Liquidating your ESOPs? Know the tax implication first

So many youngsters eagerly join startup firms working on cutting-edge ideas backed by innovative technologies. Both local and international firms offer employee stock option plans (ESOPs) to their employees, thus, allowing them an ownership interest in the organisation.

These ESOPs offered as perquisites in place of salaries are rights or options to eligible employees to secure company equity shares at a predetermined rate. Employees can exercise their rights after the vesting period. After this, they can wait to sell the shares in the market at a profit or loss depending on the market value of the share at the time of liquidation.

READ MORE: ESOP Frenzy: Are you aware of these key terms related to ESOP?

Taxation on ESOPs liquidation

Many taxpayers inquire about the implications of liquidating ESOPs on their income tax returns (ITRs). Since ESOPs are employee benefit plans, the earnings on their liquidation are taxed under the head “Capital Gains”. The earnings from the difference between the sales price and exercise price of shares are taxed as either short-term or long-term capital gains depending on how long the shares were held.

Short-term capital gain: Taxpayers must calculate the holding period from the date of exercise of the ESOPs up to the date on which they are sold. If sold within a year of the ESOPs being exercised, the earnings would be considered short-term gains. As per the current regulations under the Income Tax Act, 1961, a short-term capital gain is calculated at the normal tax slab rates.

Long-term capital gain: Shares or ESOPs held for more than a year will be treated as long-term capital gains. Long-term capital gains are taxed at 20 per cent (for unlisted shares) or at 10 per cent (for shares of companies listed on the stock exchanges). Also, long-term capital gains, on listed shares, up to Rs 1 lakh is exempt from tax.

READ MORE: Getting ESOPs as a salary package? Here’s why you should consider them

What happens if you sell at a loss?

Not all startup firms may perform as anticipated. Taxpayers may incur losses too. In case of losses, taxpayers can carry forward short-term capital losses in their ITRs to adjust and set them off against gains in the future.

Listing of shares matters

There is a difference between how listed and unlisted shares are taxed. The tax treatment of unlisted shares remains the same. This means that the Income Tax regulations for shares unlisted in India or listed out of India will be likewise. For example, shares of an American company will not be deemed listed in India and hence would be considered unlisted for the purpose of taxes in India.

Also, the unlisted equity shares will be treated as short-term capital assets and their earnings will be deemed short-term capital gains if sold within two years of being held. The same would be treated as long-term capital assets and their earnings classified as long-term capital gains if sold after two years of being held. This is because equity shares listed on recognized stock exchanges (where securities transaction tax is paid on earnings from their sales) are treated as long-term assets if held for more than a year.

READ MORE: What are ESOPs? Key things to know if your company is offering you ESOPs

Recent amendments in the Income Tax Act mandate taxpayers to disclose details of foreign assets or income from foreign assets. This implies that taxpayers who own ESOPs of a foreign company must disclose their foreign holdings under Schedule FA in their ITRs. Resident taxpayers are mandated to disclose these details.

BM Singh, ESOP Expert & Managing Partner, BMSA