Taxation of ESOPS in India

Taxation of ESOPs (both received in India and outside) has been a contested issue for many years. ESOPs in India are taxed in two ways: when the income is realized and when the share shares sold.

What are ESOPS?

Employee stock option plan or scheme (commonly known as ESOPs) represents schemes by which companies allow a certain amount of investment or shareholding in the company to their employees in return for their performance. There are different versions of plan and can be in the form of a stock option scheme, employee share purchase plan, stock appreciation rights plan, sweat equity, incentive plans, etc. but ESOPs is considered the catch all term to describe all such plans.

It can be done by providing the right to purchase a certain number of shares in a company a pre-determined price after a specific period. Under the Companies Act, 2013 a company can issue sweat equity shares for classes that are already issued. The issue of ESOPs is also regulated by SEBI guidelines.

ESOPs have become increasingly popular, especially among start-ups as it provides the opportunity to retain good employees providing high level of performances even if their capital investment is low. However, taxation of ESOPs (both received in India and outside) has been a contested issue for many years.
 
How are ESOPs taxed?

There are two main times when ESOPs can be taxed in India: one when the allotment of the shares is done and secondly when the shares are then sold by the employee.

When ESOPs are provided to the employee, they are usually only exercisable after a certain period of time. It is only when the shares are finally first allotted to the employee that it can be taxed. When the shares are allotted to an employee it is taxed under the Income Tax Act as a ‘perquisite’ under the head of Salaries.

Perquisites as understood under the Income Tax Act, refers to benefits or any casual emoluments that are provided to an employee over and above their salary or wages. Perquisites may be monetary or non-monetary in nature. When the shares under an ESOP are finally allotted to the employee, the difference between the exercise price and the value of the shares will be considered the perquisite value. This value will be taxable in the hands of the employee and will be deducted at source by the company. It will also be allowed as a deduction in the hands of the employer.

When the shares are eventually sold by the employee then the value gained from the disposal of shares is taxable as capital gains. It will be considered a long term or short term capital gain depending on how long the shares were held. Listed shares become long term if they were held for longer than a year while unlisted shares are only considered long term if they were held for longer than two years.

While the taxation of ESOPs of Indian residents has been fairly straight forward, there have been more issues for the taxation of such schemes when they are received by non-residents both in and outside India.
 
Tax Incentive for Start-ups:

Since 2020, start-ups are provided a further tax incentive in relation to employee stock option schemes. To provide some relief to start-ups that generally might be very capitally intensive in the first few years, a plan of deferred payment of ESOPs has been allowed.

The government has allowed that start-ups will not be taxed at the time of allotment of the shares to their employees but rather at the time of exit of the employees from the company or when the shares are sold or a period of 5 years, whichever is earlier.
 
Taxation of ESOPs of Non-Residents:

Non-resident Indians are not taxed on global income; however they are taxed on any income accruing, arising or deeming to accrue or arise in India. Non-residents of India can also avail benefits under any double taxation agreements for taxation of income that has arisen or accrued outside India. There has been particular debate on the taxation of ESOPs granted by foreign companies to non-residents, as issues of double taxation have arisen. Further, these issues may be amplified by the fact that there could be a lag in period between when the ESOP is granted and when it becomes taxable.

The UN Model on Double Taxation has sought to provide some clarity by providing following guidelines for taxing ESOPs and its perquisites:
  • The State where the ESOP was sourced can tax the income when it is realized even if the taxpayer is no longer residing in that State.
  • Once the ESOP has been realized and the benefit has been provided, then the taxpayer plays the role of an investor and subsequent gains will be taxed based as capital gains tax in the hands of the investor. 
 
When the ESOPs are received by the resident in India for work done outside India:

However, a recently the Mumbai bench of ITAT in Unnikrishnan vs. ITO has ruled that ESOPs granted to non-residents would be eligible to be taxed in India.

The facts of the case were as follows:

  • The assessee was a resident of India but was deputed to HDFC Bank, Dubai office. He was granted an employ stock option scheme as part of his employment. Within the same tax period, the assesse also realized the scheme.
  • The difference between the price granted to the assessee and the market value of the shares was taken to be the perquisite value, and the same was deducted by the employer.
  • The assessee then qualified to be a resident in Dubai for that assessment period. He filed income tax in India and availed benefits under the India-UAE double taxation treaty.
  • When this income tax return was filed the asessee claimed that the ESOP perquisite was not taxable in India since it was received for service completed in the United Arab Emirates.
  • The assessing officer contends that the ESOPs perquisites are granted for services rendered in India during a period when he was considered an Indian resident.

The Tribunal made the following observations:

  • The tribunal observed that accrual or arising of income is not the same as receipt of the income. In this case they felt that while the benefit of the ESOPs was realized in the period that the assessee was a non-resident, it had been granted when the assesee was a resident of India.
  • They held that ESOPs cannot be considered to accrue or arise as an income at the time it is realized but the benefits have to be considered in relation to the time period when it was granted to the employee.
  • Similarly, they held that the taxation of ESOPs will relate to the time period it was granted. Although the income was realized in the period he working in Dubai, the ESOPs were granted at the time he was a resident of India. Therefore, the income is taxable in India and also cannot be deducted by the Dubai office.
  • Since the benefit of the ESOP relates to a time period when the services were provided in India, the double taxation will also not be applicable.
 
The tribunal makes it clear that the period of time to be considered for taxing the employee stock option scheme is the period for which the benefits were granted and not when the scheme is realized. While it will be taxed in the period that the income is realized, it has to be done on the terms for the period it was granted. The judgement sticks to the source rule of income that the income that arises in India has to be taxed in India.
 
Conclusion:

There is often confusion surrounding the taxation of ESOPs if they have been provided to a non-resident. However, the tribunal ruling from January 2021 makes clear the following principles:

  • The ESOPs will be taxed in the year that the shares are allotted, but it will relate back to the time period that it was granted to the employee.
  • If the employee was a resident at the time the ESOP was granted i.e. it was granted for services performed in India, then it will be taxable in India.
  • If the ESOP is granted for service performed outside India, then it may be taxable outside India.