Taxation of ESOPs and Tax deductibility of ESOP Expenses
December, 08th 2021
Under an ESOS, a company grants options (right without any obligation) to acquire a certain number of shares in the company or its holding/subsidiary company generally at a predetermined price (exercise price) within a pre-determined period (exercise period) to its employees. The option to acquire shares can be exercised once the conditions are fulfilled, referred to as ‘vesting conditions. Such vesting conditions may be continued employment for a defined time or performance-based or both. Upon vesting, the employee gets an unfettered right to ‘exercise’ the vested options by payment of the exercise price. On exercise, the shares are allotted/transferred to the employees who may sell them subject to a lock-in period, if any, specified under the scheme.
The analysis of the taxation provisions of ESOPs under the Income-tax Act, 1961 (the Act) are presented in two parts
1. Taxability from Employees point of view and
2. Tax Deductibility of ESOP Expenses from employers’ point of view
The benefit received under an ESOS is taxed as a perquisite according to the provisions of section 17(2)(vi) of the Act. Section 17(2)(vi) provides that the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at a concessional rate to the assessee shall be treated as perquisite.
Thus, taxation arises at the time when the specified security is allotted or transferred to the employee.
The important aspects of section 17(2)(vi) are as under:
Value means the fair market value (FMV) of specified securities on the exercise date less any amount actually paid or recovered from the employee for such specified securities. The mechanism for determining FMV has been prescribed under Rule 3(8) & 3(9) of the Income tax Rules, 1962 (the Rules)
Specified security means securities as defined in section 2(h) of the Securities Contracts (Regulation) Act, 1956 (SCRA). Where stock options are granted under any plan or scheme, then the securities offered under such plan or scheme i.e., the resultant securities arising on exercise of such options is included therein. The resultant securities could be shares, debentures or any other securities. Allotted or transferred – specified security must be allotted or transferred.
Allotment signifies primary issue by the Company while transfer would include secondary transaction by way of purchase from the Trust / other entity.
Directly or indirectly – wide enough to cover options granted through a trust especially when the trust is settled or controlled by the Company. By the employer or former employer – For ESOPs to be taxed, the grant / benefit should flow from the employer or former employer.
Interesting issue arises where the ESOPs are granted by the holding company or by a promoter. Rule 3(8) & 3(9) – Determination of FMV In case of listed equity shares If it is listed on any recognized stock exchange on the date of exercise, the FMV shall be average of the opening and the closing price. If it is listed on more than one stock exchange on the date of exercise, the FMV shall be the average of the opening and the closing price on the recognised stock exchange with the highest trading volume. In considering both the opening or the closing price, the first settlement or the last settlement respectively on such exchange shall be considered. Where both ‘buy’ and ‘sell’ quotes are available, the sell quotes shall be considered. Where there is no trading recorded on a particular day, the FMV shall be closing price on the recognised stock exchange or recognised stock exchange with highest trading volume on the closest date immediately preceding the date of exercise. It may be noted that here only the closing price is to be considered as opposed to average of opening and closing price for considered for regularly traded shares. Recognised stock exchange shall have the meaning as per section 2(f) of the SCRA which refers to the stock exchange as recognised by the Central Government under section 4 of the SCRA.
Thus, if equity shares are listed on a stock exchange outside India, then such equity shares shall not be considered as listed on a recognised stock exchange. Accordingly, such equity shares are considered as unlisted shares for the purpose of this Rule. In case of unlisted equity shares or securities other than equity shares The FMV shall be the value as determined by Category 1 Merchant Banker (registered with SEBI). The FMV shall be determined either on the exercise date or any earlier date not more than 180 days prior to the exercise date. The date of report of the merchant banker is not relevant but what is relevant is the valuation date as of which the merchant banker determines the underlying valuation of the share. Thus, a valuation report once obtained will be valid for 180 days. How are gains arising on subsequent sale of shares taxed? Gains arising on subsequent sale of shares shall be taxable as ‘capital gains’ – long term or short term, depending upon the period of holding of such shares. The period of holding shall be computed from the date of allotment of such shares as per section 2(42A). As per section 49(2AA), the FMV as per Rule 3(8) considered for determining the perquisite value u/s 17(2)(vi) shall be taken as cost of acquisition. This ensures that the employee does not suffer double taxation on the perquisite value already taxed as salaries.