Taxation of ESOPs for Startups in India

Understanding when, how, and who pays tax on ESOPs under Indian law

Introduction

An Employee Stock Option Plan (ESOP) is one of the most powerful wealth-creation tools for startup teams — but its success depends on how it’s taxed. Many employees expect ESOPs to be “free shares”, only to discover tax liabilities even before liquidity. Likewise, founders and CFOs often misinterpret when and how taxation applies, leading to TDS mismatches and employee disputes.

In India, ESOPs are taxed at two distinct stages — once when employees exercise their options, and again when they sell the shares. Understanding the timing of tax events, valuation requirements, and DPIIT startup exemptions is essential for both compliance and strategic planning.

This article breaks down the ESOP taxation framework under the Income Tax Act, 1961, the Companies Act, 2013, and relevant notifications — with practical insights drawn from real advisory experience.

When Does ESOP Taxation Arise in India?

Under Indian tax law, ESOPs trigger tax at two key points in time:

1. At the time of exercise (as a perquisite):
   When the employee converts vested options into shares by paying the exercise price.
   The difference between Fair Market Value (FMV) on the exercise date and the exercise price is treated as a taxable perquisite under Section 17(2)(vi) of the Income Tax Act, 1961.
2. At the time of sale (as capital gains):
   When the employee later sells those shares (either to investors, during buyback, or post-IPO).
   The difference between sale price and FMV at the time of exercise is taxed as capital gains — short-term or long-term depending on the holding period.

Let’s illustrate this with an example:
If an employee exercises 1,000 options at ₹100 per share when FMV is ₹400, a perquisite of ₹3,00,000 (₹400 – ₹100 × 1,000) arises at exercise. If those shares are later sold for ₹600 per share, a capital gain of ₹2,00,000 (₹600 – ₹400 × 1,000) arises at sale.

How Are Perquisites on ESOPs Calculated and Taxed?

The perquisite value is based on the Fair Market Value (FMV) of shares on the exercise date, determined by:

• A Merchant Banker valuation (for unlisted shares), or
• The market price on the stock exchange (for listed shares).

Employers are required to deduct TDS under Section 192 on the value of this perquisite, treating it as part of salary income. The company must also report it in Form 12BA and Form 16 issued to the employee.

The challenge arises because employees must pay tax on notional value before realizing any liquidity — a pain point that led to special relaxations for startups.

DPIIT Startup Tax Deferral Benefits

Recognising the liquidity issue, the government introduced Section 156 of the Finance Act, 2020, allowing DPIIT-recognised startups to defer perquisite taxation on ESOPs.

Under this benefit, tax on ESOPs is deferred until the earlier of:

1. 48 months from the end of the relevant assessment year,
2. The date of sale of such shares by the employee, or
3. The date the employee ceases to be in employment.

This means employees of registered startups can exercise ESOPs without immediate tax outflow. The employer still deducts TDS — but only when one of the above events occurs.

Expert Insight:
During a DPIIT-recognised startup’s ESOP restructuring we advised on, the founders implemented deferred taxation to help mid-level employees exercise early. By aligning the exercise schedule with their next funding round, the company unlocked retention benefits without burdening staff with upfront tax.

This deferral framework applies only if:

• The company is DPIIT-registered under the Startup India initiative,
• The shares are issued under a duly approved ESOP scheme, and
• The company meets the eligibility conditions under the Income Tax Act, Section 80-IAC.

Capital Gains Tax on Sale of ESOP Shares

Once shares are sold, the difference between sale price and FMV (at the time of exercise) is taxed as capital gains.

• If the shares are held for more than 24 months, the gains are long-term, taxed at 20% with indexation.
• If held for less than 24 months, they are short-term, taxed at slab rates applicable to the individual.

In listed companies, the thresholds differ — 12 months is the cut-off for long-term classification, taxed at 10% (without indexation) under Section 112A.

Expert Insight:
In one Series B fintech case, several employees exercised ESOPs a few months before the company’s secondary sale. The shares were sold within the short-term window, leading to higher tax rates. Post-transaction, we advised the company to introduce an exercise timing advisory policy to help employees plan more tax-efficient exits.

Employer’s Tax and Accounting Obligations

From the employer’s perspective, ESOPs create both tax and accounting implications.

At the time of exercise, the employer must deduct TDS and deposit it within statutory timelines. For DPIIT startups availing the deferral, the TDS is deducted later — at the deferred event date.

For accounting, Ind AS 102 mandates the company to recognise the fair value of ESOPs as an employee cost over the vesting period. This cost is recorded in the Profit and Loss Account and credited to the ESOP Outstanding Accountunder reserves.

Expert Insight:
In a due diligence for a Series C investment, we noticed the target startup had not expensed ESOP cost over vesting years, inflating its EBITDA. Rectifying this under Ind AS 102 reduced short-term profits but strengthened investor confidence and compliance credibility.

Companies should also ensure the FMV used for accounting matches or aligns closely with the FMV certified by a Registered Valuer under the Companies Act, to avoid discrepancies during audits or tax scrutiny.

ESOP Buybacks and Tax Treatment

When ESOP shares are bought back by the company under Section 68 of the Companies Act, the buyback tax of 20% (plus surcharge and cess) under Section 115QA becomes payable by the company.

This tax is final and discharges employee liability — meaning the employee receives the buyback proceeds tax-free.

For example, if a company buys back shares worth ₹1 crore, it pays ₹20 lakh plus surcharge and cess as buyback tax. Employees incur no additional tax on that amount.

However, in a secondary sale (where investors purchase shares directly), capital gains tax continues to apply in the hands of employees.

ESOP Tax Planning for Startups and Employees

Proactive tax planning can significantly enhance ESOP effectiveness.
Startups should:

• Time grant and exercise events to coincide with funding rounds for valuation alignment.
• Communicate tax obligations transparently in grant letters.
• Encourage employees to consult tax advisors before exercising.

Employees, in turn, should plan their exercises considering cash flow and holding period, not just market optimism.

Expert Insight:
A SaaS startup we advised introduced structured exercise windows twice a year. This allowed employees to plan liquidity and taxation in advance, while the company synchronised valuations with its internal audit cycle — a governance move that impressed later-stage investors.

For More Clarity, See Our Related Articles

• ESOP Compliance and Reporting in India — A complete guide on approvals, filings, and disclosures under the Companies Act.
• How to Design an ESOP Scheme that Works for Startups — Learn how to structure eligibility, vesting, and performance linkage effectively.
• ESOP Buyback and Exit Planning under the Companies Act — Understand how startups can manage liquidity and compliance during employee exits.

Together, these articles form the ESOP Lifecycle Series — guiding founders and professionals from design to taxation.

Conclusion

Taxation often determines whether an ESOP feels like a reward or a burden. For founders, understanding the legal and fiscal mechanics ensures compliance and avoids unpleasant surprises. For employees, it turns paper wealth into real, sustainable gain.

As Indian startups mature, tax-efficient ESOPs have become a hallmark of credible governance. Structured planning, transparent communication, and timely filings can transform ESOPs from complex legal instruments into the simplest expression of shared success.

About the Author

Prashant Kumar is a Company Secretary, Published Author, and Partner at Pratham Legal, a full-service Indian law firm advising on corporate, regulatory, and transactional matters.

He is a subject matter expert on ESOP structuring, compliance, and taxation, having advised numerous high-growth startups and investor-backed companies on ESOP design, valuation, and exit planning. Over the years, he has led several high-value ESOP transactions and advised on complex taxation issues under the Income Tax Act, 1961 and Companies Act, 2013.

Prashant helps founders and boards translate employee ownership into compliant, tax-efficient, and governance-aligned frameworks.
He can be reached for discussions on ESOP strategy, buybacks, and taxation advisory at:
📞 +91-9821008011
📧 prashant@prathamlegal.com