Income tax
Short answer
ESOPs are taxed twice. At exercise, the difference between the fair market value and the exercise price is a perquisite, taxed as salary and subject to TDS by the employer — even though no cash has changed hands. At sale, the gain over the fair market value at exercise is a capital gain, short-term or long-term depending on the holding period from the exercise date.
Event one: exercise
When an employee exercises options, the difference between the fair market value of the share on the exercise date and the price actually paid is a perquisite under Section 17(2). It is added to salary income, taxed at slab rates, and the employer is required to deduct TDS on it.
The fair market value for this purpose is not a number the company picks. For unlisted shares it must be determined by a Category I Merchant Banker as on a specified date, and that report is what the perquisite calculation rests on.
The cash-flow trap
This is the part employees are rarely warned about. At exercise you owe tax on a paper gain, in cash, on shares you cannot sell — because the company is private and there is no market. The employer deducts the TDS, usually from salary, so a large exercise can wipe out several months of take-home pay.
The practical answers are to exercise in tranches, to time exercise around a secondary or a buyback where liquidity exists, or — for eligible startups — to use the deferral described below. All three need to be planned before exercise, not after.
The DPIIT startup deferral
Employees of eligible DPIIT-recognised startups can defer the perquisite tax under Section 192(1C): the TDS obligation shifts to the earliest of five years from the end of the relevant financial year, the date the employee leaves, or the date the shares are sold. It is a genuine cash-flow relief, but it applies only to a narrow set of companies, and eligibility must be confirmed before relying on it.
Event two: sale
When the shares are eventually sold, the gain over the fair market value already taxed at exercise is a capital gain. The holding period runs from the date of exercise, not the date of grant or vesting — a distinction that decides whether the gain is short-term or long-term, and therefore the rate.
For unlisted shares the long-term threshold is twenty-four months. Selling shortly after exercise, which is common in a secondary, almost always produces a short-term gain.
What the company has to get right
A valid ESOP scheme approved by shareholders, a merchant-banker valuation supporting the perquisite computation at each exercise, correct TDS deduction and reporting, and a cap table that reflects options on a fully-diluted basis. Investors examine all four in diligence, and errors here are among the most common findings.
This article is general information, current at the date shown, and is not advice on your specific facts. Tax and corporate law change, and thresholds and deadlines are amended regularly — check the position before you act on it, or ask us.
Where we help
Valuation Advisory
DCF, Rule 11UA, Registered Valuer and merchant-banker reports — one defensible number across Income Tax, Companies Act and FEMA.
See the practiceMore on Income tax
Which ITR form should I file?
A decision path from ITR-1 to ITR-7 — and the three situations that quietly push you up a form.
What should you do when you get an income tax notice?
How to read the section number, what each common notice actually wants, and the mistake that turns a small notice into a large one.