You can lower tax burden on sale of Esops in unlisted firms

Employees are allowed some flexibility in choosing a fair market value that helps them reduce their tax burden

If you work for an unlisted company that is doing well and have received shares through an employee stock option plan (Esop), there are chances that stockbrokers may come knocking at your door. As more companies look at initial public offerings (IPOs), high net worth individuals (HNIs) have started picking stocks of unlisted companies, hoping to make a killing when they list. Stockbrokers are approaching employees of unlisted companies to negotiate deals on behalf of their HNI clients.

“This calendar year has been a bumper one for IPOs. The primary market boom is leading to huge demand for shares of unlisted companies, especially those that are in the pre-IPO stage or have received regulatory approval for an IPO,” says Abhijit Bhave, chief executive officer, Karvy Private Wealth. He points out that HNIs are able to corner shares of such companies at a lower price. By taking this route, they also avoid the risk of not being allotted the desired number of shares, as could well happen in an IPO. When the company lists, they reap high profits. 

While an employee looking for an exit can get a good deal in such sales, he needs to consider the taxation of Esops before selling his shares. If Esops are sold within two years of allotment, there can be a much higher tax outgo as they attract short-term capital gains (STCG) tax. The gain is added to the employee's income and taxed according to the applicable tax slab. “Esops are taxed twice: First at the time of taking the shares from the company, known as exercising the option. A tax also has to be paid on the gains made when selling the stock,” says Kuldip Kumar, partner and leader (personal tax), PwC.

         Esops de-jargoned

• Vesting period: The time after which employee can opt for allotment of shares
• Exercise stock option: When an employee buys shares from an employer
• Exercise price: The price an employee pays to buy the shares from an employer
• Fair market value: The original price of the stocks as certified by an investment banker 

Assume that a company grants Esops to an employee. The fair market value of the stock is Rs 1,000 and the employee is given the option to buy it at Rs 500. When the employee exercises the option and takes the shares from the company, he needs to pay tax on the difference between the fair market value and the exercise price at which he receives them. In this example, he will pay tax on Rs 1,000 minus Rs 500. There will be perquisite tax on the gain (Rs 500 in the example), which the employer will deduct as part of his salary and deposit with the income tax department. The fair market value is determined by a company-appointed merchant banker.

The employee will also need to pay capital gains tax when he sells the shares, depending on the period of holding. Sales within two years attract STCG tax. Here, the gains are added to the income and taxed at the marginal income tax rate. If the employee sells the shares after two years, he has to pay long-term capital gains (LTCG) tax, levied at 20 per cent after indexation benefit.

Tax experts say the income tax department allows the employee to consider fair market value on the day of exercising the option or 180 days prior to it. Say, an employee exercises the option in September when the fair market value is Rs 1,000 but in March, the fair market value was Rs 800. If he chooses the lower value, he can save on perquisite tax. In the example above, the exercise price is Rs 500. The taxable amount on the September value is Rs 500 whereas on the March value it is reduced to Rs 300. If the employer allows choosing of fair market value, an employee can save tax legally. "An individual also needs to remember that the capital gain has to be paid as advance tax, and not at the time of filing income tax return,” says Archit Gupta, founder and chief executive officer, Cleartax. He adds that if the company is located outside the country, the employee also needs to report it in Schedule FA of the ITR form, which deals with foreign assets.