How is an employee stock option taxed, at grant, exercise and sale?

Is an employee taxed when a stock option is granted?

No. The grant of a stock option, on its own, is not a taxable event for the employee.

A tax liability only arises once the employee actually exercises the option and receives shares.

What happens for tax purposes when the option is exercised?

At exercise, the difference between the fair market value of the share on the date of exercise and the exercise price the employee pays is taxed as a perquisite.

This perquisite is added to the employee's salary income for the relevant financial year.

The employer generally has an obligation to deduct tax at source on this perquisite at the time of exercise, subject to the deferral described below.

How is the fair market value at exercise worked out for an unlisted company?

For an unlisted company, the fair market value at exercise is generally determined under a specific rule tied to a valuation by a merchant banker.

This valuation is separate from, though related to, the Rule 11UA valuation used for a funding round.

The valuation date used is the date of exercise, not the date the option was originally granted.

What happens for tax purposes when the shares are eventually sold?

On sale, the employee is taxed on a capital gain, calculated as the difference between the sale price and the fair market value already taxed as a perquisite at exercise.

Whether the gain is a short-term or long-term capital gain depends on how long the shares were held before sale.

The perquisite value already taxed at exercise becomes the cost of acquisition for this capital gains calculation.

What deferral is available to an eligible startup's employees?

An employee of an eligible startup, meaning one holding the relevant DPIIT recognition and approvals, can generally defer the tax deduction at source that would otherwise apply at exercise.

The deferral shifts the point at which tax is actually withheld and paid, without changing the amount of tax eventually due.

It is aimed at the specific cash flow problem of an employee owing tax on shares in a private company that cannot yet be easily sold.

What triggers bring the deferred tax due?

The deferred tax generally becomes due at the earliest of a fixed number of years from the year of exercise, the sale of the shares, or the employee ceasing to be an employee of the company.

Whichever of these three events happens first ends the deferral period.

The exact number of years used for the first of these triggers is stated in the statutory basis table below.

Does the company have any withholding obligation at exercise?

Where the deferral applies, the company's obligation to withhold tax at source is also deferred, to match the same trigger points as the employee's tax liability.

Where the deferral does not apply, for example because the employer is not an eligible startup, ordinary withholding at exercise continues to apply.

The company should confirm its own eligibility before assuming the deferral applies to its option scheme.

Does the type of instrument, ESOP compared to RSU, change the tax treatment?

A restricted stock unit is generally taxed on broadly similar principles to a stock option once shares actually vest and are transferred to the employee.

The precise mechanics can differ depending on how the specific plan is structured, so plan documents should be reviewed alongside the general position described here.