ESOP: How Employee Stock Ownership Plan Works, Its Benefits And Taxation

Employee stock ownership plan (ESOP) is an employee benefit plan in which the employer offers shares of the company at a very low cost in order to encourage employees participation in the ownership of the company.

The main purpose of employee stock ownership plan is to increase shareholders value by expanding employee ownership of the company.

Many listed companies in India and abroad use employee stock ownership plan (ESOP) as a tool to incentivise, retain and attract key talent.

ESOP is also referred to as an Employee Stock Option Plan.

Before applying the ESOP scheme, it has to be approved by the shareholders of the company by passing a special resolution in the general meeting.

In this article, you will learn what ESOP is, how an employee stock ownership plan works and its benefits. 

At the end, you will learn the tax implications of ESOP.

How does an Employee Stock Ownership Plan (ESOP) work?

ESOP, which is also referred to as employee stock option plan, is simply a contract that gives a person the right, but not the obligation, to buy or sell a stock at a predefined price and date.

In other words, the employee stock ownership plan (ESOP) is the option given to the whole-time directors, officers or employees of a company which gives such directors, officers or employees, the benefit or right to purchase or subscribe at a future date, the securities offered by the company at a predetermined price.

Employers initially decide the number of shares to be offered under ESOP. In it they fix the price and eligibility of the employee in addition to the number of shares.

After the offering, ESOP remains in the trust fund for a specific period of time, referred to as the vesting period.

ESOP allow a company’s employee to buy a certain number of shares at an agreed price after vesting period has expired.

Vesting period means the period during which the vesting of the option granted to the employee in pursuance of the ESOP scheme takes place.

Vesting means the process by which the employee is given the right to apply for shares of the company against the option granted to him in pursuance of the ESOP scheme.

Employees should be with the organization for the vesting period to get the benefit of ESOP.

After the expiry of vesting period, employees have the right to exercise their rights for ESOP. The employee has to make an application to the company for issue of shares against option vested in him in pursuance of the scheme.

The date of expiry of vesting period is referred to as vesting date.

After the vesting time period, the employee should exercise his rights to apply for shares against the option vested in him in pursuance of the scheme.

By exercising their rights, now eligible employees can buy the company’s shares at the allotted prices, which is normally lower than the market value. 

Interested employees can sell their shares to make a profit.

The scheme under which a company grants employee stock option is referred to as employee stock option scheme (ESOS).

You might have also heard about the employee stock purchase scheme (ESPS). It’s a scheme under which the company offers shares to employees as part of a public issue or otherwise.

What are the benefits of ESOP?

ESOP gives employees the right to own the company and participate in its earnings. It offers employees an ownership interest in the company.

Employees can get additional income in the form of a dividend that the company distributes out of its profit to shareholders.

As ESOP is bought at a very discounted rate, it increases the wealth of the employee.

Employers are also benefited due to employee retention and increase in productivity. Many employers in India and abroad are using ESOP as a tool for attracting talent to the company.

Tax on employee stock ownership plan (ESOP)

At the time of buying shares through ESOP, the difference between the market price and exercise price of the share is considered as perquisite in the hands of the employee and taxed based on the slab rates applicable for the financial year in which the shares are bought.

Perquisites are taxable under the heading “income from salaries”.

Market price means the latest available closing price, prior to the date of the meeting of the Board of Directors in which options are granted/ shares are issued, on the stock exchange on which the shares of the company are listed.

If the shares are listed on more than one stock exchange, then the stock exchange where there is highest trading volume on the said date shall be considered.

For example, suppose the current market price of the stock is Rs 200 per share. You have exercised ESOP at Rs 150 per share on 1st January 2022.

Your taxable value of perquisite will be Rs 200 – Rs 150 = Rs 50 per share.

Assuming you bought 500 shares of the company, your total perquisite for the financial year 2021-22 will be Rs 25,000 (i.e. 500 shares * Rs 50 per share).

Rs 25,000 will be added to your salary income as perquisite and taxed accordingly based on the tax rates and income slabs applicable.

At the time of selling shares, the difference between the price at which you sold the stock and the market price on the date of buying, will be charged to tax as capital gain.

If shares are held for 12 months or less, then short term capital gain tax will be charged at the rate of 15%.

If shares are owned for more than 12 months, then tax rate is 10% on gains exceeding Rs 1,00,000.

Example 1: Short term capital gain on employee stock ownership plan (ESOP)

Example 2: Long term capital gain on employee stock ownership plan (ESOP)

In the second example, as long term capital gain is less than Rs 40,000, tax to be paid is nil. In the first example, short term capital gain will be added to other income to get taxed at the rate of 15%.

Who can’t participate in ESOP scheme

The ESOP scheme must define who is eligible to participate to get shares under the employee stock option plan. In general they allow all permanent employees of the company and directors. However you need to check the company’s scheme to get an idea on who can participate.

However, following persons are not eligible to participate in employee stock ownership plan (ESOP) scheme;

• An employee who is a promoter or belongs to the promoter group.
• A director who either by himself or through his relative or through any body corporate, directly or indirectly holds more than 10% of the outstanding equity shares of the company.

Other key points on employee stock ownership plan (ESOP)

The employee shall not have the right to receive any dividend or to vote or in any manner enjoy the benefits of a shareholder in respect of option granted to him, till shares are issued on exercise of option.

There shall be a minimum period of one year between the grant of options and vesting of options.

Option granted to an employee shall not be transferable to any person.No person other than the employee to whom the option is granted shall be entitled to exercise the option.

In the event of the death of an employee while in employment, all the options granted to him till such date shall vest in the legal heirs or nominees of the deceased employee.

In case the employee suffers a permanent incapacity while in employment, all the options granted to him as on the date of permanent incapacitation, shall vest in him on that day.

The Board of Directors shall at each annual general meeting place before the shareholders a certificate from the auditors of the company that the scheme has been implemented in accordance with the guidelines and in accordance with the resolution of the company in the general meeting.

If the company has followed all the guidelines related to ESOP and notified to the stock exchange and other statutory bodies, then the shares arising pursuant to an ESOP scheme and shares issued under an ESPS shall be listed immediately upon exercise in any recognized stock exchange where the securities of the company are listed.

Some listed companies do not find an ESOP attractive, because it can give a significant amount of voting power to employees. Existing shareholders may not find ESOP attractive as it dilutes their proportional ownership in the company and rights on earnings.