ESOPs create wealth but can be tricky

To avoid getting taxed twice, hold on to the stocks for at least a year from the date you receive these

Many stories appear in the media about those whose employee stock ownership plans (ESOPs) made them millionaires when their companies got listed. A recent one is that of RBL Bank. The bank had issued ESOPs at exercise prices ranging between Rs 52 and Rs 120. A large number of ESOPs were exercised at an average price of Rs 59.40 a share. When the stock listed at Rs 274 apiece, the employees enjoyed a windfall.

In India, Infosys popularised ESOPs in the 1990s. The company’s various schemes have created hundreds of dollar millionaires and thousands of rupee millionaires. While these stories paint a rosy picture, and are even inspirational, all of them don’t end equally well.

How ESOPs work
ESOPs are a motivational tool, given to employees to impart a sense of ownership. There are four stages in an ESOP scheme. The first is its grant. At this point, the company communicates to its employees that they are being given options that can be converted into shares at a predetermined price, at a future date. This price is normally a discounted one compared to the market value of the share, which enables employees to make gains.

Next, there is a vesting period for which employees must wait before exercising their options. Usually, companies follow a graded schedule. For instance, a company could have a five-year vesting period, with 20 per cent of options vesting each year. This means employees can convert 20 per cent of their shares after the first year, another 20 per cent after the second, and so on. A vesting period is kept to enable companies to retain employees.

Next comes the event of exercise, when employees convert their options into shares by paying the exercise price. The company then allots the shares. The last stage is when employees sell their shares. While companies are free to decide the vesting period, regulations require that both listed and unlisted firms have a gap of at least one year between the date of grant and vesting.

Watch for pitfalls  
The road to ESOP riches can sometimes be a potholed one and employees need to be watchful. Shares of unlisted companies do not trade on the stock exchanges. So, ensure there is a proper exit mechanism.

Evaluate the exercise price. “If the difference between the market value of the shares on the date of exercise and the exercise price is not high, the ESOP might not be very lucrative,” says Shalini Jain, partner-people advisory services, EY. A long vesting period, too, can make ESOPs unattractive.  Employees also need to know what happens to their vested options if they leave the company. “Vested options are the ones that the employee has already earned. He needs to check if there are provisions to protect his interests in such a situation,” says Jain.

Taxed twice  
While employees stand to make significant gains from ESOPs, they should remember these are taxed at two stages. The first is when the shares are allotted at the time of exercise. At that time, this income is taxed as compensation income. The taxable value is the fair market value (FMV) of the share on the day it is exercised, reduced by the exercise price. The FMV in the case of a listed company is the quoted stock price. An unlisted company is required to get a valuation report from a category-one merchant banker registered with Sebi. Whatever value the merchant banker certifies becomes the FMV.

Employees are taxed again when they sell the shares. Here, the taxable value is the sale price less the FMV on the date of exercise. This gain is taxable as capital gain.

In the case of listed companies, if security transaction tax has been paid and the shares held for more than one year, the long-term capital gain is exempt from taxation. Short-term capital gain is taxed at 15 per cent.

In case of an unlisted company, short-term capital gain applies if the shares are held for up to 24 months from the date of allotment. These gains are taxable at the rate applicable to the individual. Long-term capital gains apply if the shares are held for more than 24 months. These are taxable at 20 per cent, plus surcharge and cess.

Many employees sell the shares immediately upon receiving these to enjoy the gains. Says Suraj Nangia, partner, Nangia & Co: “Employees tend to forget the potential tax liability arising out of the capital gains and end up facing an unforeseen tax burden at a later stage.” To optimise the returns, he advises employees to hold the shares for some time, so that a zero or lower tax rate applies.

ESOPs AT START-UPs ARE RISKIER

• Failure rates in start-ups are high. Unless the company succeeds, the ESOP might prove worthless
   
• Getting shares through ESOPs takes time, as you have to cross the cliff and the vesting period
  

 

The vesting period could be three, four or five years
 

The period before the end of the first year is called the cliff. Leave within this period and you get nothing
 

If vesting doesn’t happen equally each year but increases gradually, the scale is tilted against employees who leave early