Budget 2023: ESOP taxation needs a look-in

Given the continuous evolution of ESOPs domestically and internationally, regulators have time and again revised and issued requisite guidelines.

Published: 28th January 2023 01:52 PM  |   Last Updated: 28th January 2023 05:52 PM   |  A+A-


Image used for representational purpose only. (File Photo)

Employee Stock Option Plan (ESOP), the secret recipe in building employee wealth, has been gaining prominence over the years as a powerful means to lure and retain talent. Traditionally, kings in India parted a portion of their kingdom to their admirals and lieutenants, as reward for their contribution.  Over the years, many such practices evolved and what we witness today in the corporate world is a way of remunerating employees by providing ownership rights (ESOPs). Regulatory developments had also kept pace with the speed of ESOP development in India. Given the continuous evolution of ESOPs domestically and internationally, regulators have time and again revised and issued requisite guidelines.

There are various stock incentive plans that are offered as part of the strategic employee compensation and retention plan, like stock options, stock purchase plans, stock appreciation rights, phantom stocks and others, each of which could have different variants and taxation norms in India.

Typically, the programme would involve grant of the benefit by the employer which will vest over a period of time.  Once the vesting tenure is over, employees can exercise and their shares will be allotted or cash settled, depending on the type of programme.  

As ESOPs envisage grant of option in respect of shares at a pre-determined price - usually the price is lower than fair market value - there is an element of benefit accruing to employees when they exercise the options, which are considered as taxable income in the hands of employees.

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However, the tax implications for ESOPs were somewhat ambiguous until the government brought in certain amendments through the Finance Act of 1999. One view that existed prior to the amendment was that tax could be attracted on mere grant of stock options. Nevertheless, the 1999 amendment made it apparent that stock options will be taxed as perquisites, at the time of exercise of the option by the employee, and later as capital gains at the time of sale of the security. Pursuant to strong representations, the law was further amended by the Finance Act 2000 and 2001, whereby stock options would be subject to capital gains tax once, at the time of sale, if the shares had been issued under the Employees Stock Option Plan or Scheme, in accordance with the central government’s corresponding guidelines.

Subsequently, ESOPs were brought under the fringe benefit tax (FBT), whereby the employer was required to pay tax on the allotment of shares to an employee. Consequent to the abolition of FBT in 2009, the government reinstated the two-stage taxation of stock options in the hands of employees, first at the time of exercise and then at the time of sale. This unearthed similar hardships wherein employees were taxed when they exercised the options and had not realised any gains nor was there any certainty on the eventual realisation of the gains.

Considering that there is no income that is realized in the hands of the employee at the stage of allotment of shares, it is important that the government lifts the tax at the time of allotment of shares and defers it to a point when the benefit is truly realised by the employee upon actual sale. Particularly, employees of unlisted entities may not have enough cash on hand to pay tax at the time of the ESOP exercise, due to lack of liquidity; therefore a deferral in taxing events is at the top of their wish list.

While the government amended regulations in 2020 to allow deferral in the tax payment, by five years, or till the time that employees leave the company or when they sell their shares, whichever occurs first; this is applicable only for employees working for certain eligible startup companies.

Yet another aspect that needs explicit mention under the tax law is the taxation of ESOPs in case of mobile employees who divide their careers among many nations and qualify as Non-Residents (NR) or Not Ordinarily Residents (NOR) of India. While there are certain judicial rulings permitting pro-rata taxation based on the number of days spent in India during the grant-to-vest period, it is expected that the government clarifies this aspect to minimise litigation.

Hopefully, the upcoming Budget of 2023 has some favourable proposals to benefit ESOP holders, especially in times of economic slowdown where companies are lacking cash and are relying on equity compensation to attract employees and retain them.

Sudhakar Sethuraman, and Ratna K

Director, Deloitte India


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