Taxation on ESOP RSU Stock Options

ESOPs (Employee Stock Ownership Plans) have become common in India and are gaining popularity. Many international companies with employees in India also offer ESOPs.

An ESOP is a plan that allows employees to own shares in the company they work for. It works like a profit-sharing plan. In an ESOP, the company offers its shares to employees at a very low price. These shares are kept in a trust fund until the employee becomes eligible (after a certain period) or leaves/retires from the company.

Budget 2024 Latest Updates

The following changes were made in Budget 2024, effective from the financial year 2024-25:

1. For classifying assets as long-term or short-term, there will only be two holding periods: 12 months and 24 months. The previous 36-month holding period has been removed.
2. For listed securities, the holding period will be 12 months. Any listed securities held for more than 12 months will be considered long-term. For other assets, the holding period will be 24 months.
3. Unlisted bonds and debentures will now be taxed the same way as debt mutual funds and market-linked debentures. They will be taxed on capital gains at the applicable income tax slab rates, meaning they will be treated as short-term assets regardless of how long they are held.
4. The tax rate on Short-Term Capital Gains for listed equity shares, units of equity-oriented funds, and units of business trusts has increased from 15% to 20%. Other short-term financial and non-financial assets will still be taxed at the usual income tax slab rates.
5. To help lower and middle-income groups, the exemption limit for Long-Term Capital Gains on the sale of equity shares, equity-oriented funds, or business trust units has been increased from Rs. 1 lakh to Rs. 1.25 lakh per year. However, the tax rate on these gains has increased from 10% to 12.5%. The new exemption limit of Rs. 1.25 lakh will apply for the whole year, but the higher tax rate will only apply from July 23, 2024.

Terms on ESOPs

Before understanding the tax rules for ESOPs and RSUs, here are some important terms to know:

• ESOP (Employee Stock Option Plan): This plan lets employees own shares in the company they work for over a certain period. The details of the plan are decided between the employer and the employee.
• ESPP (Employee Stock Purchase Plan): This plan allows employees to buy shares of their company at a discounted price. The amount is deducted directly from their salary or paid from their bank account.
• RSU (Restricted Stock Units): These are often given by companies outside India. RSUs are given to employees as a reward when they meet certain targets. Employees don’t need to pay anything for these.
• Grant Date: The date when the employer and employee agree that the employee will have the option to buy shares in the future.
• Vesting Date: The date when the employee becomes eligible to buy the shares, after meeting certain conditions agreed upon earlier.
• Vesting Period: The time between the grant date and the vesting date.
• Exercise Period: After the options vest, the employee has the right (but not the obligation) to buy the shares for a certain period. This is called the exercise period.
• Exercise Date: The date when the employee decides to use the option and buy the shares.
• Exercise Price: The price at which the employee buys the shares, which is usually lower than the current market value of the stock. This price is agreed upon when the ESOP is granted.

Once the employee meets the conditions or the time period passes, the stock options “vest.” This means the employee can buy the shares at the exercise price, which is usually lower than the market value. The employee can choose not to buy the shares, and in that case, no tax is paid.

Calculating Taxes

ESOPs are taxed in two situations:

1. When the employee exercises the option (as a perquisite):
   When an employee buys shares through the ESOP, the difference between the market value of the shares (on the day they are bought) and the exercise price is taxed as a benefit (perquisite). The employer will deduct TDS (Tax Deducted at Source) on this benefit, and the amount will be included in the employee’s salary income for tax purposes, as shown in their Form 16.
   Note: From the financial year 2020-21, if the ESOPs are given by an eligible start-up, the employee doesn’t have to pay tax in the year they exercise the option. The TDS on this benefit is delayed until one of the following happens:
   • Five years after the year the ESOPs were allotted
   • The employee sells the ESOPs
   • The employee leaves the company
2. When the employee sells the shares (as capital gain):
   After buying the shares, the employee can choose to sell them. When they sell the shares, another tax event happens. The difference between the selling price and the market value on the day the shares were bought is taxed as capital gains.

Capital Gain computation is as follows:

Example: Mr. Z works at ABC Ltd. He was given the option to buy 2000 shares at Rs. 80 per share on April 1st, 2021. He chose to buy the shares on January 1st, 2023. Later, he sold some of his shares on October 1st, 2023, and the rest on March 3rd, 2024.

How to Calculate FMV

The Fair Market Value (FMV) of a stock is the market price of the stock when the employee buys it. This is important because when the employee sells the stock, the FMV at the time they bought it will be used to calculate how much they paid for it.

Advance Tax on Capital Gains

Advance tax rules require you to pay an estimate of your total tax for the year in advance, in installments. TDS is deducted when you exercise your options, and you need to pay advance tax if you make capital gains from selling the shares later.

For the financial year 2023-24, the advance tax installments are due on June 15th, September 15th, December 15th, and March 15th. By March 15th, you must have paid all your taxes for the year.

If you don’t pay the advance tax on time, or if you pay less than required, you will be charged a penalty under sections 234B and 234C. However, it can be difficult to estimate capital gains tax in advance.

So, if you pay your advance tax installments on time, but the amount is short because of capital gains, you won’t be penalized. The remaining amount, after selling shares, must be paid in the next advance tax installment when it’s due.

Other Considerations

To properly calculate tax on the sale of ESOPs, there are a few other things to keep in mind:

1. Sell to Cover the Transaction
   When the stocks are exercised after the vesting period, the employer must deduct TDS (Tax Deducted at Source) under Section 192 based on the fair market value (FMV) of those shares. The FMV of these shares is treated as a benefit (perquisite) and is taxed as salary income.
   Since stocks are a non-cash benefit, the question is: how will the employer deduct and pay the TDS? Employers can either ask you to pay the TDS directly through a bank transfer, or, in most cases, they will do a “sell-to-cover” transaction. This means they will sell some of the shares you’ve been given to cover the taxes.

2. Capital Gains/Losses

The tax rates on your capital gains depend on how long you hold the shares. The holding period is calculated from the exercise date to the date you sell the shares.

• For equity shares listed on a stock exchange (where STT is paid when sold), if you hold them for more than a year, the gains are considered long-term. If sold within a year, they are short-term gains.
• Long-term gains on listed shares are taxed at 10% for amounts above Rs 1 lakh, while short-term gains are taxed at 15%. From 23rd July 2024, long-term gains on listed shares will be taxed at 12.5% for amounts over Rs 1.25 lakh.
• If you make a loss, you can carry forward the short-term capital loss and use it to offset gains in future years.

3. Listed or Unlisted Shares

The tax rules for listed and unlisted shares are different. If you own shares of a company that is not listed in India (like an American company), those shares are treated as unlisted for tax purposes in India.

• For unlisted shares, they are considered short-term if sold within 2 years, and long-term if sold after 2 years. This rule applies to sales made after 1st April 2016.
• The holding period is counted from the exercise date to the sale date.
• Short-term gains are taxed based on your income tax slab rates, while long-term gains are taxed at 20% after adjusting for inflation (indexation).

5. Buyback of Stock Options
A buyback happens when the company buys back the stock options from the employee before they turn into shares. This is common in unlisted Indian companies or startups. These companies offer ESOPs to employees but only allow them to convert options into shares during big events like an IPO or new investments. Since the shares aren’t easy to sell because the market is inactive, the employer might buy back the options early to give employees some liquidity.

The buyback amount is treated as ‘Salary’ by the employer, and TDS is deducted under Section 192. This will appear in your Form 16, and you don’t need to mention it separately in your tax return.

6. Residential Status
Your tax is determined by your residential status. If you are a resident, all your income from anywhere in the world is taxable in India. However, if you are a non-resident or a resident but not ordinarily resident, and you exercised your options or sold shares outside India, you don’t have to pay tax in India. So, your residential status is important for determining your tax liability.

7. Disclosures
If you have ESOPs or RSUs from a foreign company, you may need to report your foreign holdings in Schedule FA of your income tax return. This applies to residents who have foreign assets.

8. When Options Are Not Exercised
On the vesting date, employees have the right to buy the shares, but they are not required to do so. If the employee decides not to exercise their options, there will be no tax consequences.