ESOPs in India: How Employee Stock Options Work and How They Are Taxed
An ESOP gives employees the right to buy company shares at a fixed price later. Tax arrives twice: at exercise, the gap between market value and exercise price is salary income with TDS, and at sale the gain is capital gains. Eligible startups can defer the exercise-stage TDS for a set period.
An Employee Stock Option Plan, or ESOP, gives employees the right to buy shares of the company at a fixed price in the future. It is a popular tool for startups that cannot match large salaries but want people to share in the upside.
The four stages
- ✓Grant: The company offers a number of options at an exercise price, set in a grant letter.
- ✓Vesting: The employee earns the right to exercise over time, often four years with a one-year cliff.
- ✓Exercise: The employee pays the exercise price and receives shares.
- ✓Sale: The employee sells the shares, ideally after a liquidity event.
Tax at exercise
When options are exercised, the difference between the fair market value of the shares on the exercise date and the exercise price is treated as a perquisite. It is taxed as salary income, and the employer must deduct TDS on it. This is a tax on a gain the employee has not yet realised in cash, which surprises many people.
Tax at sale
When the shares are sold, the gain over the fair market value used at exercise is treated as capital gains. Whether it is short term or long term depends on the holding period and on whether the shares are listed or unlisted.
Deferral for eligible startups
Employees of eligible startups can defer the TDS on the exercise perquisite. The tax becomes payable within a set period, the earliest of a stated number of years, the date of sale or the date the employee leaves. Check whether your company has the required recognition.
Design questions for founders
- ✓How big should the pool be, and who should receive it?
- ✓What vesting schedule and cliff fit your hiring plan?
- ✓What happens to unvested options on resignation or termination?
- ✓Will there be a buyback or a window for exercise?
Communicating with employees
Many employees do not know what their options are worth or what they will owe in tax. Share a simple illustration, and remind them that options can also end up worth nothing.
An ESOP is a promise of a future share, so explain it as carefully as a salary.
Rules interact with company law and securities regulations, so use a legal and tax adviser to draft the plan and keep records of every grant and exercise.
Written by
HR Manager, Airwix Technologies (Sleet)
Nihit Dobariya is the HR Manager at Airwix Technologies in Ahmedabad, where he runs HR and payroll for the team behind Sleet. He writes about payroll, PF and ESIC, professional tax, the labour codes and everyday HR practice for Indian employers, and checks each rule against the official notification before it is published.
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