Employee Stock Option Plans (ESOPs) have become one of the most preferred compensation tools for businesses, particularly start-ups and high-growth companies. ESOPs allow employees to acquire ownership in the company, aligning their interests with long-term business growth.
From a tax perspective, ESOPs trigger taxation at two different stages:
The Finance Act, 2026 continues to treat ESOP benefits as taxable perquisites under Section 17(2)(vi) of the Income-tax Act, 1961.
This article explains the tax implications of ESOPs, valuation rules, capital gains treatment, and the special tax deferment available to employees of eligible start-ups.
Organizations use ESOPs for several strategic reasons:
By granting ownership interests, companies encourage employees to contribute towards long-term value creation.
The taxation of ESOPs arises at two distinct stages:
Stage 1: Taxation at the Time of Allotment of Shares
When an employee exercises an ESOP and shares are allotted, the difference between the Fair Market Value (FMV) of the shares on the exercise date and the amount paid by the employee is treated as a taxable perquisite under the head “Salaries”.
Perquisite Value Formula
Perquisite Value = FMV on Exercise Date – Amount Paid by Employee
This perquisite forms part of the employee’s salary income and is subject to tax deduction at source (TDS) under Section 192.
Important Point
The FMV on the date of allotment is not relevant. The valuation is based on the FMV on the date the employee exercises the option.
Shares Listed on One Stock Exchange
FMV = Average of Opening Price and Closing Price on the Exercise Date.
Shares Listed on Multiple Stock Exchanges
FMV = Average of Opening and Closing Price on the exchange having the highest trading volume.
No Trading on Exercise Date
FMV will be based on the closing price on the nearest preceding trading day.
FMV shall be determined by a registered merchant banker on:
Suppose an employee receives 100 ESOP shares with the following details:
| Particulars | Amount |
|---|---|
| Number of Shares | 100 |
| Exercise Price | ₹500 per share |
| FMV on Exercise Date | ₹6,500 per share |
Perquisite Value
Perquisite = (₹6,500 – ₹500) × 100
= ₹6,00,000
The amount of ₹6,00,000 will be taxed as salary income in the year of allotment of shares.
When the employee sells the shares acquired through ESOPs, the resulting profit is taxable under the head “Capital Gains”.
Period of Holding
For capital gains purposes, the holding period begins from the date of allotment of shares and not from the exercise date.
Cost of Acquisition
The FMV considered for perquisite taxation on the exercise date becomes the cost of acquisition while calculating capital gains.
Illustration
For determining whether the gain is short-term or long-term, the holding period will be counted from 1 May 2022.
However, the cost of acquisition will be the FMV as on 1 April 2022, i.e., the exercise date.
Recognizing that employees may not have sufficient liquidity to pay tax on ESOPs immediately, the Income-tax Act provides a deferment mechanism for employees of eligible start-ups covered under Section 80-IAC.
Benefit Available
Although ESOP perquisites remain taxable in the year of allotment, payment and deduction of tax can be postponed.
When Does Tax Become Payable?
The employer must deduct tax within 14 days from the earliest of the following events:
Whichever occurs first will trigger the tax liability.
Assume:
| Particulars | Amount |
| Annual Salary | ₹40,00,000 |
| ESOP Perquisite Value | ₹90,00,000 |
| Total Taxable Income | ₹1,30,00,000 |
The employee will report the ESOP perquisite in the return of income for the year of allotment.
However, the tax attributable to the ESOP component will not be immediately payable.
If the employee neither sells the shares nor leaves the company, the deferred tax becomes payable after the expiry of 48 months from the end of the relevant assessment year.
In such a case, the tax attributable to the ESOP perquisite is recovered at the deferred stage in accordance with the provisions of Section 192.
ESOPs provide employees with an opportunity to participate in the growth of their employer while creating long-term wealth. However, understanding the dual tax implications—salary taxation at allotment and capital gains taxation on sale—is crucial for effective tax planning. Employees of eligible start-ups should also evaluate the benefits of the ESOP tax deferment provisions, which significantly ease the immediate cash-flow burden associated with ESOP taxation.
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