Employee Stock Option Plan(ESOP) Taxation

Employee Stock Ownership Plans (ESOP) allows employees to buy stocks of their company at below-market value rates or they are provided stocks as remuneration up to a specific percentage.

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What is an ESOP?

ESOP or an Employee Stock option Plan – which is also called as Employee Stock Ownership Plans in India is a system by which a company allows its employees to purchase shares of the company. In certain cases, a foreign holding company provides the employees of an Indian subsidiary with such an option. Under this scheme, employees are granted options, which allows the employee to buy the stock at a rate below the prevailing market value of the stock or the employee is provided a certain percentage of his/her remuneration in stocks of the company.

Why are ESOPs given?

There are a multitude of reasons for which an employer would give an ESOP to an employee. The trend of giving ESOPs is more prevalent in start ups, which cannot afford to provide large compensation packages to its employees. By providing an employee with an ESOP, the employer gets the employee vested in the interests of the company and provides the employee with a sense of ownership, thereby, motivating the employee to perform a task with an actual vested interest in the company. Some companies provide ESOPs to employees which can be exercised on a future date, to provide incentive for a long term commitment by the employee to the company

What benefits does the company enjoy by providing ESOPs?
  • Acquiring the shares of a departing owner

    The owners of private companies can use the ESOP to sell their shares. Companies are allowed to make tax deductible contributions to the ESOP to buyout the shares or the company can use the ESOP to borrow money to buy the shares.

  • Borrowing money at lower after-tax cost

    Cash borrowed under ESOP is used to buy company shares and shares of existing owners. Contributions to the ESOP are tax deductible as they are made to repay the loan amount. Both principal and interest are tax deductible.

  • Creates an employee benefit

    A company can issue treasury shares or new shares to an ESOP and deduct the value from the taxable income. Companies sometimes contribute cash to the ESOP to buy shares from existing public or private owners. In public companies, ESOPs are often used in conjunction with the employee savings plan. Rather than matching the employee’s savings through cash, the employers can match the employee’s savings through stocks from an ESOP, and usually the employers will match the savings at a higher level through stocks.

Who Should Buy?

Individuals running a shop or having an office or place where they are carrying out business activity

What are the tax implications of ESOPs?
  • Options provided by the company are not taxable.
  • Vested options are not taxable.
  • When an employee exercises the option of buying shares, the difference between the market value of the shares and the exercise value of the share will be taxable according to the tax bracket the employee falls under.
  • When an employee sells the shares it is considered capital gains. If the employee sells the shares within one year 15% tax is levied against the capital gains. If the employee sells the shares after one year they are considered long term assets and are not taxable.
  • If an employee has ESOPs in a company based abroad, when the shares are sold it will be considered short-term capital gains and will be added to the income of the employee. The employee will be taxed according to the tax bracket he/she falls into after that.
  • If capital gains are long term, 10% tax will be levied without the benefit of indexation or 20% tax will be levied with the benefit of indexation
What are the disadvantages of ESOPs?
  • Options can become an obligation for the company. ESOPs do not have an option premium and the only compensation a company can hope for is indirectly through increased liquidity and sometimes through a tax advantage. The risk for the exercise remains the same as it is for normal stocks. This can make options riskier than normal stocks..
  • Only when the exercise on the options is executed does it generate liquidity for the company and the amount of liquidity is uncertain till the date of the exercise. The liquidity benefits with ESOPs is highly uncertain.
  • There are still various unclear guidelines for the valuation and accounting procedure for ESOPs in a company.
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