What are the different types of ESOPs?
ESOPs can take several forms, including:1. Restricted Stock Units (RSUs): RSUs are a type of equity compensation where employees are granted company shares, but they don’t actually receive them until certain conditions are met. For instance, some companies offer ESOPs after a vesting period where shares are received by an employee after waiting for a certain period.
Methodology for granting RSUs:
- Employees are awarded a specific number of RSUs, which are subject to vesting criteria (such as time-based milestones or performance targets).
- Upon vesting, the RSUs convert into actual company shares and the employee becomes the owner of those shares.
Vesting: The vesting period can range from a few months to several years and employees typically need to remain with the company for the shares to be fully received by them.
Key Benefit: RSUs are an attractive form of compensation because they require no upfront investment from employees, and employees are only taxed once the shares are actually delivered.
2. Phantom Stock Plans: Phantom stock plans are a way to provide employees with the benefits of stock ownership without actually issuing any shares. The “phantom” part means that employees do not own real company stock but are given units that mirror the value of the company’s stock.
Methodology for granting Phantom Stock Plans:
- Employees are granted phantom stock units which are tied to the value of the company’s real stock.
- The value of the phantom shares fluctuates with the company’s stock price, and employees receive a cash payment equal to the increase in stock value upon vesting or at a specified time (e.g., when they leave the company or retire).
Vesting: Similar to RSUs, phantom stock usually vests over a period of time or upon meeting specific performance goals.Key Benefit: Phantom stocks allow employees to benefit from the company’s performance without actually diluting ownership or issuing real shares. It also doesn’t require any upfront cost to employees.
3. Employee Stock Purchase Plans (ESPPs): An Employee Stock Purchase Plan (ESPP) allows employees to purchase company stock at a discounted price, typically through payroll deductions.
Methodology for granting ESPPs:
- Employees can set aside a percentage of their salary, which is then used to purchase company shares.
- The company typically offers these shares at a discount, which could range from 5% to 15% off the market price.
- There may be limits on how much stock an employee can purchase, but this program is often very attractive because it allows employees to buy stock at a discount.
Key Benefit: ESPPs give employees an opportunity to invest in the company at a discount, which can be very beneficial if the stock price increases over time. Employees also have the ability to sell the shares once they are purchased, allowing them to make a profit if the stock appreciates.
4. Stock Appreciation Rights (SARs): Stock Appreciation Rights give employees the right to receive a cash payment (or sometimes stock) equivalent to the increase in the company’s stock price over a set period.
- Methodology for granting Stock Appreciation Rights:
- Employees are granted SARs that represent the right to receive the difference between the company’s stock price at the time of grant and its stock price when the SARs are exercised.
- Employees do not need to purchase any stock. Instead, when they exercise their SARs, they receive the difference between the stock price at grant and the price at exercise.
Vesting: SARs often have a vesting schedule similar to RSUs, where employees must remain with the company for a certain period or meet specific performance targets before they can exercise their rights.
Key Benefit: SARs provide employees with the upside potential of stock price appreciation without requiring them to buy shares. Additionally, employees do not need to own shares to benefit from SARs, making it a less complicated form of equity compensation.
| Particulars | Restricted Stock Units (RSUs) | Phantom Stock | Employee Stock Purchase Plans (ESPPs) | Stock Appreciation Rights (SARs) |
| Key differences | Grant of company’s shares that vests over a period | A promise of a future cash payment linked to the value of company’s shares | An opportunity for employees to purchase company’s shares, typically at a discounted price | The right to receive a future payment based on the increase in the company’s shares price over a specific period |
| Ownership | Actual shares ownership after vesting | No actual shares ownership | Actual shares ownership upon purchase | No actual shares ownership |
| Timing of receipt/purchase | Shares are received after meeting vesting requirements (typically time-based) | Payment is typically made after a specified period or upon achieving certain performance goals | shares is purchased at designated times during offering periods | Payment is typically made after a specified period or upon achieving certain performance goals |
| Key benefits | Value increases with the company’s shares price, offering significant potential gains | Provides a cash payout that mirrors shares performance, offering potential gains | Allows for investment in company shares at a discount, potentially leading to increased returns | Provides a cash payout based on shares price appreciation, offering potential financial gains without requiring an initial investment |
| Potential risks | Value is directly tied to the shares price and can decrease | No actual ownership; Payout depends on company performance; | Employee requires funds for purchase; shares price can decline | Payout depends on company performance; no actual ownership |
| Rationale from Company’s standpoint | Aligns employee interests with shareholder value and encourages long-term commitment | Rewards employees without diluting existing shares, particularly useful for private companies | Encourages employee ownership and investment in the company’s success | Incentivizes employees to perform which leads to shares price appreciation without issuing equity |
3. How are ESOPs taxed in India?
Irrespective of the type of ESOP received by an employee, the taxation of ESOP is same. ESOP taxation in India occurs at different stages:
GRANT
- Employer grants units / options to the employees
- Exercise price as well as the vesting criteria are determined by the employer
- Tax incidence: None
VESTING
- An employee gains a right to exercise the ESOPs’ once vesting period is completed and vesting conditions are satisfied
- Tax incidence: None
EXERCISE
- The employee exercises the ESOPs post payment of exercise price. Shares are allotted by the employer
- Tax incidence: Tax is applicable on the difference between Fair Market Value (FMV) and exercise price as a perquisite and taxed as salary income
SALE
- Shares are sold by an employee either on the listing of shares or prior to listing in the open market
- Tax incidence: Trigger of capital gains taxation when shares are sold by employee
Key Points to Remember for Taxation in India:
Vesting/Exercise Stage: In all cases (RSUs, ESPPs, SARs, and Phantom Stock), when the shares or their equivalent value are received by the employee, the income is considered salary income and taxed as per the employee’s tax slab.
Sale Stage: When shares or equivalents are sold:
- Tax is determined based on the holding period from the date of allotment till the date of sale.
- Short-term capital gains tax applies to shares held for less than 24 months (unlisted) or 12 months (listed).
- Long-term capital gains are taxed at 12.50% and short term capital gains are taxed at applicable slab rates.
4. What are the employer’s tax obligations related to ESOPs?
Employers must deduct tax on ESOP perquisites as part of salary income when shares are allotted. This withholding impacts the employee’s net salary for that month.
Mr. Raghav receives 1000 shares under ESOP at Rs 500 per share, while the market price is Rs 1500. The taxable perquisite value is Rs 1000 per share, totalling Rs 10,00,000. Assuming a 30% tax rate, the employer will deduct Rs 3,00,000 as tax from salary income.
5. Are there any special tax provisions for eligible start-ups regarding ESOPs?
Yes, eligible start-ups with an Inter-Ministerial Board (IMB) certificate can defer tax withholding on ESOPs. The tax can be deferred to within 14 days of any of the following events:
- 48 months from the end of the relevant financial year
- Date of selling the ESOP shares
- Date the employee leaves the start-up
This provision aims to ease immediate tax burdens for start-ups and their employees.
Scenario:
In 2024, Raj joins TechInnovate (Eligible start-up with IMB certificate) and is granted 1,000 ESOPs as part of his compensation package.
Mechanics:
1. Tax Deferral on ESOPs:
- Raj doesn’t need to pay tax on the ESOPs in 2024 when they are granted or vested.
- Since TechInnovate is an eligible startup, Raj can defer the tax payment on his ESOPs.
2. 48 Months Deferral:
- The tax on the ESOPs can be deferred to 48 months from the end of the relevant financial year. In this case, the relevant financial year ends on March 31, 2025.
- This means Raj has until March 31, 2029, to pay the tax on ESOPs. This gives Raj four years before he is required to pay tax.
1. Sale of the ESOP Shares:
- Alternatively, Raj can choose to sell his ESOP shares any time before 2029. For example, if he decides to sell the shares in 2028, the tax will be due within 14 days of the sale.
- If Raj waits until 2028 to sell the shares, the tax would be triggered by the sale, and he must pay it within 14 days after sale transaction.
2. Employee Leaving the Start-up:
- If Raj decides to leave the start-up before selling the shares (say in 2026), the tax would also be due within 14 days of him leaving the company.
- So, if Raj leaves TechInnovate in 2026, he must pay tax on the ESOPs within 14 days of his departure.
6. How is the perquisite value of ESOPs calculated for tax purposes?
The perquisite value is the difference between the Fair Market Value (FMV) of the share on the exercise date and the exercise price. This value is then multiplied by the number of shares exercised to arrive at the total taxable perquisite.
For Listed shares: The FMV of listed shares is typically the closing market price of the share on the stock exchange where it is listed, on the date of exercise.
For Unlisted shares: The FMV is determined through a professional valuation using methods like the DCF method, NAV method, or earning multiples, or through a valuation certificate from a qualified professional.
(The article is written by Hardik Mehta, Lead Tax, Ionic Wealth by Angel One.)
