What are ESOPs and Tax on Sale of ESOPs? (with Examples)

ESOP stands for Employees Stock Option Plan. As the name suggests, this is an option given to the employees to become the shareholders of the company.

This option can be exercised after the employee has completed a specified no. of years with the company.

Some employers may also ask the employee to whom this option has been given to pay a small amount to convert these ESOP’s into Equity Shares.

Before understanding the levy of tax on ESOP’s, there are several key terms which a person should understand and these have been explained below.

Key terms associated with ESOP’s

Under the scheme of ESOP, there are 4 key terms that you need to be aware of,

1. Vesting Period

There is a certain lock-in period, wherein the employee has to stay in employment with the company before getting entitled to receive the shares. This lock-in period is called the vesting period.

If an employee leaves before the vesting period then he/she will not be entitled to any shares.

2. Options

Number of shares which are proposed to be allotted to the employee after the vesting period is known as options during the vesting period.

As the name suggests, ‘options’ is the choice given to the employee to buy the shares of the company. As long as the employee does not complete the vesting period and acquires the shares, it is called options.

3. Exercise Price

Once the vesting period is over, and the employees can convert the options into shares by paying a small price, which is called the exercise price. The exercise price is a nominal price that the employees pay to convert the options into shares.

4. Exercise Period

Once the employee has completed the vesting period, he gets entitled to convert his options into shares by paying the exercise price. The period during which the employee can convert the options into shares is called the exercise period. It begins at the end of the vesting period.

Let’s take an example to understand it better,

Illustration

Suppose your company has offered 100 options in the ESOPs Scheme to you. The vesting period is 3 years and the exercise period is 2 years. The Exercise Price (i.e. the price which you have to pay) is Rs. 50. The actual price of the share is Rs. 150

At the end of Year 3, the vesting period is complete and the employee can now convert these options into shares by paying the exercise price of Rs. 50.

After paying the exercise price of 50 x 100 = 5000, the employee will now become the holder of 100 shares.

And once you have the shares, the employee is free to sell them at any time like other shares.

Why are ESOPs issued?

ESOPs are issued by the company as a means to reward the employees performance and offer them a share of profit in the company by giving them the ownership through equity shares.

It is a cashless incentive method and brings in a sense of ownership within the employees. Moreover, the value of the shares is derived by the company’s performance, which further motivates the employee to work for the growth of the company as the personal goal aligns with company goals.

Benefits of ESOPs

The benefits of ESOPs can be seen from two angles, one for the employer and the employee’s perspective.

1. Benefits to the Employer

• Cashless Incentive

Many a times the company wants to reward or motivate its employees by giving incentives but due to cash crunch it is unable to do so. In such cases, the employer can issue ESOPs to its employees as an incentive without paying cash.

• Motivated Employee

By offering ESOPs to the employees, they get a sense of ownership in the company, which motivates the employee to improve his performance as his performance will directly affect the growth of the company which in turn will increase the value of his shares.

• Increase Employee Retention

ESOPs come with a vesting period which ensures that the employees will stay in the company for the said period, as they want to turn the ESOPs into shares. And once they have earned the shared, it gives them a sense of ownership, which further encourages them to stay in the company, thereby increasing the employee retention rate.

2. Benefits to the Employer

• Ownership

When ESOPs turn into equity shares, the employees get a share in the holding of the company which makes them feel belonged to the company and not just an employee. This ownership gives both pride and success.

• Share in profit

By holding equity shares in the company, the employee gets a share in the profit of the company by way of dividend. Also, with the growth of the company the value of shares of the company increases.

Tax on ESOP

ESOPs are taxable at two stages-

1. At the time when options are exercised by the employee and converted into shares

When the employee pays the exercise price and converts it into equity shares, it becomes taxable in the hands of the employee as a ‘perquisite’ received from the employer. The value of this perquisite is the difference between the Fair market Value of the shares and the Exercise Price. This amount is subject to TDS deduction by the employer as it forms a part of the salary.

This can be explained with the help of an example. In the above mentioned example, the employee was given shares worth Rs. 150 for Rs. 50 only. Thus, he made a profit of Rs. 100 as shares worth Rs. 150 were given to him for Rs. 50 only. This Rs. 100 would be considered as his Salary Income and taxed as Perquisites. The company would also deducted TDS on this Rs. 100 which is considered as Perquisites.

2. At the time of sale of shares

When the employee sells his shares, the profit arising on sale of such shares would be considered as capital gain in the hands of the employee. 

This can be explained with an example. Say for example, in the above case – the employee sells keeps these shares for 5 years and sells them for Rs. 400. The profit which he earned from these shares would be taxed as his Capital Gains and would be computed as follows:-