ESOPs not much of celebration for employees of unlisted companies; here's why

The tax imposed on buyback of shares and employee stock options is different

E-commerce major Flipkart recently approved buyback of $100 million in employee stock options (ESOPs) — a bonanza for its 6,000-odd current and former employees. However, before uncorking the champagne bottle, the employees need to figure the tax implications. In unlisted companies, the tax treatment for employees will vary, depending on whether the buyback relates to stock options or to shares issued by the company. 

If company buys back stock options:

Experts say that Section 46A of the Income Tax Act, 1961, specifically deals with tax implications in case of buyback by a company of its own shares or specified securities. “The term ‘specified securities’ has been assigned meaning as per Section 68 of the Companies Act, 2013, which includes employee stock options. Thus, a view can be taken that in case of buyback of employee stock options, the provisions of Section 46A of the Act shall be applicable,” says Homi Mistry, partner, personal taxes, ESOP, Deloitte Haskins & Sells. Accordingly, the difference between cost of acquisition and the value of consideration received by the employee shall be taxable as capital gains, he adds. 

The gains will be taxable as short-term (held for 36 months or less) or long-term, depending on the holding period of the options. If the options qualify to be a long-term capital asset, the differential capital gains will be taxable as long-term capital gains, subject to indexation benefit on costs (if any). “In case of stock option generally there is no option price recovered from the employees at the time of grant. Thus, in such a case, the entire consideration received will be taxable as capital gains,” says Mistry.

Source: Corporate Professionals

Experts say tax authorities are known to take the position that stock options were granted to employees on account of the employer–employee relationship. Accordingly, any income arising out of the same should be taxable as salary income. Drawing an analogy from taxation of the share perquisite income which arises on allotment/ transfer of shares on exercise of employee stock options, tax authorities have in several cases contended that the taxable value in employee stock options should be the Fair market Value (FMV) as determined by a Category-I merchant banker registered with the Securities and Exchange Board of India. 

Samsuddha Majumder, partner, Trilegal, points out that stock options are taxed twice — as perquisite (part of salary income) during allotment by the employer and as capital gains at the time of transfer by the employee. “However, there is no double taxation of the same gains or income,” he adds. As in case of other types of salaries and perquisites, the employer is required to deduct tax at source while transferring the ESOPs to the employee when the latter exercises the option.

If an unlisted company buys back shares: 

Employees end up owning shares of companies in various ways such as exercise of ESOPs, grant of restricted stock units or through employee stock purchase plan. When it comes to a buyback of such shares, the company becomes liable to pay income tax (at the rate of 20 per cent + cess + surcharge of the amount of buyback). “However, the receipt of the amount of the shares in the hands of the employees is tax free,” says Mohini Varshneya, head, ESOP services, Corporate Professionals. Majumder points out any gain from buyback of shares by an unlisted company is not subject to capital gains tax but a ‘buyback distribution tax’.  If an employee sells these shares to a third party, he is liable to pay the long-term/short-term capital gain tax. In this case, the company need not pay any taxes, as the sale transaction will happen between an employee and the purchaser. This situation could apply to many unlisted start-ups, which bring in investors while raising additional round of funds. 

In case of shares in listed companies, if the employee sells these on the exchange after they have become long-term assets, then he/she is exempt from capital gains if the shares are sold on a stock exchange and securities transaction tax is paid. For buybacks by listed companies too, tax is not applicable. 

How short is short-term:

 A capital gain/loss is said to be ‘short-term’ if the ESOP securities, after being transferred by the employer to the employee, had been held for:

(A) In unlisted shares — two years or less

(B) In listed shares — one year or less

(C) In other securities — three years or less.

In each case, the gains/loss is said to be long-term if the securities were held for longer than the above time period.