Employee Stock Option Scheme

What is Employee Stock Option Scheme?

The ESOP is an employee benefit plan that gives the workers ownership interest in the company in shares of stocks. ESOPs are usually setup as trust funds which can be funded by either putting in newly issued shares or by putting cash in to buy existing company shares or borrowing money through the entity to buy company shares. They are used by companies to all sizes be it smaller firms or large publicly traded corporations. Meanwhile, the employees can keep on investing in the company’s shares and this bundle of shares can increase depending on their employment term. Later, these shares can be sold at the time of retirement or termination of the employee.

Who can Employee stock ownership scheme be offered to?

According to the Rule 12 para 1 of the Companies (Share Capital and Debentures) Rules, 2014, for an employee to enjoy the ESOP scheme, he/she must be considered an employee of the company. Here, the employee refers to a permanent employee (whether working in India or not) or director of the company (whether is a whole time director or not and/or working in India or not). But, any independent directors or those who do not have any financial relationship with the company or hold more than 10% of the company's shares or any employee who is just a promoter are not entitled to receive the ESOP scheme.

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How are ESOPs taxed?

Typically the ESOPs are taxed at 2 instances,[A] At the time of exercise- i.e. the date on which the employee buys the ESOP and the difference between the FMV (existing Fair Market Value) and the exercise price (the price at which the employee exercises the option) is being taxed and called a perquisite and TDS (Tax Deducted at Source) is also deducted on this perquisite. One important thing to note is that this harms the cash flow as a higher amount of tax is deducted from the employee's salary without any incremental inflow. The instance of tax deductibility arises only on the allotment of shares. Rule 3 para 8 of the Income Tax Rules, 1962 states that the FMV is calculated as the average of the opening and closing price as of that date in the case of a listed company. But, in the cases of unlisted companies, the FMV on a particular date is decided to the price to be taxed so decided by a merchant banker.

 [B] At the time of sales by the employee- as a capital gain, it is taxed on the difference between the sale price and FMV the date on which ESOPs are sold.  Here, the capital gains are further divided into short term capital and long term capital gains. The short term capital gains are those gains from the sales of the shares held for 12 months or less and therefore taxed at 15% according to Section 111A of the IT Act, 1961. On the other hand, long term capital gains are those gains from the sales of the shares retained for 12 months or more and therefore taxed at 10% according to Section 112A of the IT Act.

However, in the cases wherein the employees receives the ESOPs from an eligible startup, then the ‘perquisite’ will be deductible on earlier of either [a] after the expiry of 5 years from ESOPs allotment or [b] on the date of sales of ESOPs [c] on the date of exit from the company. In simple terms, an eligible startup refers to a company or LLP incorporated after 1st April 2016 but before 1st April 2022. It should also have the turnover of INR 100 crores or less to meet the condition. One of the major benefits for the ESOP owners in startups is that the employees do not need to pay taxes as soon as the shares are allotted to him under the ESOP scheme by an eligible startup. A new scheme of delayed taxation of such benefit has been made applicable from the ESOP allotted on/after 1st April 2020, the taxes will now need to be withheld by the employers on such ESOP benefits after four years.

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What are the benefits of ESOPs?

These ESOPs forms a part of the employees’ pay thus enabling the companies to use ESOPs to keep the participants focused on the corporate performance and share price appreciation. Thus, the participants see the value in the performance of the company’s stock thereby encouraging them to do what’s best for the shareholders since the participants themselves are a part of the shareholders.  ESOPs are designed to align the interests and motivations of the employees to that of the company’s shareholders. Through ESOPs the companies have found a way through which the company's talent be retained and promoting the employees' performance at the same time. ESOPs also enable the companies to pay relatively less salaries while offering such options as an incentive in the bargain. ESOP are majorly used by the startups who cannot afford to pay huge pay to their employees to provide a feeling of ownership to the employees and thus motivate them to perform their task with a vested interest in the company. There are a lot of times when family business are on the verge of closing due to reasons like loss, pandemic, etc., but these aging owners can avoid selling their business to a third party by setting up a ESOP scheme. The information can also remain private and confidential with the employees who will now be the owner of these ESOPs. There are a lot of tax advantages for both the company and the employees, for the C-corporations (corporations who are taxed separately from the owners) the contributions made to the ESOP are tax deductible, and for S-corporations (corporations and owners taxed jointly) the portioned owned by ESOP is exempt. For the employees they are exempted to pay the tax at the time when they receive the shares, they only have to pay the tax at the time they decide to withdraw the money after retiring.