ESOP tax in India: Why the bill starts at exercise and smart ways to cut it

COURTKUTCHEHRY SPECIAL ON ESPOS LAW FOR STARTUPS EMPLOYEES

ESOP tax in India: Why the bill starts at exercise and smart ways to cut it

How perquisite and capital gains are taxed, with special rules for startups and buybacks

Conflicting High Court views on ESOP compensation and practical planning that works

By Our Legal Reporter

New Delhi: December 17, 2025:

The big picture: ESOPs are powerful—but tax begins at exercise

Employee stock options (ESOPs) can be life‑changing, especially in startups and tech firms. But the tax meter starts ticking the day you exercise, not the day you sell. In India, ESOP tax typically occurs in two stages: first, as a perquisite under “salary” at exercise (based on fair market value minus your strike price), and later as capital gains upon sale (short‑term or long‑term depending on holding period). That structure makes timing, valuation, and cash planning critical for employees who may owe tax without having sold a single share.

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Several reports recently flagged a common trap: windfalls look great on paper, but employees underestimate the immediate tax at exercise and the second bite at sale. Legal and tax advisories echo this caution, urging employees to align exercise decisions with liquidity events and to document valuations meticulously to withstand scrutiny during assessments.

How ESOPs are taxed: the two-step regime you must plan for

• Perquisite at exercise: The difference between the fair market value (FMV) on exercise date and the grant/strike price is taxed as salary income. Employers must withhold TDS. In unlisted companies, a merchant banker valuation is needed; listed shares use exchange price norms. This is where most employees first face a large tax bill.
• Capital gains at sale: When you sell, gains are computed from the FMV used at exercise (your “cost” post-exercise). If listed equity is held for at least 12 months, gains are long‑term; for unlisted, the period is 24 months. Indexation and special rates apply based on asset type and holding periods.
• Startups: limited deferral: Recognized startups may allow deferral of TDS on ESOP perquisites until the earliest of 5 years from exercise, sale of shares, or cessation of employment. It’s not a tax exemption—only a timing relief. Employees should still budget for eventual payment.

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This framework also applies to RSUs and SARs with specific nuances, but the salary‑plus‑capital gains concept generally holds across equity compensation forms.

Legal framework and documents you should have at hand

ESOPs are governed by the Companies Act and related rules, requiring a clear scheme, board/shareholder approvals, vesting schedules, and registers. From a tax perspective, keep the grant letter, vesting computations, exercise notice, FMV certificate, and broker contract notes. Strong documentation is your best defence if the tax office questions valuation, timing, or character of income.

In restructurings or corporate events, employees may receive cash compensation or modified options; tax treatment turns on whether the payment is substitution for salary or a capital receipt. Where values shift sharply (e.g., post‑restructuring), courts look at substance over form, increasing the need for thorough paper trails.

Courts on ESOP compensation: divergent views you must know

A notable recent theme in High Court litigation is the inconsistent treatment of ESOP‑related cash compensation. In some cases, courts viewed certain payouts as capital receipts not taxable as salary; in others, similar payments were treated squarely as taxable perquisites. Three High Courts have taken divergent positions, creating uncertainty for employees and employers. The lesson is simple: the exact facts—plan terms, timing, and whether compensation replaces or relates to employment income—drive outcomes.

Tax analyses of high‑profile restructurings (e.g., Flipkart–PhonePe) underline this grey zone. When employers voluntarily compensate employees for lost ESOP value due to corporate changes, classification can be contested, with arguments ranging from ex gratia salary to damages or capital receipts. In practice, clarity in scheme language and board resolutions is crucial to support the intended tax treatment.

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Planning to reduce tax: practical strategies that hold up

• Time exercise to liquidity: If you expect a secondary sale or buyback, exercising close to the event reduces cash‑flow mismatch and perquisite risk without exit. Avoid exercising far ahead of a liquidity window.
• Use tranche‑based exercise: Exercise only vested options you intend to sell soon. Tranching helps manage perquisite spikes and capital gains timing.
• Validate FMV: For unlisted shares, get a robust merchant banker valuation and keep full working papers. A defensible FMV can reduce disputes on perquisite quantification.
• Consider startup deferral: If your employer is an eligible startup, explore TDS deferral mechanics. Budget for eventual tax; deferral is not forgiveness.
• Switch regimes wisely: Compare old vs new tax regime impacts. ESOP perquisite is salary income either way, but deductions and slab effects differ. Model the total tax before choosing a regime.
• Hold for long‑term gains (where feasible): For listed equity, a 12‑month hold can lower tax via long‑term rates and thresholds. For unlisted, 24 months applies—balance market risk with tax benefit.
• Harvest losses thoughtfully: If you hold other securities with losses, time sales to offset short‑term gains from ESOP shares where the law allows.
• Document everything: Board approvals, scheme terms, grant/exercise dates, FMV certificate, and sale contract notes—these close audit gaps and support favourable characterisation.

These steps won’t eliminate tax entirely, but they can materially reduce or defer it and improve audit resilience.

Special cases: buybacks, cashless exercise, and cross-border issues

• Buybacks and secondary sales: Company‑facilitated exits often set price, timing, and documentation. Ensure perquisite and capital gains computations use the correct FMVs and sale prices; cashless exercise can simplify funding for TDS.
• Foreign parent ESOPs: If options relate to overseas stock, think about double tax agreements, foreign tax credits, and timing differences. Salary perquisite remains taxable in India if services were rendered here; capital gains may interact with treaty provisions depending on residency.
• Change in control events: If ESOPs are canceled or modified, assess whether any cash is salary or capital receipt. Courts assess the real nature of payment—language in plan amendments matters.

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Compliance checklist to avoid painful notices

• Pre‑exercise: Confirm vesting, get FMV certificate, plan TDS cash, and line up liquidity.
• On exercise: Record the perquisite, pay/withhold TDS, and capture all documents.
• On sale: Keep broker notes, compute capital gains from exercise‑date FMV, decide regime, and assess set‑offs.
• Year‑end filing: Attach computation notes explaining valuations and timing; this preempts queries.
• If selected for scrutiny: Share plan documents, valuation reports, and working papers; align HR, payroll, and finance records.

A complete file is the difference between smooth processing and prolonged litigation.

Direct answers

• When does tax start? At exercise, via perquisite on FMV minus strike; later at sale, capital gains apply.
• Any court guidance? Yes—High Courts have issued conflicting rulings on ESOP compensation characterization, making facts and documentation decisive.
• How to minimize tax? Time exercise to liquidity, tranche exercises, secure defensible FMVs, use startup deferral if eligible, pursue long‑term capital gains where feasible, and keep rigorous documentation.
• What about restructurings and voluntary payouts? Classification can be contested; clear scheme language and resolutions help support the intended tax treatment.

Also Read: Gujarat High Court: Long Possession Cannot Create Ownership Rights

Keywords for faster searches (Google + ChatGPT)

• Core topic: ESOP taxation India perquisite at exercise; ESOP capital gains sale; RSU SAR tax India
• Court angle: ESOP compensation court rulings India; High Court divergent ESOP judgments; Flipkart PhonePe ESOP tax analysis
• Planning: ESOP startup TDS deferral; merchant banker FMV ESOP; cashless exercise ESOP India; long‑term capital gains ESOP holding
• Compliance: ESOP documentation checklist; ESOP valuation India rules; ESOP tax return notes; ESOP buyback taxation

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