Taxation of ESOPs in Startups – Perquisites, Deferrals & Deductions

Employee Stock Option Plan (ESOP) has gained popularity as a tool for employee retention, especially in startups that may not be able to offer hefty pay packages. ESOPs provide employees with an opportunity to become equity shareholders of the company over a period of time. However, the taxability of ESOPs can be complex.

Legal Basis & Nature

The value of the perquisite shall be its market value as on the date of exercising the ESOP, as reduced by the amount recovered from the employee. When securities allotted under ESOPs are subsequently transferred by the employee, the gains arising therefrom shall be taxable under the head 'Capital Gains'. [Section 17(2)(vi)]

The employer is required to deduct TDS (tax at source) under Section 192 on this perquisite component in the year of exercise/allotment (unless deferred, in certain cases)

A major issue is that employees may not receive any cash at exercise (especially in unlisted firms), yet would need to pay tax on a notional gain.

Because of this, startups and employees press for tax deferral or more favorable treatment.

Deferral / Relief for Eligible Startups

To avoid tax payment before liquidity, under limited circumstances, a deferment of the tax liability on the perquisite portion, specifically for “eligible startups”.

Who qualifies as an “eligible startup”?

Only an eligible start-up as referred to in Section 80-IAC and its employees would get the benefit of deferment of TDS and tax payment on perquisite arising from ESOPs.

Tax treatment of ESOPs where the employer is an eligible start-up

The taxability of ESOPs arises in the hands of the employee at two stages.

• Firstly, when securities are allotted to the employee and,

• secondly, when the same is sold.

At the time of allotment of securities, the difference between the fair market value of shares on the date of exercising the option and the amount actually paid by the employee for such securities is taxable as perquisite and chargeable to tax under the head salary. Consequently, the employer is required to include the amount of perquisite in the salary of the employee and deduct tax thereon under section 192 in the year in which securities are allotted.

As employees do not get any immediate benefit from securities allotted under the ESOPs, the deduction of tax thereon in the year of allotment itself was very burdensome for them as it reduces the cash flow in their hands. To reduce the burden of taxes, various provisions of the Income-tax Act, inter-alia, Section 192 (TDS on salary), Section 140A (self-assessment tax), Section 191 (direct payment of tax by the employee), and Section 156 (notice of demand) amended to defer the deduction and payment of tax on income in the nature of perquisites arising from ESOPs.

Section 192, which provides for the deduction of tax by the employer from the salary of the employee, provides that an eligible start-up shall deduct tax from income arising in the nature of perquisites from ESOPs within 14 days from the happening of any of the following events (whichever is earlier):

1. On the expiry of 48 months from the end of the assessment year in which securities are allotted under ESOPs;

2. From the date the assessee ceases to be an employee of the organization; or

3. From the date of sale of securities allotted under ESOP.

For this purpose, the tax shall be deducted on the basis of rates in force for the financial year in which securities are allotted or transferred under ESOPs.

Thus, an employee is required to disclose the value of perquisite from ESOPs in his return of income for the year in which securities are allotted. However, due to the deferment of payment of tax, the employee shall not be required to pay tax on perquisites arising from ESOPs in such year.

The tax to be payable on the salary income, excluding the perquisite value of ESOPs, should be computed as per the following formula.

Tax payable on salary income excluding ESOPs perquisite =

For example, Mr. A, working in an eligible start-up company, has been allotted 100,000 shares at the rate of Rs. 10 per share under the ESOP scheme in the Financial Year 2024-25.

The fair market value of shares at the time of exercising of option by Mr. A is Rs. 100.

The perquisite value of ESOPs taxable in the hands of Mr. A shall be Rs. 90 Lakhs [100,000 shares* (Rs. 100 – Rs. 10)].

The annual salary of Mr. A (excluding perquisite value of ESOPs) in that year is Rs. 40 Lakhs.

He continues with the company even after the expiry of 48 months from the end of the assessment year in which shares are allotted and he does not sell the shares even after the expiry of said period.

What shall be the mechanism for deferment of TDS and tax on the perquisite value of ESOPs in such a case?

Assessment Year 2025-26

Mr. A would be required to disclose the perquisite value of ESOPs, i.e., Rs. 90 lakhs in his return of income but he shall not be liable to pay any tax thereon in the year of allotment of shares. The tax to be payable on the salary income, excluding the perquisite value of ESOPs, shall be computed in the following manner:

Assessment Year 2029-30

As Mr. A continues with the company after the expiry of 48 months from the end of the Assessment Year in which shares are allotted and he does not sell the shares even after the expiry of said period, the liability to deduct tax or make payment of tax on perquisite value of ESOP will arise in the Assessment Year 2029-30, i.e., 48 months from the end of the Assessment year (2025-26) in which shares are allotted. The tax liability for the Assessment Year 2029-30 shall be computed as under:

Deductions / Expense Allowability (for Employers / Startups)

While much focus is on the employee side, companies also have tax and accounting implications when issuing ESOPs.

Accounting Expense vs Tax Deduction

• From an accounting/bookkeeping perspective, ESOPs (the discount or “cost” component) are often recognized as an employee compensation expense (similar to stock-based compensation).

• However, the Income Tax Act does not explicitly provide a carve-out for ESOP-related expense to be allowed as a deduction in all cases. Some tax authorities challenge the deduction, calling it not a “revenue” expense.

• There are favorable judicial/tribunal decisions that have allowed ESOP expenses (or portions thereof) as deductible expenses, especially where the ESOP is structured as part of employee remuneration.