Employee Stock Option Plan Scheme (in short, ESOP scheme) is a right given to employees (including whole-time directors and officers) to purchase shares of a company at a future date and at a pre-determined price. It is one of the equity-based incentives available to employees in today’s era of globalization and has emerged as an effective tool to attract, retain and reward human capital. A stock option granted under the plan confers a right but not an obligation on the employee. An option can be converted to shares if the holder of the option fulfils certain conditions. These conditions are the vesting criteria and can be either number of years of continued service after receiving the option, meeting of some performance-oriented goals by the option-holder, or both. After the vesting criteria are satisfied, the option becomes “vested.” A vested option provides an option-holder with an unfettered right to “exercise” the option and be “allotted” shares of the company. But if the employee is terminated on ground of misconduct, his vested options would lapse.
ESOP scheme contemplates a four-stage process which has been described in the following flow-chart:
In India, ESOPs were first brought into limelight in the early 90s when Indian IT companies started using ESOPs as an incentive plan for its senior management. ESOP is pre-dominantly used in the IT companies because in an IT industry, employees are considered to be the most valuable assets.
Benefits of ESOP:
- Employers do not have immediate pay-out obligation even while they continue to lure the employees and receive their best services.
- Enhances job satisfaction of employees due to ownership incentive.
- The ESOP also serves the purpose of a retirement benefit plan.
- Employees get a good opportunity of becoming partners in capital-creation in a two-fold manner wherein on one side they are issued shares at a discounted price an on the other side, they become eligible for all the future share-holder payouts whether be it dividends or buy-back.
Extending benefit through ESOP is, thus, like creating a win-win situation for both employer and employees.
Tax Treatment of ESOP Scheme under the Income Tax Act, 1961:
As per the provisions of the Income Tax Act, 1961, all the options exercised under an ESOP scheme on or after April 1, 2009, shall be liable to be taxed both at the time of allotment as well as at the time of transfer.
In the hands of the employer of a Listed Public Company, Public Limited Company and Private Limited Company:
In case any share is issued by a company under the ESOP Scheme on or after April 1, 2009, then under the provisions of the Income Tax Act, 1961, there shall be no tax liability in the hands of the employer/company.
In the hands of the Employee:
The employees to whom shares have been issued under the ESOP Scheme, shall be liable to pay tax under the amended provisions of Section 17 (2)(vi) and 49 (2AA) of the Income Tax Act, 1961.
At the time of allotment of shares: At the time of allotment of shares, the tax would be payable on the amount of difference between the fair market value (determined by Merchant Banker) on the date of exercise and the exercise price. Such amount would be liable to be taxed as a perquisite paid by the employer to the employee under Section 17 of the Income Tax Act, 1961.
At the time of transfer of shares: At the time of transfer of shares, employees shall be liable to pay tax under the head “capital gain” of Section 49, Income Tax Act, 1961. The tax shall be calculated on the amount of difference between the fair market price of the shares at the time of transfer and the price at which the shares were obtained. Transferors are, however, not liable to pay any tax in the case of long-term capital gain.
In case the transferor held the shares for a period less than one year, the gain or loss arising due to the transfer shall be regarded as short-term capital gain/loss and in case of shares held for a period more than one year, gain or loss arising thereof shall be treated as long-term capital gain/loss. Employees shall be subject to the payment of capital gain tax at the time of sale of shares issued under this scheme at the rate as applicable on that date.
All the options exercised on or after April 1, 1999, shall also be liable to TDS under Section 192 of the Income Tax Act, 1961. All the options vested before April 1, 1999 but exercised on or after April 1, 1999 shall also be liable to be taxed under the amended portions of the Income Tax Act, 1961. All the shares issued or transferred on or after April 1, 1999 through the trust route, shall also be liable to be taxed under the Act.