In the previous article, we looked at the difference between ESOPs and Sweat Equity. In this article, we take a look at how ESOPs and Sweat Equity is taxed.

Taxation of ESOPs

ESOPs are taxed on two occasions, firstly when the employee exercises his option i.e. buys the shares and secondly when the employee sells his shares.

At the time of buying shares:

Perquisite value of ESOP is calculated as follows:

Perquisite value = Fair Market Value (FMV) of the share – Exercise price

Fair Market Value means the accepted current value of the share

Rule 3(8) of the Income Tax Rules, 1962 states that where the shares allotted are that of a listed company, the fair market value shall be the average of the opening price and closing price as of that date. In case the shares in question are unlisted, the value of shares as determined by a Merchant Banker on a specified date will be taken to be the fair market value of the unlisted shares.

Exercise Price means The predetermined price at which the employee is given the option to buy the share.

TDS is deducted by the Employer on this perquisite value.

This amount is shown included as part of total income from salary in the employee’s Form 16.

A recent amendment made in the Finance Act, 2020, gives the employer the option to deduct the tax on perquisite on the earlier of the following events:

• After the expiry of five years from ESOPs allotment
• On the date of sale of ESOPs
• On the date of exit from the company

At the time of selling shares

At the time of selling shares, tax is computed on capital gains, which is calculated as follows:

Capital Gains (CG) = Selling Price – FMV at the time of buying

Capital Gains Tax for Listed Companies

If the shares are sold after 1 year of buying, Long Term Capital Gains Tax applies @ 10% of CG after crossing a threshold of Rs1 lakh.

If the shares are sold within a year of buying, Short Term Capital Gains tax applies @ 15% of CG.

Capital Gains Tax for unlisted companies

Stocks ofunlisted companies are treated differently from those of listed companies and thresholds for short term and long term is also different.

In case of unlisted companies, if the shares are sold after 2 years of buying, Long Term Capital Gains Tax applies @ 20% of CG.

If the shares are sold within a year of buying, the capital gains are added to the income of the person and Short Term Capital Gains tax applies at slab rate.

Taxation of Sweat Equity

Taxation of Sweat Equity also happens on two occasions similar to ESOPs. First, when the sweat equity is allotted to the employee. Secondly when the employee sells the allotted shares.

The difference is that on both occasions, the taxation is done in the hands of the employee, i.e. tax is paid directly by the employee and not deducted by the employer as TDS as is done in the case of ESOPs at the time of exercising the option.

On allotment, tax is calculated on perquisite. This is calculated similar to that of ESOPs.

On selling of the allotted shares, tax is imposed on capital gains which are again calculated similar to that of ESOPs.

Conclusion:

Companies who want to issue ESOPs or Sweat Equity must take these factors into consideration before designing their employee retention plans. The right plan can help startups retain employees while minimizing their compliance burden and costs.