Incentive Structures provided to corporates
Unraveling Employee Stock Options and Their Tax Implications
Employee Stock Option Schemes (ESOPs) are a compensation structure that serves as an enticing incentive for employees. These schemes are offered by some companies, granting employees the right to partake in the company's growth, a product of their dedication and contributions over the years.
In today's competitive talent landscape, it has become crucial to reward well-deserving employees as part of their compensation packages. These rewards should be aligned with their experience, position within the organization, and their contributions to the company's overall growth and profitability.
But are ESOPs truly worth it? Absolutely!
Typically, ESOPs are granted after employees have completed a certain number of years of service, especially if the company is a well-established player in the market. However, some startups also issue ESOPs due to initial funding constraints, offering employees a chance to share in the company's future profits and growth.
ESOPs can be granted by both Indian companies and foreign companies with Indian subsidiaries. Under this scheme, employees are offered company shares at a predetermined fixed price, which is often significantly lower than the current market price.
The company usually grants options to employees, allowing them to choose whether to "exercise" these options after a lock-in period, which typically begins at a minimum of one year. When employees purchase the shares, the difference between the option price and the market price is treated as a perquisite and taxed accordingly.
It's essential to distinguish between whether the shares are listed or unlisted, as this impacts taxation both at the time of purchase and sale.
For listed shares, the cost of acquisition at the time of purchase is based on the average of the highest and lowest prices on the date when the options are exercised. However, for unlisted shares, the market value is determined based on a valuation certificate provided by a merchant banker.
When employees decide to sell the shares, the applicable tax is capital gains tax (short-term or long-term), depending on when the sale occurs. For listed Indian companies, the holding period for short-term and long-term capital gains is one year, with a 15% tax on short-term gains and zero tax on long-term gains.
In the case of unlisted companies, shares become long-term assets after three years. Taxation is based on indexation benefit at a flat rate of 20% plus surcharge.
When ESOPs are granted by a foreign company to an Indian subsidiary, there are tax implications at the time of share purchase. The benefits of long-term capital gains tax applicable to Indian listed shares cannot be availed, necessitating a review of the Double Taxation Avoidance Agreement between the two countries.
Restricted Stock Option Units (RSUs) are a form of compensation received by employees from their employer after a specified period. RSUs are often linked to performance milestones or the length of an employee's tenure with the organization. They are taxed at the time of vesting and are considered a perquisite. Some shares are withheld by the company and used to pay advance tax. The difference between the vesting price and the market price constitutes the perquisite amount.
RSUs serve as an enticing incentive for employees to stay with the company for the long term. For example, a company may offer an employee 100 shares annually over five years, in addition to their regular salary. If the market price is $740, and the company expects the employee's contributions to boost the price to $950 in five years, it's a win-win situation. However, RSUs are granted in increments over time, and employees cannot sell them until they vest, which occurs based on set goals and performance targets.
Employee Stock Purchase Programs (ESPP) allow employees to purchase company stock voluntarily at a discount to the market price. ESPP typically takes place every six months, with the discount based on the lowest traded price in that period. This program offers an opportunity to earn significant returns on equity through purchase and immediate sale at a profit.
Taxation for ESPP is based on the difference between the market price and the discounted value paid, which is treated as capital gains.
It's important to understand the cost and capital gains structure for each of these schemes, as it varies depending on the type of share, whether it's listed or unlisted, and the holding period.
In conclusion, while companies offer these benefits to incentivize employees, both employers and employees must carefully consider the circumstances of death, disability, early retirement, termination, and resignation, as these factors can significantly impact the value, ownership, taxation, and performance of the shares upon exiting the company.