A guide to the taxation of ESOP trusts under the Income-tax Act, 1961
Arjun Gupta
Advocate, Bombay High Court

Introduction

Employee Stock Option Plans(“ESOP”) have become a popular way for companies and startups to incentivize talented employees by rewarding them with shares in order to retain their services and keep them in employment, and such ESOP’s serve as an alternative to awarding them with basic incentives in the form of bonuses and other cash payments. ESOP’s also form part of the companies’ tax planning structure.

Typically, an ESOP is an option which is exercisable by an employee of the company beyond a certain timeframe(known as the vesting period) which results in shares of the company being awarded/allotted to the employee pursuant to exercise of the option. It is noteworthy that most public limited companies have several employees working under their payroll and payment under an ESOP to the credit of the employees amounts to several crores in such cases. The ESOP plan is framed in an agreement/contract between the employer and employee or under a trust deed. This is the first step in the creation of an ESOP. The next step is the creation of a Grant. The process by which the company issues Options and the terms and conditions thereof, are set out in the Grant. Shares are not directly open to allotment: the timeframe within which the option vests in the employee but the employee has no right to exercise the option is known as the Vesting Period. In other words, during the Vesting Period the employees cannot exercise the option to have the shares of the company allotted to it. The period during which the option is exercisable by the employee is known as the Exercise Period, and once the option is exercised during this period, the shares of the company are credited to the employee’s DEMAT account and it is then that issues of taxability of such receipt in the hands of the employee arise and issues of taxability arise further, when the said shares are sold.

ESOP’s in the modern era are managed through trusts. The Securities and Exchange Board of India(“SEBI”) has issued the Securities And Exchange Board Of India(Share Based Employee Benefits And Sweat Equity) Regulations, 2021 which deal with the ESOP and similar structures and other ancillary aspects. The Income-tax Act, 1961(“Act”) also deals with taxation aspects of ESOPS. Lastly, the Companies Act, 2013 has a role to play as well. In this article, we will be dealing with taxation of ESOP trusts and the several myriad issues involved.

SEBI(Share Based Employee Benefits And Sweat Equity) Regulations, 2021 in a nutshell

The SEBI(Share Based Employee Benefits And Sweat Equity) Regulations, 2021 were notified by SEBI on 13th August, 2021. It is important to note some relevant paragraphs of these regulations which have been explained hereunder:

• Regulation 1(3) states that the provisions of the regulations shall apply to:

(i) employee stock option schemes;
(ii) employee stock purchase schemes;
(iii) stock appreciation rights schemes
….

• Regulation 1(4) states that the provisions of these regulations shall apply to any company whose equity shares are listed on a recognised stock exchange in India and who seeks to issue sweat equity shares or has a scheme:-

(i) for direct or indirect benefit of employees;
….
xxx

Definitions of important terms under the Regulations

• Regulation 2(j) defines ‘employee stock option scheme or ESOS’ as a scheme under which a company grants employee stock options to employees directly or through a trust;

Regulation 2(k) defines ‘employee stock purchase scheme or ESPS’ as a scheme under which a company offers shares to employees, as part of public issue or otherwise, or through a trust where the trust may undertake secondary acquisition for the purposes of the scheme;

Regulation 2(l) defines “exercise” as making of an application by an employee to the company or to the trust for issue of shares or appreciation in form of cash, as the case may be, against vested options or vested SARs in pursuance of the schemes covered under Part A or Part C of Chapter III of the regulations, as the case may be;

Regulation 2(m) defines “exercise period” as the time period after vesting within which an employee can exercise his/her right to apply for shares against the vested option or appreciation against vested SAR in pursuance of the schemes covered under Part A or Part C of Chapter III of the regulations, as the case may be;

Regulation 2(n) defines “exercise price” as the price, if any, payable by an employee for exercising the option or SAR granted to such an employee in pursuance of the schemes covered under Part A or Part C of Chapter III of the regulations, as the case may be;

Regulation 2(p) defines “grant” as the process by which the company issues options, SARs, shares or any other benefits under any of the schemes;

Regulation 2(z) defines “option” as the option given to an employee which gives such an employee a right to purchase or subscribe at a future date, the shares offered by the company, directly or indirectly, at a pre-determined price;

Regulation 2(ll) defines “scheme” as a scheme of a company proposing to provide share based benefits to its employees under Chapters III of these regulations, which may be implemented and administered directly by such company or through a trust, in accordance with these regulations;

Regulation 2(nn) defines “secondary acquisition” as acquisition of existing shares of the company by the trust on the platform of a recognised stock exchange for cash consideration;

Regulation 2(qq) defines “stock appreciation right or SAR” as a right given to a SAR grantee entitling him to receive appreciation for a specified number of shares of the company where the settlement of such appreciation may be made by way of cash payment or shares of the company.

Explanation 1,—A SAR settled by way of shares of the company shall be referred to as equity settled SAR.
Explanation 2,—For the purpose of these regulations, any reference to stock appreciation right or SAR shall mean equity settled SARs and does not include any scheme which does not, directly or indirectly, involve dealing in or subscribing to or purchasing, securities of the company.

Regulation 2(uu) defines “trust” as a trust established under the provisions of the Indian Trusts Act, 1882 (2 of 1882) including any statutory modification or re-enactment thereof, for implementing any of the schemes covered by the regulations;

Regulation 2(yy) defines “vesting period” as the period during which the vesting of option, SAR or a benefit granted under any of the schemes takes place;

• Regulation 3 states that a company may implement a scheme directly or by setting up an irrevocable trust. If a secondary acquisition of shares is taking place by the company, the same will mandatorily have to be made only through a trust. If a trust is to be formed, the same must be decided upfront at the time of taking approval of the shareholders. A trust deed shall be drawn up containing details as per Part A of Schedule 1 of the regulations and shall be filed with the recognized stock exchanges.

The trustees of the trust shall not vote in respect of the shares held by the trust to avoid misuse of exercising voting rights. The trust cannot deal in derivatives and shall undertake only delivery based acquisitions. The trust cannot become a medium for trading in shares. Secondary acquisition in a financial year by the trust shall not exceed two per cent of the paid up equity capital of the company as at the end of the previous financial year. The trust shall be required to hold the shares acquired through secondary acquisition for a minimum period of six months except where they are required to be transferred in the circumstances enumerated in clause (b) of sub-regulation (14), whether off-market or on the platform of a recognised stock exchange. Sub-regulation 14 states that the trust shall be permitted to undertake off-market transfer of shares only under the following circumstances:
(a) transfer to the employees pursuant to scheme(s); (b) while participating in an open offer under the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 or while participating in a buy-back, delisting or any other exit offered by the company generally to its shareholders.

• Regulation 9 states that options/SAR’s are not transferable to any other person.

• Regulation 18 deals with Vesting Period for ESOP/ESOS and states that the Vesting Period shall be a minimum of one year. However, the company may specify the lock-in period for shares issued pursuant to exercise of the option. If a lock-in period is imposed, the shares do not have any realizable value and cannot be utilized by the employees.

• Regulation 19 states that an employee shall not have the right to receive any dividend or to vote or in any manner enjoy the benefits available to a shareholder in respect of an option granted to him/her, till shares are issued to him/her upon exercise of the option.

• Regulation 20 states the consequence of failure to exercise an option. It states that the amount paid by the employee, if any, at the time of grant, vesting or exercise of option— (a) may be forfeited by the company if the option is not exercised by the employee within the exercise period; or (b) may be refunded to the employee if the options are not vested due to non-fulfilment of conditions relating to vesting of option as per the ESOS.

• Regulation 21 under Part B: Employee Stock Purchase Scheme deals with Employee Stock Purchase Scheme. Here, the shares are to be compulsorily under a lock-in period for a minimum period of one year after they are allotted.

• Regulation 23 deals with SAR and a company is free to implement the cash or equity based settlement of SAR.

• Regulation 46 states that the SEBI(Share Based Employee Benefits), Regulations, 2014 and the SEBI(Issue of Sweat Equity) Regulations, 2002 are hereby repealed.

Summary of SEBI Regulations

ESOP’s may be formed under a trust deed or by opting through the direct scheme route, however, if there is a secondary acquisition of shares, formation of a trust under a trust deed is mandatory. The rationale is that a company cannot purchase its own share and is required to do so through an independent body and acquisition of secondary shares entails purchase by a company of its own shares from the market which can be done only through a third medium such as a trust. Hence, formation of a trust becomes mandatory.

SAR’s or stock appreciation rights can be equity based or cash based and essentially deal with the appreciation in value of shares which are held by the trust(or directly) which shares are not held by the employee. The employee is simply entitled to the appreciation in value of the shares over a period of time which is credited to him at the end of the period under an SAR. The Vesting Period of ESOP’s/ESOS and SAR’s shall be a minimum of one year. The lock in period can be decided by the company.

Taxation of income under an ESOP under the Income-tax Act, 1961

• Let us now examine the relevant provisions of the Act dealing with income derived under an ESOP.

• Section 17(2) deals with ‘perquisites’. Section 17(2)(vi) makes reference to receipt of perquisites in the hands of the employees pursuant to allotment of shares under an ESOP. Allotment of shares in the hands of the employee pursuant to an ESOP is treated as a perquisite and taxable in the hands of the employee. Section 17(2) states that perquisite includes:

(vi) the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at concessional rate to the assessee.
Explanation.—For the purposes of this sub-clause,—
(a) “specified security” means the securities as defined in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and, where employees’ stock option has been granted under any plan or scheme therefor, includes the securities offered under such plan or scheme;
(b) “sweat equity shares” means equity shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called;
(c) the value of any specified security or sweat equity shares shall be the fair market value of the specified security or sweat equity shares, as the case may be, on the date on which the option is exercised by the assessee as reduced by the amount actually paid by, or recovered from, the assessee in respect of such security or shares;
(d) “fair market value” means the value determined in accordance with the method as may be prescribed;
(e) “option” means a right but not an obligation granted to an employee to apply for the specified security or sweat equity shares at a predetermined price;

The value of the perquisite will be the fair market value of the shares on the date when the option is exercised less any price paid by the assessee for acquisition of the shares as above. Shares allotted under an ESOP are covered under the definition of ‘specified securities’. Perquisites are included within the meaning of ‘salary’ and are made chargeable to tax under Section 15/Section 16.

• Explanation 1 to Section 2(42A) determines the period of holding for a capital asset and makes reference to shares allotted under ESOP’s. Under clause (hb) of Explanation 1, ‘in the case of a capital asset, being any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer free of cost or at concessional rate to his employees (including former employee or employees), the period shall be reckoned from the date of allotment or transfer of such specified security or sweat equity shares’

Therefore when the employee sells the shares allotted under an ESOP, the capital gains arising to him will be computed as long term capital gains or short term capital gains as per the period of holding as above.

• Section 192 deals with deduction of TDS on salary and TDS is deductible on perquisites as well. Therefore,

Sub-section (1A) states: Without prejudice to the provisions contained in sub-section (1), the person responsible for paying any income in the nature of a perquisite which is not provided for by way of monetary payment, referred to in clause (2) of section 17, may pay, at his option, tax on the whole or part of such income without making any deduction therefrom at the time when such tax was otherwise deductible under the provisions of sub-section (1).
Sub-section (1B) states: For the purpose of paying tax under sub-section (1A), tax shall be determined at the average of income-tax computed on the basis of the rates in force for the financial year, on the income chargeable under the head “Salaries” including the income referred to in sub-section (1A), and the tax so payable shall be construed as if it were, a tax deductible at source, from the income under the head “Salaries” as per the provisions of sub-section (1), and shall be subject to the provisions of this Chapter.

Relevant judicial precedents pertaining to ESOP

• In CIT vs. Infosys Technologies Ltd. , the Supreme court was faced with the issue of whether there was a failure of the assessee to deduct tax at source on ‘salary’ in the nature of perquisites being shares allotted under an ESOP. The facts of the case are:

The respondent-assessee was a public limited company based in Bangalore. To implement the Employees’ Stock Option Scheme, the assessee created a trust known as Technologies Employees’ Welfare Trust and allotted 7,50,000 warrants at Re. 1 each to the said trust. Each warrant entitled the holder thereof to apply for and be allotted one equity share of the face value of Rs. 10 each for a total consideration of Rs. 100. The trust was to hold the warrant and transfer the same to the employees of the company under the terms and conditions of the scheme governing the ESOP. During the assessment years 1997-98, 1998-99 and 1999-2000, warrants were offered to the eligible employees at Re. 1 each by the trust. They were issued to the employees based on their performance, security and other criteria. Under the ESOP scheme, every warrant had to be retained for a minimum period of one year. At the end of that period, the employee was entitled to elect and obtain shares allotted to him on payment of the balance Rs. 99. The option could be exercised at any time after 12 months but before the expiry of the period of five years. The allotted shares were subject to a lock-in period. During the lock-in period, the custody of the shares remained with the trust. The shares were non-transferable. The employee had to continue to be in service for 5 years. If he resigned or if his services be terminated for any reason, he lost his right under the scheme and the shares were to be re-transferred to the trust for Rs. 100 per share. Intimation was also given to the BSE that 7,34,500 equity shares were non-transferable and would not constitute good delivery. Till September 13, 1999, all the shares were stamped with the remark “non transferable”. Thus the said shares were incapable of being converted into money during the lock-in period.

For the assessment year 1999-2000, the Assessing Officer held that the total amount paid by the employees pursuant to the exercise of the option was Rs. 6.64 crores whereas the market value of those shares was Rs. 171 crores. He held that the “perquisite value” was the difference between the market value and the price paid by the employees for exercise of the option. He, therefore, treated Rs. 165 crores as perquisite value on which TDS was charged at 30%. It was held by the Assessing Officer that the respondent-assessee was a defaulter for not deducting TDS under section 192 amounting to Rs. 49.52 crores on the above perquisite value of Rs. 165 crores. Similar orders were also passed by the Assessing Officer for the assessment years 1997-98 and 1998-99. These orders were confirmed by the Commissioner of Income-tax (Appeals).

The Supreme Court held that the shares had no realizable value inasmuch as they were under a lock-in period post exercise of the option. That it would be impossible to compute the benefit or perquisite in the hands of the employee pursuant to exercise of the option since as noted above the perquisite had no value since it was under the lock-in period. The employee also had no access to the shares and therefore no income/salary arose to the employee upon which income was liable to be deducted at source.

The Supreme Court also rejected the argument of the Revenue that Section 17(2)(iiia) inserted by the Finance Act, 1999 w.e.f 1st April, 2000[corresponding to Section 17(2)(vi)] is retrospective since the legislature had consciously not treated the provision as retrospective and the cost to be worked out was a novel method which did not exist in the earlier regime.

In the authors view, this judgment of the Supreme Court is without blemish since shares under lock-in indeed do not have any realizable value.

• In ACIT vs. Bharat V. Patel , the Supreme Court was faced with the issue of taxation of SAR’s(stock appreciation rights) when the shares attached to the rights had appreciated and the appreciation value was granted to the assessee. The AO held that the same is taxable as capital gains and the AO’s order was upheld by the CIT(A) and the Tribunal. However, the High Court accepted the case of the responsent-assessee.

The facts in brief are that the assessee was the chairman-cum-managing director of (P&G) India Ltd which was a subsidiary of P&G USA. SAR’s were allotted to the assessee between 1991-1996 without any consideration. The said SAR’s were redeemed on October 15, 1997 and the assessee received an amount of Rs. 6crore~ from P&G USA. The Supreme Court noted the stand of the Revenue that the same is taxable under Section 17(2)(iii) or in the alternative under Section 28(iv).

The Supreme Court observed that the case of the assessee would come under Section 17(2)(iiia)[as it then stood]. However, in the authors view, SAR’s can never be treated as a specified security and no specified security is allotted to the assessee and hence Section 17(2)(iiia) has no application. The Supreme Court upheld the decision of Infossys Technologies and held that the provision is not retrospective. Hence, the amounts cannot be taxed under Section 17(2)(iiia) for the Assessment Year 1998-1999. Further, the amounts cannot be taxed under Section28(iv) since the assessee is not running any business. Hence, the amounts ought to go untaxed.

This judgment is in view ignores the fact that Section 17(2)(iiia) does not deal with SAR’s. It deals only with ESOP’s. SAR’s may be taxed as salary separately as will be shown later in this article. Also, the amounts received by the assessee have gone wholly untaxed for want of a provision to impose the tax.

• In Sumit Bhattacharya vs. ACIT , the Special Bench of the Hon’ble ITAT was faced with the issue of taxation of SAR’s and the facts of the case are nearly identical to the case of Bharat Patel(above). The Hon’ble ITAT noted that the consideration received on account of appreciation in the value of shares is received in cash since the subject matter is an SAR and not an ESOP, and such receipt of consideration is pursuant to services rendered by the employee(assessee) to the company. Hence, the receipt is in the nature of income. The Tribunal distinguished between shares received pursuant to an ESOP being executed and SAR, in the former case shares are received, but in the latter case, only cash is received. Hence, the amounts received by the assessee are towards fruits of employment taxable under the head salaries or in the alternative if the assessee contends that it is not receivable from the de jure employer, taxable under the head income from other sources.

Conclusion

Taxation of ESOP’s is at a nascent stage and has its own complexities. Several other issues such as the taxability of capital gains arising when the shares are not under lock-in period, or the set off of capital losses of the Trust pursuant to transfer of the shares to employees when the options have been exercised, or cases where the Trust has borrowed monies from the company and if the same is waived by the company, then the taxability in the hands of the Trust etc. The law on taxation of ESOP’s is ever evolving and it will be interesting to see some finality on the issue.

Posted on: October 19th, 2023