ESOP Vesting Period: All You Need to Know

You must have heard the stories of many drivers, office assistants, and secretaries working with Infosys becoming millionaires. This could become possible owing to a system of making such stakeholders as stockholders of the company by granting them what is generally known as ESOP (Employee Stock Option Plan or Employee Stock Ownership Plan). Here we are talking about the various aspects related to ESOP.

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What is ESOP?

ESOP is a system under which the employees of a company are generally given the right to acquire the shares of the company for which they are working. In some cases, the foreign holding/subsidiary company also grants such options to the employees of the Indian subsidiary/ holding company. Under such a scheme, the employees are granted some rights, called stock options, to get the shares of the company for free or at a concessional rate, at a predetermined price or the price to be determined on the prefixed method, as compared to the potential market rate.

Why do companies offer ESOPs?

There are various reasons for which the employees of a company are given such stock options. The phenomenon of stock options is more prevalent in start-up companies that cannot afford to pay huge salaries to their employees but are willing to share the future prosperity of the company. In such cases, the employees are given stock options as part of the compensation package. Moreover, in some cases, the employee is given such stock options which he can exercise on future date/s, in order to ensure the long-term commitment of the employee. So apart from rewarding the employees with monetary gains, ESOP also helps create a sense of belonging and ownership amongst the employees.

What is Vesting Period in ESOPs?

With stock options, like ISOs or NSOs, you aren’t getting actual shares of stock—yet. Instead, you’re getting the right to exercise (buy) a set number of shares at a fixed price later on. You usually have to earn your options over time—a process called vesting. And you can only exercise vested stock options (unless your company allows early exercising).

If your company gives you RSUs, on the other hand, they’re giving you stock in the future. You may have to stay at the company for a certain amount of time, and sometimes you or the company must hit a stated milestone in order for these shares to vest. But unlike stock options, you don’t need to purchase them—you just need to wait for them to vest. Your vesting schedule, which shows when you’ll earn your options or shares, should be detailed in your option grant (e.g. 1,000 options over four years).

Consult: Top Corporate Lawyers in India

How does the Vesting period work?

Under the ESOP schemes, the stock option is free when it is given to an employee. The terms and conditions on which an employee can exercise his rights are spelled in the ESOP scheme. The option given to the employee can be exercised after a certain lock-in period, which is generally more than one year.

The right to exercise the option may get vested in the employee in the next future date/s. The dates on which the employee becomes entitled to exercise the right to acquire the shares is called as “vesting date.” The rights may vest fully or partially over the vesting period. For example, an employee is given 1000 options on 31st March 2016 which can be exercised in phases like 20% on completion of one year, 30% on completion of the second year, and the balance on completion of the third year from the date of such grant. So in the instant case, the vesting date for 200 options is 1st April 2017, for 300 shares it is 31st March 2018 and for the balance of 500 shares, it is 31st March 2019. The plan may stipulate the same or different grant price or exercise price for such vesting. The grant price or the price at which the employee can buy the share from the company is generally fixed and is generally substantially lower than the prevailing market price of the shares in case the shares are listed.

Since the employee is given just an option without any obligation attached to it, the employee doesn't need to exercise the option. The employee may decide to exercise the option or may decide to let the option lapse in case the prevailing price of the shares is lower than the exercise price. The employee is given a time period during which he has to exercise the option failing which the vested rights may lapse. The date on which the employees exercise their option to buy the shares is known as the ‘exercise date’.

There are no cash outflows or taxation implications when the options are granted as well as when the options are vested in the employee.

When to exercise your Options?

An employee doesn't need to exercise the option once it vests with him. The employee can exercise the right within the stipulated time period. When the employee should exercise the options is a very important question from a financial and taxation angle as well. Once the employee exercises the option, he has to pay for the shares at the price predetermined and thus causing cash outflow. In case the shares are not listed on a stock exchange, the same cannot be liquidated and thus the money gets locked till the shares get listed or the promoters offer you an exit option. Moreover, there is a taxation implication if you delay your exercise date because the holding period for capital gain purposes will start from the exercise date. So the decision has to be taken after having considered the cash flow and tax implications of such a decision.

What are the Tax Implications when exercising the Options?

The taxation of ESOP has a typical structure. It is taxed in two stages. The first stage is when the employee exercises the option to buy the shares at the exercise price. The second stage is when the shares are ultimately sold.

Let us first discuss the first stage. As and when the options under the ESOPs are exercised, the difference between the exercise price and the value of the security is treated as a prerequisite in the hand of the employee. The employer is required to deduct tax at source on the employee exercising the option, treating the same as a prerequisite. The value of the shares allotted to the employee shall be the average of the market price (average of highest and lowest price) on the date the option is exercised in case the shares are listed on any stock exchange in India. In case the shares are not listed the fair market value of the same shall be as per the valuation certificate obtained from the merchant banker. The certificate of valuation of shares should not be older than 180 days from the date of exercise of the option. Even if the shares are listed outside India, the company will have to obtain the certificate from the Merchant Banker as such shares are treated as unlisted shares for ESOP purposes.

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What are the Tax Implications when the shares acquired under ESOP are disposed of?

Now let us understand the second leg of the taxation of the ESOP shares, i.e. when the employee actually sells the shares. The incidence of sales will attract capital gains tax. The gains can be either long-term or short-term, depending on the period for which the employee has held the shares. The holding period requirement is different for listed shares as well as for unlisted shares. Listed shares shall become long-term if held for more than one year. Unlisted shares become long-term after three years. The period of three years has been proposed to be reduced to two years in the current budget.

The rate at which the short-term or long-term gains shall be taxed will depend on whether the shares have been traded on the platform of the stock exchange on which the Security Transaction Tax has been paid. In case shares are traded through a broker, the long-term capital gains are taxed under Section 112A at 10% over Rs 1 lakh of capital gains. However, such short-term capital gains shall be taxed at a flat rate of 15% under Section 111A.

However, in case the shares are not sold through the platform of the stock exchange, the long-term capital gains shall be calculated after applying the indexation to the original cost of purchase. Indexed gains so calculated shall be taxed at a flat rate of 20% plus applicable surcharge and education cess. You have the option to pay tax @ 10% on capital gains without applying for indexation benefits. Such short-term capital gains are being treated like any other income and added to other income and taxed at the slab rate applicable.

To compute the capital gains the fair market value as on the date of exercise, take into account for perquisites of the options are treated as the cost of acquisition and not the price paid by the employee.

The tax implications would be different in case the ESOPs are allotted to a person who is not an employee either by the holding or subsidiary company or any non-executive director or any other eligible person. The question of it being taxed as a prerequisite does not arise when the option is exercised by such persons. However, the capital gains tax will have to be paid as and when such shares are sold.

Consult: Top Corporate Lawyers in India

Taxation of Foreign ESOPs

In case the ESOPs are granted by foreign companies to the Indian resident, the same would be taxable in India. Moreover, the taxation provisions of the country of the company which grants the option as well as the double taxation avoidance agreement shall have to be looked into for understanding the exact tax implication. Moreover, concessional tax on long-term capital gains under Section 112A or concessional rate of 15% tax on the short-term capital gain in respect of such shares would not be available as these shares would not be sold on Indian stock exchanges as these are not likely to be listed in India.

When should you sell the Shares?

The decision to sell the shares acquired under ESOP is like any other investment decision. You need to take into account the capital gains implication as well as the need for liquidity for arriving at the decision. Moreover, whether and when to sell will also depend on the future prospects of the company. It may also happen that the shares which you have acquired under ESOP are not listed. So, in such a situation you cannot sell the shares until the shares are listed or the promoters offer you an exit, which may not be on very attractive terms. In such a situation, it will make sense for you to wait for a little till the shares are listed on a stock exchange.

Connect with an expert lawyer for your legal issue

Should you accept ESOPs in lieu of Cash as part of your Salary?

An old saying goes, “One bird in the hand is better than two in the bush.” Common sense would demand that one should opt for cash in lieu of ESOPs, but here such a comparison may not be so easy to make because generally, the projected price of shares under the ESOP plan may be significantly higher than the cash component being offered. Moreover, the option to choose cash in lieu of the ESOP may not always be available.

You must have heard the stories of many drivers, office assistants, and secretaries working with Infosys becoming millionaires. This could become possible owing to a system of making such stakeholders as stockholders of the company by granting them what is generally known as ESOP (Employee Stock Option Plan or Employee Stock Ownership Plan). Here we are talking about the various aspects related to ESOP.

Connect with an expert lawyer for your legal issue

What is ESOP?

ESOP is a system under which the employees of a company are generally given the right to acquire the shares of the company for which they are working. In some cases, the foreign holding/subsidiary company also grants such options to the employees of the Indian subsidiary/ holding company. Under such a scheme, the employees are granted some rights, called stock options, to get the shares of the company for free or at a concessional rate, at a predetermined price or the price to be determined on the prefixed method, as compared to the potential market rate.

Why do companies offer ESOPs?

There are various reasons for which the employees of a company are given such stock options. The phenomenon of stock options is more prevalent in start-up companies that cannot afford to pay huge salaries to their employees but are willing to share the future prosperity of the company. In such cases, the employees are given stock options as part of the compensation package. Moreover, in some cases, the employee is given such stock options which he can exercise on future date/s, in order to ensure the long-term commitment of the employee. So apart from rewarding the employees with monetary gains, ESOP also helps create a sense of belonging and ownership amongst the employees.

What is Vesting Period in ESOPs?

With stock options, like ISOs or NSOs, you aren’t getting actual shares of stock—yet. Instead, you’re getting the right to exercise (buy) a set number of shares at a fixed price later on. You usually have to earn your options over time—a process called vesting. And you can only exercise vested stock options (unless your company allows early exercising).

If your company gives you RSUs, on the other hand, they’re giving you stock in the future. You may have to stay at the company for a certain amount of time, and sometimes you or the company must hit a stated milestone in order for these shares to vest. But unlike stock options, you don’t need to purchase them—you just need to wait for them to vest. Your vesting schedule, which shows when you’ll earn your options or shares, should be detailed in your option grant (e.g. 1,000 options over four years).

Consult: Top Corporate Lawyers in India

How does the Vesting period work?

Under the ESOP schemes, the stock option is free when it is given to an employee. The terms and conditions on which an employee can exercise his rights are spelled in the ESOP scheme. The option given to the employee can be exercised after a certain lock-in period, which is generally more than one year.

The right to exercise the option may get vested in the employee in the next future date/s. The dates on which the employee becomes entitled to exercise the right to acquire the shares is called as “vesting date.” The rights may vest fully or partially over the vesting period. For example, an employee is given 1000 options on 31st March 2016 which can be exercised in phases like 20% on completion of one year, 30% on completion of the second year, and the balance on completion of the third year from the date of such grant. So in the instant case, the vesting date for 200 options is 1st April 2017, for 300 shares it is 31st March 2018 and for the balance of 500 shares, it is 31st March 2019. The plan may stipulate the same or different grant price or exercise price for such vesting. The grant price or the price at which the employee can buy the share from the company is generally fixed and is generally substantially lower than the prevailing market price of the shares in case the shares are listed.

Since the employee is given just an option without any obligation attached to it, the employee doesn't need to exercise the option. The employee may decide to exercise the option or may decide to let the option lapse in case the prevailing price of the shares is lower than the exercise price. The employee is given a time period during which he has to exercise the option failing which the vested rights may lapse. The date on which the employees exercise their option to buy the shares is known as the ‘exercise date’.

There are no cash outflows or taxation implications when the options are granted as well as when the options are vested in the employee.

When to exercise your Options?

An employee doesn't need to exercise the option once it vests with him. The employee can exercise the right within the stipulated time period. When the employee should exercise the options is a very important question from a financial and taxation angle as well. Once the employee exercises the option, he has to pay for the shares at the price predetermined and thus causing cash outflow. In case the shares are not listed on a stock exchange, the same cannot be liquidated and thus the money gets locked till the shares get listed or the promoters offer you an exit option. Moreover, there is a taxation implication if you delay your exercise date because the holding period for capital gain purposes will start from the exercise date. So the decision has to be taken after having considered the cash flow and tax implications of such a decision.

What are the Tax Implications when exercising the Options?

The taxation of ESOP has a typical structure. It is taxed in two stages. The first stage is when the employee exercises the option to buy the shares at the exercise price. The second stage is when the shares are ultimately sold.

Let us first discuss the first stage. As and when the options under the ESOPs are exercised, the difference between the exercise price and the value of the security is treated as a prerequisite in the hand of the employee. The employer is required to deduct tax at source on the employee exercising the option, treating the same as a prerequisite. The value of the shares allotted to the employee shall be the average of the market price (average of highest and lowest price) on the date the option is exercised in case the shares are listed on any stock exchange in India. In case the shares are not listed the fair market value of the same shall be as per the valuation certificate obtained from the merchant banker. The certificate of valuation of shares should not be older than 180 days from the date of exercise of the option. Even if the shares are listed outside India, the company will have to obtain the certificate from the Merchant Banker as such shares are treated as unlisted shares for ESOP purposes.

Connect with an expert lawyer for your legal issue

What are the Tax Implications when the shares acquired under ESOP are disposed of?

Now let us understand the second leg of the taxation of the ESOP shares, i.e. when the employee actually sells the shares. The incidence of sales will attract capital gains tax. The gains can be either long-term or short-term, depending on the period for which the employee has held the shares. The holding period requirement is different for listed shares as well as for unlisted shares. Listed shares shall become long-term if held for more than one year. Unlisted shares become long-term after three years. The period of three years has been proposed to be reduced to two years in the current budget.

The rate at which the short-term or long-term gains shall be taxed will depend on whether the shares have been traded on the platform of the stock exchange on which the Security Transaction Tax has been paid. In case shares are traded through a broker, the long-term capital gains are taxed under Section 112A at 10% over Rs 1 lakh of capital gains. However, such short-term capital gains shall be taxed at a flat rate of 15% under Section 111A.

However, in case the shares are not sold through the platform of the stock exchange, the long-term capital gains shall be calculated after applying the indexation to the original cost of purchase. Indexed gains so calculated shall be taxed at a flat rate of 20% plus applicable surcharge and education cess. You have the option to pay tax @ 10% on capital gains without applying for indexation benefits. Such short-term capital gains are being treated like any other income and added to other income and taxed at the slab rate applicable.

To compute the capital gains the fair market value as on the date of exercise, take into account for perquisites of the options are treated as the cost of acquisition and not the price paid by the employee.

The tax implications would be different in case the ESOPs are allotted to a person who is not an employee either by the holding or subsidiary company or any non-executive director or any other eligible person. The question of it being taxed as a prerequisite does not arise when the option is exercised by such persons. However, the capital gains tax will have to be paid as and when such shares are sold.

Consult: Top Corporate Lawyers in India

Taxation of Foreign ESOPs

In case the ESOPs are granted by foreign companies to the Indian resident, the same would be taxable in India. Moreover, the taxation provisions of the country of the company which grants the option as well as the double taxation avoidance agreement shall have to be looked into for understanding the exact tax implication. Moreover, concessional tax on long-term capital gains under Section 112A or concessional rate of 15% tax on the short-term capital gain in respect of such shares would not be available as these shares would not be sold on Indian stock exchanges as these are not likely to be listed in India.

When should you sell the Shares?

The decision to sell the shares acquired under ESOP is like any other investment decision. You need to take into account the capital gains implication as well as the need for liquidity for arriving at the decision. Moreover, whether and when to sell will also depend on the future prospects of the company. It may also happen that the shares which you have acquired under ESOP are not listed. So, in such a situation you cannot sell the shares until the shares are listed or the promoters offer you an exit, which may not be on very attractive terms. In such a situation, it will make sense for you to wait for a little till the shares are listed on a stock exchange.

Connect with an expert lawyer for your legal issue

Should you accept ESOPs in lieu of Cash as part of your Salary?

An old saying goes, “One bird in the hand is better than two in the bush.” Common sense would demand that one should opt for cash in lieu of ESOPs, but here such a comparison may not be so easy to make because generally, the projected price of shares under the ESOP plan may be significantly higher than the cash component being offered. Moreover, the option to choose cash in lieu of the ESOP may not always be available.

Advocate Chikirsha Mohanty

4.0 | 2+ user ratings

Greater Kailash - 1, Delhi

5 years

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