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FAQs on ESOP for Employees

Part III of the ESOP Series addresses the common questions that employees have on ESOPs.

1. Does an ESOP announcement equate to gains on ESOPs? Or does it provide a certainty of making gains in the future?

An ESOP announcement is merely a positive announcement by the company to reward the employees through ESOPs. The actual gains materialize only after the following stages are crossed:

  • The employee meets the conditions of vesting
  • ESOPs are exercised and
  • Shares are ultimately liquidated

2. Is it mandatory to exercise ESOPs?

Exercising ESOPs is a right of the employees and not an obligation. The employees may decide not to exercise the ESOPs even after they have signed the ESOP agreement.

3. Exercising ESOPs entails a very huge cashflow. Why is it so? How to address it?

The traditional ESOP plan requires the employees to arrange for funds – firstly, to purchase the shares and secondly to pay tax on the notional gains on the exercise of ESOPs. This event involves a substantial cash outflow and acts as a deterrent to employees exercising the ESOPs, especially where the possibility of making gains in the future is not clear.

To address this, communication is very important. The employees are generally informed about the ensuing cash outflow right at the time of executing the documents. Some employers accumulate funds where a portion of the employee’s monthly remuneration is deposited. The accumulated funds are used to exercise the ESOPs. Alternatively, employers tie-up with lenders to provide funding at a concessional rate.

4. If the company is unlisted and it may or may not list in the next 4-5 years, how can the acquired shares be sold?

Listing is not the only method of providing an exit to employees. ESOP buyback is also very popular. In this case, employees are rewarded cash, equivalent to the market value of the vested ESOPs instead of allotment of shares. In case the ESOP plan is managed by a trust, an employee can sell the shares to the trust. 

5. What happens to vested / unvested ESOPs if a new investor acquires substantial stake in the company or the company decides to go for merger / demerger?

The ESOP Agreement generally provides that the rights of the ESOP holder shall be protected in the event of a new investment or a merger / demerger. It may not be possible to contemplate exactly how the interests of the ESOP holders would be protected at the time of execution of the agreement. 

For instance, in the case of a merger of 2 entities, stock option holders of the amalgamating company may be granted ESOPs in the amalgamated company or provided an exit by way of cash settlement. 

6.What happens if there is a bonus or rights issue while the ESOPs have not yet vested?

In such an event, the quantum of ESOPs granted is suitably increased so that the ESOP holders do not lose out.

7. What happens to the ESOPs in case of a resignation?

Vested options up until the time of separation can be exercised within a prescribed time window set by the company and shares can be bought. The options lapse if the employee does not exercise them in that time period.

Here, it would be important to note that any lateral movement of employees within group companies is not considered as resignation. The employee continues to enjoy the benefits of the stock option plan.

8. What are the rights in the unfortunate event of death or incapacitation?

In the case of termination of employment by reason of death or incapacitation, the unvested ESOPs vest immediately. The legal heirs are entitled to exercise the vested options and the accelerated unvested options.

9. How is income from ESOPs taxed for the employees?

Tax is payable only when you exercise your right to acquire ESOPs and solely on the quantum of ESOPs exercised. The ESOPs which are not exercised are not taxed. 

Income from ESOPs is taxable in two stages as follows:

1. At the time of exercise:

When you exercise the ESOPs, the notional taxable value of ESOPs is taxed as ‘Salaries’ in the financial year in which the shares are exercised. The employer deducts tax on such income and remits the rest of the salary to your account.

How is the taxable value of ESOPs determined? 

The law provides that the difference between the Fair Market Value (FMV) of shares on the exercise date and the amount paid by you to acquire the shares is considered as perquisite (benefit in kind). This is the value which is taxed under the head ‘Salaries’ at the normal progressive tax rates applicable to an individual. The employer deducts tax at source in the year of exercise on the value so arrived.

Ironically, though you do not receive any cash income at the time of exercise, tax is payable on a notional value.             

2. At the time of sale of shares:

Whenever you decide to sell the shares acquired under the ESOP plan, the income from sale is taxed as ‘Capital Gains’ in the financial year in which the shares are sold. The difference between the actual sale price and the FMV of shares on the exercise date is considered as taxable value for ‘Capital Gains’. Capital gains are taxed at concessional tax rates as compared to Salaries.

Capital gains may be long term (shares are held for 12 months or more) or short term (shares are held less than 12 months).

10. What is the income tax implication if an employee becomes a non-resident of India at the time of exercise of ESOPs?

Taxability of ESOPs in India is generally dependent on where the income is earned. For example, if the ESOPs were allotted for services rendered in India, the income on exercise may be taxed in India even after you become a non-resident. If exercise of ESOPs was conditional upon achievement of certain milestones while performing the duties abroad, it may not be taxed in India.

This must be clearly captured in the ESOP documents to ensure that overseas income from ESOPs is not taxed in India.

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