After Flipkart’s acquisition by Walmart, many Flipkart employees may sell their vested Employee Stock Options (ESOPs). Walmart has also set aside $500 million (Rs3,363.88 crore) for buyback of shares and ESOPs from the existing and former employees of Flipkart.
However, Flipkart employees have the option to liquidate their vested ESOP in three instalments. But, whenever they exercise their ESOP, they may have to pay tax on the gains they will make from it. Read more about how and when ESOPs are taxed and why it matters whether Flipkart buys the vested options or Walmart does.
What is an ESOP?
In simple words, ESOPs are a company’s shares offered to employees at a discounted price. “ESOPs provide a right or option to an employee, to buy shares at a future date at a pre-determined price,” said Parizad Sirwalla, partner and head-global mobility services-tax, KPMG in India. ESOPs are considered perquisites that an employee gets either as performance bonus or as a part of pay package.
“The primary objectives (of offering ESOPs) are reward and retention, to attract and retain quality talent,” said Ishita Sengupta, partner, personal tax, PwC India.
Once ESOPs are allotted, “employees have to fulfil the vesting criteria (which can be a combination of time and performance). After that, the employee earns the right to convert the options into shares,” said Sengupta.
At the time of exercising their ESOP (converting ESOP into shares) the employee has to pay the allotment price or the amount gets adjusted from the salary. “There may also be a lock-in period during which the employee cannot sell these shares,” said Sirwalla.
Taxation of ESOPs
ESOPs are taxed at two stages. First, at the time they are vested and then at the time when vested ESOPs (shares) are traded or sold by the employee. At the time of vesting, the difference between the price at which ESOPs had been allotted and the fair market value (FMV) of the ESOP on the day of vesting, gets added to employee’s income for the year.
Calculating FMV differs based on whether the company is listed or unlisted. In case of a listed company, “where the shares are listed only on one Recognized Stock Exchange (RSE) in India, FMV shall be average of the opening and closing price of the share on the date of the exercising of the option. Where the shares are listed on more than one RSE in India, the RSE that records the highest trading volume has to be considered to calculate FMV. If share is not traded on exercise date, the FMV shall be closing price on a date closest to the exercise date immediately preceding the exercise date,” said Sirwalla.
However, in case of unlisted companies, “FMV shall be the value determined by a Category 1 Merchant Banker on exercise date or any other date not more than 180 days prior to the exercise date,” explained Sirwalla.
The second instance at which ESOPs are taxed is when the employee transfers or sells the shares. If the transfer results in gains, taxation will depend on whether it is short-term capital gains (STCG) or long-terms capital gains (LTCG). “The holding period to qualify as short term for listed shares is up to 12 months, while for unlisted shares in India it is up to 24 months,” said Sirwalla. “STCG for listed shares is 15.6% (plus applicable surcharge) while in case of unlisted shares it is taxed at the slab rate applicable to the individual,” added Sirwalla.
As amended in the Finance Bill 2018, LTCG tax for listed shares is 10.4% (plus applicable surcharge) on gains above Rs1 lakh per year. Prior to 1 April 2018, LTCG tax on listed shares was “nil.” However, LTCG on unlisted shares is 20.8% with indexation. To calculate the tax, one will have to calculate indexed cost of acquisition of such shares. Besides that, as amended in the Finance Bill 2018, in case of listed shares, if the shares were vested before 31 January 2018, one can also take advantage of grandfathering provisions. This will nullify the gains made prior to 31 January 2018. However, as per a draft notification by Central Board of Direct Taxes, dated 24 April 2018, grandfathering benefit may be available for certain genuine transactions (which also include ESOPs) even if Securities Transaction Tax (STT) is not paid at the time of purchase, but STT is paid at the time of selling shares. The final notification is awaited in this regard.
However, in case of Flipkart, based on the emails sent to employees, Flipkart has offered liquidation of vested ESOPs in three instalments—50% on the date of closing of the ongoing transaction with Walmart, and 25% each after one and two years from first liquidation. In such a situation, if we consider that Flipkart is buying back vested ESOPs from employees, then the tax liability lies with the company, i.e. with Flipkart, according to section 10(34A) of the Income Tax Act, 1961, and not the employees.
However, if Walmart is buying the ESOPs from Flipkart employees, it will be considered as transferring shares to a third party and in such a case, the tax liability lies with the employees.
So, before you decide to vest your ESOP or transfer your shares, don’t forget to factor in your tax liability.