Employee Stock Option or ESOP is a mechanism through which companies provide options to their employees to purchase equity shares and become stakeholders in the companies, at a pre-determined price, and upon “Exercise”. To read more on the basics of ESOPs please see here.
Over the last couple of years, we have advised many companies on setting up and implementing ESOP and in the process, we have received queries from both employers and employees on exercise of ESOPs, right time for exercising, tax incidences, etc. In this post, we have attempted to put them in the form of answers to Frequently Asked Questions.
- Why are ESOPs granted?
Stock options could be granted for various reasons, ranging from motivating employees to contribute to Company’s growth, to incentivizing employees, rewarding for optimal performance, and also attracting talent pool. In most cases of early stage ventures, ESOPs are used effectively as a compensation packaging.
- Who can companies grant ESOPs to?
All employees of a company (including employees of parent and subsidiary entities) can be granted ESOPs, other than promoters, independent directors and directors (holding more than 10% of the outstanding equity shareholding in a company, either directly or indirectly). Depending on the structure of the ESOP scheme adopted by a company the board of directors of such company or the trustees of an ESOP trust of such company, have the ability to formulate and identify certain category of employees, like senior management, performance based, etc., who shall be eligible to obtain grants of ESOPs in such companies.
A registered ‘start-up’ (as defined under the Start-up India Action Plan) can further issue stock options to promoters and even directors holding more than 10% of the outstanding equity shareholding.[1]
Consultants/ advisors, however, cannot be granted employee stock options, under the current legal framework.
- What does “Exercise” mean?
Exercise is an event through which an employee or ESOP holder actually exercises the right to purchase equity shares of the company, at a pre-determined price (“Exercise Price”), upon completion of vesting of granted ESOPs, or any portion thereof, and upon payment of the Exercise Price. The moment ESOPs are Exercised, the concerned employee becomes a shareholder in the company.
- What is “Exercise Price”?
Exercise Price, as explained above, means the purchase price payable by an employee for each equity share that he/she is entitled to get, upon Exercise of vested ESOPs. The Exercise Price could be a fixed number or formula driven, and such number/formula is required to be captured in the ESOP scheme.
- What is “Exercise Period” and when can an employee Exercise ESOPs?
The time period within which an employee can Exercise vested ESOPs, is known as “Exercise Period”. Typically, the Exercise Period would be captured in a company’s ESOP scheme, or in stock option agreements executed with employees.
The Exercise Period could be any time, once ESOPs are vested. Some of the instances of how an Exercise Period may be structured, are as follows:-
- It could be an annual/semi-annual window in a given financial year, within which all employees with vested ESOPs may Exercise (vested ESOPs only);
- It could be linked with termination/resignation, and any time within the notice period an employee may Exercise vested ESOPs;
- It could also be at a merger, entity buy over, change of control situation in a company (considering the cash outflow of the Exercise Price by employees at the time of Exercise and tax incidence as discussed in Point No. 6 below).
However, it is recommended that only one of the above-mentioned options are chosen in order to avoid operational confusion. The ESOP scheme of many companies also provide that if vested ESOPs are not Exercised within an immediately next Exercise window, especially in case of termination/resignation, the vested ESOPs shall also lapse.
- What are the applicable Tax incidences upon an employee Exercising ESOPs?[2]
In the hands of an employee:
- At Exercise: The difference between Exercise Price and fair market value of the shares of a company, at the time of Exercise, is taxable as ‘perquisite’ [Ref: Section 17 (2) (vi) of the Income Tax Act, 1961] under the head of ‘Salary’. The exact amount of tax payable would depend upon the relevant tax slab under which an individual employee falls.
The employer/ company has to deduct TDS on the perquisite amount. For instance, if the Exercise Price per ESOP is INR 10/- and the fair market value of each share in a company, at the time of Exercise, is INR 100/-, the difference amount, i.e. INR 90/- (INR 100/- less INR 10/-) shall be taxable as ‘perquisite’ and TDS shall also have to be done.
- During Transfer: At the time of transfer (sale/purchase) of shares obtained upon Exercise of ESOPs, the difference between transfer price and acquisition cost is taxable as capital gains and depending upon the tenure of holding of such shares, the capital gains on the concerned employee could be long term or short-term.
It may be noted that the holding period for calculation of capital gains starts from the date of Exercise.
In the hands of companies:
Discount given to an employee, if any, on the fair market value, at the time of Exercise, i.e. the difference between the Exercise Price and the fair market value, is a permissible deductible business expenditure [Ref: Section 37(1) of the Income Tax Act, 1971] in the hands of a company.
- What is the process of Exercise?
Depending on the terms and provisions contained in the ESOP scheme of a company, the Exercise process could be the function of an employee holding vested ESOPs, giving notice to the company in this regard, within the Exercise Period. The Exercise Price needs to be paid in full to the company prior to any Exercise. Post such payment, the Company either issues fresh equity shares to the employee (in case of a notional pool) or transfers the shares to the employee (in case of a trust driven pool). Relevant statutory filings and compliances have to be done for issuance or transfer of shares by the company, as the case may be.
- What if an employee leaves before Exercising the vested ESOPs?
This is closely linked with the Exercise Period, as discussed in Point No. 5 above. As such, upon termination/resignation, vested ESOPs may be Exercised by an employee, during the relevant notice period, or held on for Exercising during a merger, entity buy over, change of control situation in a company. Many a times, the way vested ESOPs could be Exercised, is also made dependent upon whether such termination or resignation is for a good reason or a bad reason.
Unvested ESOPs, however, under all circumstances, get cancelled, upon a resignation/termination.
- Can a company grant loan to its employees for Exercising vested ESOPs?
Rule 16 of the Companies (Share Capital and Debenture) Rules, 2014 allows companies to grant loan to its employees for the Exercise of vested ESOPs. However, such loan has to be granted in compliance with applicable provisions of the same.
- Can a company put restrictions on ESOPs / shares granted under ESOP schemes?
ESOPs cannot be transferred, pledged, hypothecated, mortgaged or otherwise encumbered in any manner. Shares granted to an employee post Exercise may be subjected to transfer restrictions, and other shareholding rights and obligations as may be applicable in the charter documents of any particular company.
In case of Exercise, prior to the occurrence of a merger, entity buy over, change of control like situation, promoters may also evaluate having some control over such ESOP shareholding, such that, if required, ESOP shares can also be sold, seamlessly, of course subject to the same terms and conditions (including price) as available to other shareholders in such a situation.
Authors: Ms Ayushi Singh (Associate) and Ms Sohini Mandal (Junior Partner)
[1] Notification by Ministry of Corporate Affairs, dated 19 July 2016 available at:
[2] We are not tax experts and the contents captured hereinabove is a mere statement of the provisions. Separate tax advice shall be taken in this regard.
