Many start ups offer ESOP - Employee Stock Option Plan. To know more details
about how it works, you can follow this link
https://blog.cleartax.in/getting-esops-salary-package-know-tax-treatment/
Quick summary:
The companies give stock options (right to purchase, no obligation on part of employees) at a said exercise price, which is lower than the fair market value at a future point in time. These options would be vested (become live) after serving for a predefined time. After the vesting period, the employees may choose to exercise the option i.e. convert the options to shares by paying the exercise price to the company.
There are two kinds of taxes which are involved in here.
1. Perquisite Tax
2. Capital Gains Tax
When the employee exercises the option, the difference between the exercise price and the fair market value (FMV) of the company will be treated as income of the employee (perquisite) for that financial year and will be taxed in his income slab accordingly. FMV of a listed company would be the market price as on the exercise date and for an unlisted company, it would be as per the valuation arrived at by the company. Most of the start-ups belong to the later category.
Capital Gains Tax is to be paid when the employee chooses to sell the stocks. For a listed company (listed means listed in India), short term capital gains (selling within 1 year of purchase / exercise) attracts 15% tax on the gains and beyond one year, it attacts no tax, as the STT is paid. For an unlisted company (or listed companies abroad), short term capital gains will be as per the slab rate (within the 3 years time frame) and long term capital gains (beyond 3 years) attract tax @ 20% with indexation or @10% without indexation
Coming to the topic of the post:
Think of the perquisite tax. On the date of exercise, if the stock trades at a value lower than the exercise price, the stock options which the employee holds has no value at all. He can as well put them into dust bin. Who would want to exercise at a price higher than the market price. Instead one can directly buy from the market at a lower price, if one still has confidence in the company.
On the other hand, let us say, the options are given at Rs 100 exercise price and the stock is quoting at Rs 175. If a person holds 1000 options, he can exercise and get stocks valued at Rs 175 for Rs 100 by paying Rs 100,000. Now, the difference between Rs 175,000 and Rs 100,000 is taxed at the income slab (say 30%) - it works out to be Rs 22,500. And this is what I am saying as a tax for unrealised gain. In a listed company option, one can choose to immediately sell it in the market and at least be comfortable saying the tax is paid for the realised gain.
In an unlisted company, first of all one has no idea about the fair market value. Though it is done by following certain standard procedures, the person holding options has not much of transparency into how it is arrived at. And, he cannot choose to sell immediately, because there is no market that exists for shares of unlisted company. Paying a tax on this unrealised gain and ending up holding an illiquid and non-transparent share does not make so much of sense. There are very few exit opportunities in the unlisted category. Either hope for an IPO or for an acquisition or merger.
And consider this case where the fair market value is much higher when you exercised (paying a lot of perquisite tax) and further drops much lower even below the exercise price. Money down the drain! In this way, you would have footed the bills of the company which provided you the employment and the government, which gave you the freedom to enter into these transactions.
I do not need to name, but, many e-com companies currently fall into this bracket.
about how it works, you can follow this link
https://blog.cleartax.in/getting-esops-salary-package-know-tax-treatment/
Quick summary:
The companies give stock options (right to purchase, no obligation on part of employees) at a said exercise price, which is lower than the fair market value at a future point in time. These options would be vested (become live) after serving for a predefined time. After the vesting period, the employees may choose to exercise the option i.e. convert the options to shares by paying the exercise price to the company.
There are two kinds of taxes which are involved in here.
1. Perquisite Tax
2. Capital Gains Tax
When the employee exercises the option, the difference between the exercise price and the fair market value (FMV) of the company will be treated as income of the employee (perquisite) for that financial year and will be taxed in his income slab accordingly. FMV of a listed company would be the market price as on the exercise date and for an unlisted company, it would be as per the valuation arrived at by the company. Most of the start-ups belong to the later category.
Capital Gains Tax is to be paid when the employee chooses to sell the stocks. For a listed company (listed means listed in India), short term capital gains (selling within 1 year of purchase / exercise) attracts 15% tax on the gains and beyond one year, it attacts no tax, as the STT is paid. For an unlisted company (or listed companies abroad), short term capital gains will be as per the slab rate (within the 3 years time frame) and long term capital gains (beyond 3 years) attract tax @ 20% with indexation or @10% without indexation
Coming to the topic of the post:
Think of the perquisite tax. On the date of exercise, if the stock trades at a value lower than the exercise price, the stock options which the employee holds has no value at all. He can as well put them into dust bin. Who would want to exercise at a price higher than the market price. Instead one can directly buy from the market at a lower price, if one still has confidence in the company.
On the other hand, let us say, the options are given at Rs 100 exercise price and the stock is quoting at Rs 175. If a person holds 1000 options, he can exercise and get stocks valued at Rs 175 for Rs 100 by paying Rs 100,000. Now, the difference between Rs 175,000 and Rs 100,000 is taxed at the income slab (say 30%) - it works out to be Rs 22,500. And this is what I am saying as a tax for unrealised gain. In a listed company option, one can choose to immediately sell it in the market and at least be comfortable saying the tax is paid for the realised gain.
In an unlisted company, first of all one has no idea about the fair market value. Though it is done by following certain standard procedures, the person holding options has not much of transparency into how it is arrived at. And, he cannot choose to sell immediately, because there is no market that exists for shares of unlisted company. Paying a tax on this unrealised gain and ending up holding an illiquid and non-transparent share does not make so much of sense. There are very few exit opportunities in the unlisted category. Either hope for an IPO or for an acquisition or merger.
And consider this case where the fair market value is much higher when you exercised (paying a lot of perquisite tax) and further drops much lower even below the exercise price. Money down the drain! In this way, you would have footed the bills of the company which provided you the employment and the government, which gave you the freedom to enter into these transactions.
I do not need to name, but, many e-com companies currently fall into this bracket.
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