Employee Stock Ownership Plans (ESOPs) have become a popular wealth-creation tool for startup and growth-stage company employees. However, when an unlisted company announces an ESOP buyback, many employees are surprised to discover that their gains may be taxed twice—once when they exercise their options and again when they sell the resulting shares.
This often leads to confusion because employees assume that the tax paid at the time of exercising ESOPs settles their tax obligations. In reality, Indian tax law treats the exercise of options and the eventual sale of shares as two separate taxable events.
Understanding how these two stages work is essential for employees, founders, CFOs, and HR teams involved in ESOP liquidity programs.
When an employee exercises ESOPs, the company allots shares to the employee at the predetermined exercise price.
Under Section 17(2)(vi) of the Income-tax Act, the difference between the Fair Market Value (FMV) of the shares and the exercise price is treated as a perquisite and taxed as salary income.
Perquisite Value = (FMV on Exercise Date – Exercise Price) × Number of Shares Exercised
The resulting amount is added to the employee’s taxable salary and taxed according to the applicable income-tax slab rates.
For unlisted companies, FMV must be determined through a valuation report issued by a Category-I SEBI Registered Merchant Banker.
As per Rule 3(9)(ii) of the Income-tax Rules, the valuation certificate used for ESOP taxation should not be older than 180 days from the date of exercise.
Employers are responsible for deducting TDS on the taxable perquisite while processing payroll.
Many companies obtain a single valuation report and continue using it for multiple ESOP exercise rounds spread over several months.
If an employee exercises options after the 180-day validity period, the valuation may not satisfy the requirements of Rule 3. This can expose the employer to TDS default consequences, including interest and penalties.
Obtaining a fresh valuation before each significant exercise event is generally a safer compliance approach.
Once ESOPs are exercised, employees become shareholders.
When the company later conducts a buyback or provides an exit opportunity, the employee sells the shares and receives sale proceeds. This transaction triggers capital gains taxation.
A crucial point often overlooked is that the cost of acquisition is not the exercise price.
Instead, the FMV that was already subjected to perquisite taxation becomes the employee’s cost base for capital gains purposes.
This ensures that the same value is not taxed twice.
Capital Gain = Sale Price – FMV Considered During Exercise
Only the appreciation occurring after the exercise date is subject to capital gains tax.
For unlisted shares, the holding period determines the applicable tax treatment.
The difference can significantly affect the employee’s post-tax proceeds.
Assume Priya exercised 10,000 ESOPs in January 2024.
Perquisite Value:
(₹150 − ₹10) × 10,000
= ₹14,00,000
This amount is added to Priya’s salary income and taxed according to her slab rate.
Assuming she falls in the highest tax bracket, the tax outflow may be approximately ₹4.33 lakh including cess.
In June 2026, the company announces a buyback at ₹250 per share.
Since Priya has held the shares for more than 24 months, the shares qualify as long-term capital assets.
Capital Gain:
(₹250 − ₹150) × 10,000
= ₹10,00,000
LTCG Tax:
12.5% of ₹10,00,000
= ₹1,25,000
| Particulars | Amount |
|---|---|
| Tax on Perquisite | ₹4.33 lakh |
| LTCG Tax | ₹1.25 lakh |
| Total Tax | ₹5.58 lakh |
Although the buyback proceeds amount to ₹25 lakh, taxation occurs at two different stages under two different provisions of law.
Suppose the same buyback occurred before the completion of 24 months.
The ₹10 lakh gain would become a short-term capital gain and could be taxed at the employee’s slab rate instead of 12.5%.
For individuals in the highest tax bracket, this could substantially increase the tax burden.
Employees approaching the 24-month threshold should carefully evaluate whether delaying the transaction could result in significant tax savings.
One of the most misunderstood aspects of ESOP buybacks is valuation compliance.
Depending on the facts of the transaction, multiple valuation requirements may apply simultaneously.
A Merchant Banker valuation is required for determining FMV at the time of ESOP exercise under Rule 3.
This valuation forms the basis for perquisite taxation.
The buyback price must be justifiable and defensible from a corporate law perspective.
An independent valuation report from an IBBI Registered Valuer is generally considered the most robust support for the buyback price approved by the Board.
A properly documented valuation helps demonstrate that the buyback is being conducted at a fair and reasonable price.
Additional considerations arise when foreign investors or non-resident shareholders participate in the buyback.
FEMA pricing guidelines may require valuation by a SEBI Registered Merchant Banker or IBBI Registered Valuer using internationally accepted valuation methodologies.
Failure to comply with pricing regulations can result in FEMA-related compliance issues.
Companies often encounter situations where an earlier valuation report exists, but the proposed buyback occurs several months later.
While the Income-tax Rules impose a 180-day validity consideration for ESOP exercise valuations, corporate law and FEMA requirements focus more broadly on whether the valuation remains fair and supportable.
Problems may arise if:
To avoid such complications, companies should align valuation, exercise windows, and buyback timelines as closely as possible.
An ESOP buyback can be a rewarding milestone for employees, providing liquidity and wealth creation opportunities. However, the tax implications extend beyond the exercise stage. The interaction between perquisite taxation and capital gains taxation often leads to unexpected liabilities when employees are not adequately informed.
For both employees and management teams, a clear understanding of valuation requirements, holding periods, and tax treatment can prevent costly surprises and ensure that an ESOP liquidity event delivers its intended benefit.
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