Recent changes made about taxation related to ESOP

To increase the engagement of important employees and give them an increased sense of involvement and ownership, the practice of giving ESOPs (Employee Stock Option Plan) is on the rise. In ESOPs, the company offers shares to employees at a discounted price within a certain frame of time. Sometimes organizations resort to this option when they are short on cash or in financially challenging times ESOPs are given to the employees as part of their remuneration. In the startup ecosystem, this strategy of giving ESOPs to employees has proved to be a win-win scenario for both parties involved. 

An important point to note here is that ESOPs are part of an employee’s remuneration; thus, it attracts income tax as well. Therefore employers are required to deduct TDS on it. Since it is taken under the purview of income tax, it has been prevented to become a complete pay-out neutral payment mechanism as companies have to deduct TDS and submit the same with the income tax department. The Indian Government picked up the anxiety caused by this provision among startups, and as a result in its last Budget, such payment of tax has been deferred. A tax estimator is something that can be of great help.

How does ESOP work?

Based on various parameters, criteria and company policies, an organization announces that it is offering ESOP to its employees and they have the option to exercise it within a certain time frame at a price which is generally lower than the fair value of the shares. After the announcement, the employee can exercise power for a finite number of shares. After the employee exercises power, the said shares are transferred with or without any condition as per the company policies. The whole process of declaration, exercising of option and allotment of shares may take some time and can transcend 2-3 financial years as well. After a specified period of time, the employee can also sell those shares in the open market. 

Taxation of ESOP?

ESOPs are treated as part of salary and are included in Income from Salary while calculating income tax. As per Section 17(2), it has been categorized as perquisites, and the value of such perquisites is taxable in the hands of employees. When the employee exercises the option of ESOP, then the fair value at that time is taken into consideration for calculating the value of perquisite. However, the employer needs to deduct TDS only at the time of allotment of shares based on the value determined. 

In addition, in future, when employees sell those shares, it comes under capital gain tax and profit is calculated based on the value of perquisite determined and the price at which shares are sold. Thus, it attracts tax twice in the whole process. 

Relief in Budget 2020-21

In the recent Budget of 2020-21, the Government has deferred the payment of TDS which was required to be made by the employer in the financial year in which the shares are allotted to the employee. However, the employee still needs to include ESOPs in their income tax return, but they are not required to pay any tax on it, and neither does the employer. This means that the shares acquired by ESOPs are now taxable only when the employee sells those shares in the open market and attracts capital gain. 

The startups benefiting from this need to fulfil the following criteria: 

  1. It must have been incorporated between 01/04/2016 to 31/03/2021. 
  2. Its total turnover must be less than Rs. 100 crore in the year in which the said benefit is sought. 
  3. They must be certified as startups as per the Inter-Ministerial Board of the Government of India. 

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