ESOP and its tax implications

What is an ESOP?

An Employee Stock Option Plan is a scheme where a company grants its select employees the right to buy shares at a predetermined price, after completing the initial vesting period, thereby giving them sense of ownership and aligning their interests with company's growth.

When was ESOP introduced in India?

In 1999, SEBI introduced the Employee Stock Option Scheme & Employee Stock Purchase Scheme Guidelines 1999, which provided the first formal regulatory framework for listed companies.
Later in 2014, SEBI replaced these guidelines with Share Based Employee Benefits Regulations 2014, with updated rules for issue of ESOP by public companies.

Who can issue ESOP and what purpose ?

Any Company whether Public or Private, Listed or unlisted, including eligible startups are allowed to issue ESOP to its employees.

Purpose of issue: Primary purpose of issuing ESOP is to retain top talent by providing ownership stakes, particularly in startups that cannot offer high cash salaries. ESOPs helps in aligning employee interests with company growth by fostering a sense of ownership.

Who are eligible for ESOP?

ESOP are generally issued to
  -> Permanent Employees of the company (whether located in India or abroad),
  -> to Directors (excluding independent directors),
  -> even to employees of subsidiary company and employees of holding company.

ESOP can't be allotted to:

1. Employees who are promoters or belong to promoter group are ineligible
2. A director or employee, who either directly or indirectly through their relatives/body corporate, holds more than 10% of the outstanding equity shares of the company is not eligible.

But there is an exception to this rule, where Unlike established companies, recognized startups are exempt from the restriction prohibiting the issuance of ESOPs to promoters or directors holding more than 10% equity for up to 10 years from incorporation.

2025 SEBI Amendments in this regard:

SEBI has clarified that founders (classified as promoters during an IPO) can retain and exercise ESOPs granted before the IPO (before they are classified as promoters), provided the grants were made at least one year prior to the filing of the Draft Red Herring Prospectus (DRHP).

As it can be inferred, while they can retain old ESOPs, promoters generally cannot be granted fresh ESOPs once they are classified as promoters in the DRHP.

Are ESOPs issued based to particular level of employees or to all?

Employee Stock Option Plans can be issued either to all employees or to particular levels/categories of employees, depending on the company's policy.

Often, companies issue it to senior management or Key employees that include critical staff or top talent.

There have been notable cases where companies have issued ESOPs to their blue collared workers like :
Infosys offered ESOPs to NMS in 1994, JSW granted ₹1000cr ESOP in 2021 to its blue collared workers in steel and energy divisions and Mahindra group announced ₹500 crore ESOP to its factory and shopfloor workers as 'Diwali bonus in stock, all these aimed at rewarding shop-floor employees and aligning them with the company’s growth.

Issue Terms & Conditions

Following are the terms and conditions of issue of ESOP:

1. Vesting period: Employee must wait for minimum period of 1 year after grant of options, for them to become eligible to exercise those options.
2. Exercise price:

   The price at which employees purchase shares under an ESOP is the exercise price (or strike price).
   

   • For listed companies: It is often set below the current Fair Market Value, set at concessional exercise prices to make ESOPs attractive for employees.
   • For unlisted companies, the issue price is determined by a registered valuer, using methods like Discounted Cash Flow to ensure compliance with tax regulations.

   Exercise price must be fixed at that stage itself when options are granted. Listed companies must disclose this in accordance with SEBI guidelines.

3. Exercise period:

   Exercise period is the time frame (post the vesting period) during which employees can convert options into shares.
   Company must specify the exercise period in the offer document. Options that are not exercised within the exercise period lapse.

4. Lock-in conditions:

   Company shall specify the mandatory lock in period during which vested options or shares cannot be transferred.
   The lock in period is the minimum time employees must hold the shares after exercising their options before they can sell or transfer them.

5. Approvals:

   The approval process for ESOP is that, the Board of Directors must first approve the plan, followed by final approval from shareholders through special resolution.

   In the process of issuance, Listed Companies must comply with SEBI (Share-Based Employee Benefits & Sweat Equity) Regulations and other Companies must follow provisions prescribed in Section 62(1)(b) of Companies Act and Companies (Share Capital and Debentures) Rules.

6. Forfeiture/Lapse
1. Misconduct: If an employee is terminated for misconduct, unvested options are forfeited immediately upon the date of termination. In case of Vested options, the company has the right to repurchase them, usually at the lower of the exercise price or the current market value.
2. Resignation : Unvested options are forfeited automatically upon resignation. Vested options typically lapse if not exercised within a 30 to 90-day window after the last day of employment.
7. Rights of the holder
1. When Vested: It is understood that employees do not have voting or dividend rights until they exercise the options and become shareholders. Also, options granted cannot be pledged, hypothecated, or transferred by the employee to any other person.
2. When Exercised:

When ESOPs are exercised and converted into shares, employees becomes shareholders - which brings both rights and restrictions.

• Given as collateral: Once exercised, the holders become shareholders and the shares can generally be pledged, hypothecated, subject to T&C
• Transfer restrictions: In case the holder wants to transfer the shares, he must first offer them back to the company or existing shareholders, before selling to outsiders.
• Lock-up periods: In startups or IPO situations, SH may be restricted from selling the shares for a certain time, in order to stabilize the market.
• Approval requirements: In Private companies, transfers require prior board approval.

Tax Implications

With respect to ESOPs, there are two taxable events. Meaning, taxation arises at two distinct points in time - once at exercise and again at sale.

1. Tax at Exercise (Perquisite Tax)

ESOP exercised is taxed as part of salary income and the Employer deducts TDS. In case of eligible startups, tax payment can be deferred.
Taxable Value = Fair Market Value on exercise date – Exercise Price.

For Start-ups: Employees of eligible DPIIT-recognized startups can defer payment of perquisite tax until the earliest of:
-> 5 years from exercise,
-> sale of shares, or
-> termination of employment.

2. Tax on Sale of the shares

When the employee later sells the shares, capital gains tax applies. Cost of acquisition for this purpose is FMV at the time of exercise. Accordingly, the Capital gain= Sale price – FMV