price from the Fair Market Value (FMV), typically assessed at the end of each quarter.
• Restricted Stock Unit (RSU) – Shares are awarded to employees but are subject to specific conditions such as performance targets, revenue goals, or other achievement-based criteria.
• Stock Appreciation Rights (SARs) – Employees receive financial benefits based on the stock’s appreciation. The difference between the grant price and the execution price is paid out either in cash (Cash-Settled SARs) or in company shares (Equity-Settled SARs).

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Terms to Understand Before Assessing Tax Implications on ESOPs

There are terms related to ESOP that you need to know before you understand how ESOPs are taxed.

• Grant – The company offers employees the option to purchase its shares.
• Grant Date – The date when the employer and employee formalize an agreement, giving the employee the right to acquire shares in the future.
• Vesting – The process by which an employee earns the right to exercise stock options.
• Vesting Date – The specific date when an employee becomes eligible to purchase shares, provided all predefined conditions are met. This date is determined at the time of the grant.
• Exercise Period – The timeframe during which an employee can purchase shares after they have vested.
• Exercise Date – The actual date when an employee applies to acquire shares from the company.
• Exercise Price – The price at which an employee buys company shares. Typically, this price is set below the fair market value, depending on the type of stock option granted.

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How ESOPs are Taxed in the Hands of the Employee

Stock options are taxed at two stages: when exercised and when sold.

At the Time of Exercise

• When an employee exerts stock options, the difference between the Fair Market Value (FMV) on the exercise date and the exercise price paid is treated as a perquisite and taxed as salary income.
• Example: If an employee receives stock options at an exercise price of ₹100 per share, and the FMV on the exercise date is ₹250 per share, the taxable perquisite will be ₹150 per share (₹250 - ₹100).

At the Time of Sale

• When the employee sells the shares at a later date, capital gains tax applies in that financial year.
• Short-Term Capital Gains (STCG) applies if sold within 24 months and is taxed at the employee’s income tax slab rate.
• Long-Term Capital Gains (LTCG) applies if sold after 24 months, taxed at 10% without indexation or 20% with indexation, whichever is lower.
• Example: If the employee sells the shares after 3 years for ₹400 per share, the capital gain is ₹150 per share (₹400 - ₹250), which will be subject to LTCG tax.

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Capital Gains Tax on Stock Options

The taxation of capital gains on stock options depends on whether the stock is listed or unlisted and the holding period.

Unlisted Stock Options

• Held for 2 years or more; 20% tax rate with indexation benefit.
• Held for less than 2 years; Taxed at the employee’s income tax slab rate.

Listed Stock Options

• Held for 1 year or more; 10% tax rate on long-term capital gains.
• Held for less than 1 year; 15% tax rate on short-term capital gains.

Recent changes on Capital Gains Tax

Effective July 23, 2024, significant changes in capital gains taxation have been introduced:

These changes impact how capital gains from stock options are taxed, reducing long-term tax rates for unlisted stocks but increasing short-term tax rates for listed stocks.

If you still need help with taxation on your ESOPs, our tax experts are just a click away. Book Consultation with Online CAs Now!

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