ESOP-What is It? Benefits and Taxability of ESOP

What is ESOP?

An ESOP is a type of employee benefit plan that allows employees to buy company stocks at a price below the market value, with the added benefit of ownership interest. Over time, employees can become equity shareholders in the company and benefit from its growth. ESOPs are typically granted to employees as an incentive at the end of the financial year. They can motivate and appreciate employees by giving ownership of the company, which can help reduce employee turnover rates.

What are the benefits of ESOP?

• Tax benefits
  ESOPs offer several tax benefits to both companies and employees. Companies can make tax-deductible contributions to the ESOP trust to buy company stock, and employees can defer paying taxes on the stock they receive through the ESOP until they sell it.
• Positive growth of the company
  The National ESOP Comparison Study conducted by Rutgers University found that companies that adopted Employee Stock Ownership Plans (ESOPs) showed a 2.4% increase in annual sales growth and a 2.3% increase in annual employment growth compared to non-ESOP companies. The study was based on a sample of over 1,000 companies, and the results were held across a range of industries and companies of different sizes.
• Earn additional income
  As the company earns profit, it is distributed among the shareholders in the form of dividends. Thus, the employees earn additional income in the form of dividends.
• Benefits for employers
  ESOPs are a good way to retain employees as they have to wait out the vesting period before they can exercise their ESOPs. Also, providing the company’s shares motivates the employees to increase productivity and make the company more profitable.
• Buy shares at a preferential rate
  While exercising the ESOP, employees get the chance to buy the shares allotted to them at a nominal amount.

What are the key terms that you should know about in ESOP?

To understand ESOPs better, it's important to know some key terms.

• Grant Date - This is when the employer gives the employee the option to own shares of the company at a later date.
• Vesting Date – Once both parties agree after fulfilling certain conditions, the vesting date is when the employee is entitled to buy shares.
• Vesting Period – The period between the grant date and vesting dates.
• Exercise Period – Once the vesting of stocks is done, the employee now has a choice to buy the shares within a period of time. This period is called the exercise period.
• Exercise Date – The date on which the employee exercises the option.
• Exercise Price - The price on which employees exercise the option is the exercise price. This price is usually below the fair market value of the stock.

How does an ESOP work?

• First, the company creates an ESOP trust and contributes cash to allow employees to buy shares of stock from existing owners or the company itself at less than the fair market value.
• If the company doesn't have enough cash, the ESOP can take out a loan to buy new or existing shares while the company contributes money to help pay off the loan.
• The employee then receives a share in the trust based on the number of years worked, compensation, or both. The share stays in the trust for a set period known as the vesting period, after which the employee can claim the shares.
• The employee can then buy the shares at the agreed price below the fair market value and sell them for a profit.
• If an employee leaves or retires before vesting, the company must buy back their shares within 60 days.

Cost of ESOPs and Distributions

Legal fees, accounting fees, and administrative expenditures can be considered as initial costs for establishing an Employee Stock Ownership Plan (ESOP) in India. The overall cost of implementing and maintaining an ESOP can vary based on the plan's size and complexity.

In India, ESOP distributions can occur in various ways. When an employee exercises their stock option to acquire shares, they can choose to sell them immediately or hold onto them for potential future appreciation.

If the employee opts to sell the shares, the proceeds, after deducting any taxes due on the gain, will be disbursed to them. Alternatively, if the employee decides to retain the shares, they become partial owners of the company and may be eligible for dividends or capital gains if the stock price increases. The structure and outcomes of ESOP distributions provide flexibility for employees in managing their stock options.

Taxability of ESOP calculated under the Income Tax Act

1. Grant of ESOP: When the ESOP is granted to the employee, it is not taxable as income. However, when the employee exercises the ESOP and acquires the shares, the difference between the fair market value of the shares on the date of exercise and the exercise price paid by the employee is taxable as perquisite in the hands of the employee.
2. Sale of ESOP shares: When the employee sells the ESOP shares, the difference between the sale price and the fair market value of the shares on the exercise date is treated as capital gains. If the shares are held for less than 12 months, the short-term capital gains are taxed at the applicable rate. If the shares are held for more than 12 months, the capital gains are long-term and are taxed at a lower rate.
3. Tax deduction for employers: Employers can claim a tax deduction for the cost of the shares issued to employees under the ESOP scheme. The deduction is allowed in the year the employee exercises the option and acquires the shares.

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Example on the Taxation of ESOPs

• First level of taxation (when the option is exercised):
  1. On July 1, 2017, Mr. X exercised his option to purchase 10,000 shares of ABC Ltd. at an exercise price of INR. 60 per share. The fair market value (FMV) of the shares on the exercise date was INR 100 per share. Therefore, the perquisite value would be calculated as follows:
     Perquisite value = (FMV per share – Exercise price per share) x number of shares allotted
     = (100 - 60) x 10,000
     = INR 400,000
     So, INR 400,000 would be added to Mr. X's taxable income as perquisite in the financial year 2017-18.
• The second level of taxation (when the shares are sold):
  1. On January 31, 2018, Mr. X sold the shares at INR 120 per share. Therefore, the capital gain on the sale of shares would be calculated as follows:
     Capital gain = Sale price per share - FMV per share on the date of exercise
     = 120 - 100
     = INR 20 per share

Since the shares were held for more than 12 months, the capital gain would be treated as a long-term capital gain. If the total capital gains on the sale of shares in the financial year 2017-18 exceed INR 1 lakh, Mr. X would have to pay long-term capital gains tax at the rate of 10% on the amount exceeding INR 1 lakh.

Budget 2020 Amendment for ESOPs

As per the amendments under budget 2020 from FY 2020-21 onwards, when an employee receives ESOPs from an eligible startup, they need not pay tax in the year of exercising the option. The employer can postpone this deduction of TDS up to any of the following events, which occurs first:-

• Expiry of 5 years from the year of allotment of ESOP
• Date of sale of ESOP by the employee
• Date of termination of the employment