Understanding Goods and Services Tax on Employee Stock Option Plans in India

Recent discussions have led to questions regarding the applicability of Goods and Services Tax (GST) on Employee Stock Option Plans (ESOPs). Many wonder if GST is imposed on ESOPs, and if so, how it applies and what the full scope of its implications might be. The Central Board of Indirect Taxation (CBIC) has issued an official circular to clarify its stance on this matter. This article explores the existing ambiguities and details CBIC's latest position.

What are Employee Stock Option Plans (ESOPs)?

Fast-growing companies and startups frequently use innovative HR compensation methods to attract and retain talented employees for extended periods. Popular examples include ESOPs, ESPPs (Employee Stock Purchase Plans), and Restricted Stock Units (RSUs).

• ESOP - Employee Stock Option
• ESPP - Employee Stock Purchase Plan
• RSU - Restricted Stock Units

These compensation methods share a common goal: to entice skilled employees with the promise of company shares, often at a reduced price or even free of charge. Such offers are contingent upon meeting specific predefined terms and conditions.

One crucial condition is the Vesting Period, which specifies the minimum duration an employee must remain employed before they can exercise their ESOP. Exercising an ESOP means the employee purchases the allocated shares from the company at the predetermined price. Once acquired and in compliance with all terms, an employee can either hold these shares or sell them at market value to realize financial gains.

Example:

Consider Mr. X, who joined Company ABC on January 1, 2019. Upon joining, he was offered an ESOP to receive 100 shares of ABC at a discounted price of Rs.100 per share, with a vesting period of 5 years.

The vesting period concluded on January 1, 2024, with Mr. X still employed by ABC. He decided to exercise his option, purchasing 100 shares of ABC at Rs.100 per share as per the ESOP. On February 1, 2024, Mr. X observed ABC's shares trading at Rs.200 per share on the stock exchange. He then sold the shares he acquired through his ESOP.

His total realized gain from the ESOP was calculated as {(Rs.200 - Rs.100) * 100 shares}, amounting to Rs.10,000. If Mr. X had waited and sold his shares today, assuming ABC trades at Rs.300 per share, his ESOP gain would have been [(Rs.300 - Rs.100) * 100 shares], or Rs.20,000.

It is important to note that Mr. X would have paid Securities Transaction Tax (STT) when selling his shares on the exchange, slightly reducing his actual net gain.

Benefits of ESOPs and Similar Compensation Strategies

• These plans help startups and growing companies avoid immediate cash outflows for employee compensation while enhancing employee retention.
• ESOPs become more attractive as a company's valuation or share price rises, motivating employees to contribute their best performance towards achieving the company's long-term objectives.
• Such compensation tools also offer employees the potential for significant financial upside.
• The vesting period inherent in ESOPs contributes to retaining talent within a developing company.
• ESOPs can also provide tax benefits to employees.

The Process of ESOP Issuance

For domestic companies issuing ESOPs to their Indian employees, the process is straightforward:

• The eligible employee completes the vesting period.
• The employee informs the company of their intent to exercise the ESOP and completes the required payments.
• The company then transfers the shares to the employee's demat account.

However, the procedure for ESOP issuance differs for Indian subsidiaries of foreign multinational corporations. In such cases, the ESOPs allow employees of the subsidiary to receive shares of the foreign holding company.

• The eligible employee notifies the subsidiary to exercise their ESOP.
• The subsidiary then requests the holding company to transfer the shares directly to the employee.
• Alternatively, the holding company can transfer the shares to the subsidiary, which then passes them to the employee.
• In either scenario, the subsidiary reimburses the foreign holding company for the cost of the shares.

GST Implications for ESOPs

By nature, Employee Stock Options are components of the employer-employee relationship. They represent a flexible element of the employee compensation package, determined by factors such as:

• The employee's designation.
• The vesting period stipulated by the ESOP program.
• The company's long-term business performance.

Consequently, the Income Tax Act in India considers ESOPs as a perquisite. Previously, companies would record the Fair Market Valuation (FMV) of the ESOP as income from salary in the employee's Form 16 upon exercise. As of FY 2020-21, the Income Tax Authority began treating ESOP earnings as capital gains for qualifying startups and technology firms. Depending on when the ESOP is exercised and when the employee sells the shares, these capital gains can be classified as either short-term or long-term.

Is Goods and Services Tax Applicable to ESOPs?

Goods and Services Tax (GST) applies to the sale of goods and services within India. However, the GST Act does not categorize employer-employee relationships as taxable service transactions. This is why GST is not levied on salary payments. Since ESOPs are a variable part of employee remuneration, GST generally does not apply to them.

• Therefore, a domestic company allocating shares to its eligible employees under an ESOP program is not required to pay GST.
• According to a circular issued on June 26, 2024, GST is also not applicable if an Indian subsidiary of a foreign holding company allocates shares of the holding company to the subsidiary's employees through an ESOP program.
• When the Indian subsidiary reimburses its foreign holding company for the cost of shares transferred at Fair Market Value (FMV), such transactions are not considered the sale of goods and services. Hence, GST is not applicable to these payments.

Despite this general non-applicability, there are specific scenarios where GST implications for ESOPs can arise.

Specific Scenarios for GST Applicability on ESOPs

GST implications for ESOPs are only triggered under the following conditions:

1. If the reimbursement of share costs to the holding company includes any additional fee, commission, or markup beyond the fair market valuation of the allotted shares, GST is applicable solely to this additional amount exceeding the FMV.
2. If the holding company charges a fee to process the transfer of shares to the subsidiary for ESOP allotment, GST applies to these specific processing fees.