Would I be taxed on my ESOPs?

Few things are certain in life: death, taxes and thread-bois giving unsolicited gyaan on social media.

While there’s little we can do about the other two, when it comes to ESOP taxation, you can count on us.

Getting a share in the company’s success is one thing, but if you are unaware of the potential tax implications, you may be in for an unpleasant surprise.

Well, not on our watch! Let’s dive in.

ESOP taxation in India: A tale of two halves

In India, tax comes into the picture twice when it comes to ESOPs — once at exercise (when you buy the shares from the company), and for a second time after you sell them.

With us so far? Alright, moving on to an example to understand this better.

Your ESOP could offer you an exercise price of ₹10 when the current market value of the share is ₹100.

If we proceed with the assumption that you had 10,000 shares, this is what it would look like if you exercised:

Exercise Cost = 10 * 10,000 = ₹1,00,000

Actual Value = 100 * 10,000 = ₹10,00,000

The ESOP allows you to buy shares worth ₹10 lakhs at ₹1 lakh. That’s a significant discount.

Now, the difference between the ESOP price and the current market value of the stock is considered as the perquisite.

Based on the example above, the difference of ₹9 lakhs is the perquisite.

Perquisite tax at exercise

The amount of ₹9 lakhs is added to your income for the year and taxed at your applicable tax rate. If you fall under the 30% tax bracket, you’ll have to pay 30% of the ₹9 lakhs as perquisite tax.

Perquisite tax = 30% of ₹9,00,000 = ₹2,70,000

This may not seem much but put in the context of tens of lakhs or crores, this could lead to a massive tax liability on your part.

Since the onus is on the company to make sure this tax is paid, the amount is typically deducted from the salary. In cases where the amount is too large, one has to pay the tax first and show the challan before the shares are issued.

There has been some respite here from the Indian finance ministry announcing in 2020 that lets you defer this tax liability by five years or whenever you quit the company (whichever is sooner). However, to qualify under this rule, your company must be registered with the DPIIT as a startup.

Capital gains = more taxes

When you do sell your shares, capital gains tax is levied.

This comes with a few different scenarios.

If you sell your shares after the company has gone public, they will be considered normal equity shares. The short-term capital gains tax (STCG) in this case is 15%, and the long-term capital gains tax (LTCG) is 10%.

You need to hold the shares for at least a year to qualify for the long-term rate.

If you sell your shares before the company gets listed (through secondaries, acquisition, or a buyback), they are considered unlisted shares. In this case, the short-term holding period is considered to be two years and not one.

This means if you hold your shares for less than two years, the profit will just be added to your income for the year and charged at the applicable tax rate. The LTCG, in this case, is 20% plus surcharge.

LTCG also comes with an indexation benefit. Indexation refers to adjusting the cost price for inflation, which reduces the taxable gains.

If you’ve held out till the shares get listed, you get the benefits of the lower tax rate.

If you’re selling within a year from the date of exercise, you’ll have to pay STCG at 15%. Assuming capital gains of ₹10,00,000, this means, STCG = 15% of ₹10,00,000 = ₹1,50,000

If you’re selling after a year from the date of exercise, you’ll be eligible for LTCG at 10%. This means, LTCG = 10% of ₹10,00,000 = ₹1,00,000

This equates to a straight up benefit of saving ₹50,000 in taxes!

Summing Up

Several new-age startups like CRED are beginning to offer frequent liquidity to ESOP holders. If your company has a similar track record, it may be a good option to exercise early and save up on taxes.

But things are not always so rosy with startups, and liquidity may not always be on the horizon. By exercising early, you may end up paying (cost price + perquisite tax) for potentially nothing.

The only thing that matters here is conviction in the long-term success of the company.