ESOPs or Employee Stock Option Scheme is an incentive linked compensation structure that are offered by some companies, where employees have the right to participate in the growth of the company for which they have contributed towards for many years.

In this age of great talent, there is an impending need to show the carrot to well deserving employees as part of their compensation package and reward them judiciously over the years, based on their experience, hierarchy in the organisation and contribution to the overall growth and profitability of the company.

Is it worth it? Of course it is!

Normally ESOPs are given only after completion of certain years of service of an employee, if the company is a big and well known player in the market. However, some start ups also issue ESOPs due to lack of funding or cash shortage in the initial years as salaries to employees who are willing to share the future profits and growth of the company.

 ESOPs can be given by Indian companies or by foreign companies having Indian subsidiaries.

Under this scheme the employee will be given shares of a company, at a predetermined fixed price that is usually much lower than the prevailing market price.

The Company normally grants options to the employee and it is at the discretion of the employee to accept or “exercise” these options after a lock in period which starts with a minimum of 1 year.

When the shares are bought by the employee, the difference between the price at which the shares are allotted and the market price is treated as a perquisite and taxed in the hands of the individual and the employer deducts tax at source for this amount.

It is important to note whether the shares are listed or unlisted, since it would impact the taxation at the time of purchase and at the time of sale.

If the shares are listed, then the cost of acquisition at the time of purchase is based on the average of highest and lowest price on the date when the options are exercised.

If the shares are not listed, then the market value is determined as per a valuation certificate given by a merchant banker.

When the employee decides to sell the shares, the tax applicable is capital gains tax (short term or long term) and the amount would depend on when the sale has happened.

If the shares are of listed Indian companies, then the holding period to be considered for short term and long term is one year. Less than one year is short term capital gains and the tax applicable is 15% plus surcharge and more than one year is long term capital gains and the tax is NIL.

In case of unlisted companies, the shares would become long term after three years. The tax applicable would be based on indexation benefit that can be availed at a flat rate of 20% plus surcharge.

When ESOPs are granted by a foreign company to an Indian subsidiary, there would be a tax implication at the time of purchase of shares by the employee. Also benefits of long term capital gains tax applicable to Indian listed shares cannot be availed. Here the Double Taxation Avoidance Agreement between the two countries would have to be looked into before arriving at the tax implications.

 

RSUs or Restricted Stop Option Units is compensation received from employer to employee after a certain period of time based on a structure or plan, usually linked to performance milestones or the length of stay by an employee in an organisation. RSUs are taxed at the time of vesting ( that is application made by the employee) and is taxable as a perquisite. Therefore, some shares are with-held by the company and utilised to pay advance tax. The difference between the vesting price and the market price is the perquisite amount.

This feature has been used as a carrot to entice employees to stay with the company for the long haul. For example, if John receives an offer from Google and the company considers John a great value addition to their growth over the years, Google will device an RSU option to give John (in addition to salary benefits) 100 shares of Google per year over 5 years, making it a total of 500 shares over 5 years. If the price of Google as on date is say $740 and Google expects John’s contribution would help the price  move up to say USD 950  after 5 years, it’s a win- win deal for both. John can benefit by staying for the long term with Google- Only if he stays for 5 years he will receive 500 shares at current market price . If he leaves after 2 years, he will receive only 200 shares at a reduced market price(minus shares with -held to pay taxes, both income tax and capital gains tax) So if John left in year two, he would have lost the benefit of accumulating 300 more shares by working for another three years at, probably a higher valuation.

How to deal with RSUs- Unlike stock options, RSUs normally have an inherent value in them at the time of vesting.  However, the employee in order to benefit from the stock appreciation is usually given shares on piecemeal basis over a period of time, and cannot exercise sale unless the RSU is vested. The RSU will vest at a future date based on a certain goal achievement target set by the company. The same can also be forfeited if the employee has not meet performance targets.

This is a good mechanism by companies to retain talent, since employee’s loose ownership of unvested stocks, if they leave before the vesting date. They can however, sell stocks that are already vested.

RSUs are taxed in a similar manner as ESOPs. The fair market value of RSUs at the time of vesting is considered the cost and the Market value on the date of sale is the selling price. The difference between the two is considered capital gains.  The nature of short term and long term capital gains follow the same rule as ESOPs mentioned above.

ESPP stands for Employee Stock Purchase Program– This refers to purchase of company stock voluntarily by the employee at a discount to market price. The discount is roughly 15% of current market price. The purchase happens once in 6 months at a period determined by the company and the discount is given at the lowest traded price in the six month period.

For example, let’s divide the year between 1 Jan to 30 June and 1 July to 31 Dec.  Say an employee opts to invest 10% of her salary in ESPP. This amount will be deducted monthly from the employee’s salary and kept separately.

For example, an employee’s salary is Rs 1, 00,000 per month, 10% of this amount or Rs 10,000 will be kept aside and accumulated over six months that is Rs 60,000. The lowest trading price of the share during this period is taken. Say it is Rs 10. The employee gets a discount of 15% on this, which makes the purchase value for the employee Rs 8.50.

The accumulated amount of Rs 60,000 would be utilised to purchase shares at a discount of 8.50= 60,000/8.50= 7058.82 shares would be bought. Even if the employee chooses to sell these immediately, she can make a gain. 7058.82 *10=Rs.70588 which is a profit of Rs 10,588 over the purchased amount. The same process is repeated on 31 December.

ESPP is an assured way of earning great returns on equity through purchase and instant sale at a profit.

The taxation on ESPP is the difference between the market price and the discounted value paid which are the capital gains.

The Cost would differ in case of ESOP, RSPP and ESPP. The cost for ESOP, is the “Exercise Price” The cost for RSU is the “Vesting Price” and the cost for ESPP is the “discounted market price”

The Capital Gains would also differ for each of them. For RSU the sale price is the difference between the market price on the date of sale and the vesting price (cost of acquisition of RSU is NIL). For ESOPs the difference between market price at the time of purchase (not exercise price) and the sale price is the capital gains. For ESPP the difference between the discounted market price at the time of purchase and the sale price is the capital gains.

Capital Gains Structure in case of listed and unlisted ESOPs, RSUs and ESPPs

Types of Shares	Period of attracting long term capital gains	Tax on Short term Capital Gains	Tax on Long Term Capital Gains
Listed Shares	1 Year	15%	Tax free
Unlisted Shares(Indian Companies)	3 years	Added on taxable income	20%  with indexation
Unlisted Shares(Foreign Companies)	3 years	Added on taxable income	20%  with indexation

In conclusion- While companies are providing these benefits to employees to incentivise them, careful deliberation on circumstances of death, disability, early retirement, termination and resignation must be understood. Also, whether such shares are vested or not, their value, ownership, taxation, and performance are factors to be considered by the employer and employees on exit from the company.