Employee Stock Option Plan (ESOP) is a form of compensation provided to employees in the form of stock options. It gives employees the right to purchase a certain number of shares of the company’s stock at a fixed price (also known as the “exercise or strike price”) within a specified period of time. The purpose of an ESOP is to align the interests of employees with those of the company’s shareholders and incentivize employees to work towards the company’s long-term success.
Exercising an ESOP involves taking advantage of the option to purchase the company’s stock at the strike price. To exercise the option, the employee must pay the strike price for each share of stock they wish to purchase. If the current market price of the stock is higher than the strike price, the employee will have a profit equal to the difference between the market price and the strike price.
When an employee decides to exercise their ESOP, there are a few steps they need to follow:
- Evaluate their financial situation: Before exercising the option, the employee should assess their current financial situation and determine if they can afford to pay the strike price for the shares they wish to purchase.
- Choose the right time to exercise: Employees need to consider the market price of the stock and the expiration date of the option when deciding when to exercise the option. If the market price is higher than the strike price, it may make sense to exercise the option and purchase the stock.
- Notify the company: The employee must notify the company of their intention to exercise the option and provide the necessary documentation, such as a stock option agreement and proof of payment for the strike price.
- Pay the strike/exercise price: The employee must pay the strike price for each share they wish to purchase. This payment can be made in cash or through a brokerage account.
- Wait for the stock to vest: In some cases, the employee may need to wait for the stock to vest, which means they cannot sell the stock until a certain period of time has passed. This is a common feature of ESOPs that are designed to incentivize employees to stay with the company for a certain period of time.
Why it is important to check tax implications on ESOP if the employee is a resident of one country at the time grant of the option and a resident of another country at the time of the exercise of the option.
It is important to check the tax implications on ESOP because the taxation of ESOP benefits can vary depending on the jurisdiction in which the related employment is exercised. If a person is a resident of one country at the time of the grant of options and a resident of another country at the time of exercise of options, the tax implications on the ESOP benefit may differ. The taxation of ESOP benefits may also be governed by a tax treaty between the two countries, which can affect the taxation of the benefits. As a result, it is important to check the tax implications on ESOP benefits to ensure compliance with tax laws and to minimize tax liabilities.
Once the stock is vested, the employee can sell the stock on the open market or hold onto it as a long-term investment. If the stock’s market price has increased since the employee exercised the option, they will realize a profit equal to the difference between the market price and the strike price.
In conclusion, an ESOP is a powerful tool for companies to incentivize and retain employees. It aligns the interests of employees with those of the company’s shareholders and provides employees with a stake in the company’s success. When exercised properly, an ESOP can be a valuable source of income for employees and a powerful way for companies to reward and retain their top talent.
Important related income tax Judgement on ESOP linked to India and UAE DTAA
Facts of the Case and Submission of Taxpayer
The individual is an employee of HDFC Bank Limited in Mumbai and is currently on deputation in the HDFC Bank Representative Office in Dubai. He has been working in Dubai since October 1st, 2007 and is considered a non-resident for the current assessment year. In June 2007, he exercised options for 18,500 shares granted to him by HDFC Bank Limited which vested 50% on June 27th, 2008 and 50% on June 27th, 2009. The perquisite value of the options, being the difference in the market value and grant price of the shares, amounted to Rs 72,77,320. HDFC Bank Limited deducted tax at source of Rs 22,48,685 on the perquisite value. However, while filing the income tax return, the assessee claimed a relief of Rs 20,44,855 under section 90 and sought a refund of Rs 21,46,410.
The assessee argued that the ESOP perquisite was not taxable in India as per section 5(2) of the Act, which states that only income that “accrues or arises, or is deemed to accrue or arise, in India”, or “is received or is deemed to be received in India” is taxable for non-resident assessees. The assessee claimed that the ESOP benefits were received for services rendered in the U.A.E. and therefore, did not accrue or arise in India. The assessee also referred to section 9(1)(ii) and a number of judicial precedents in support of their argument.
The assessee also made a submission based on the India-UAE Double Taxation Avoidance Agreement (1993) 205 ITR (Statutes) 49; referred to as the India-UAE tax treaty. Their argument was detailed in the assessment order at pages 5 and 6 as follows:
At the outset, reliance is placed on Article 15 of DTAA between India and UAE on Dependent personal services which provides for taxation of salaries, wages and other similar remunerations. The ESOP benefits earned by the assessee during the captioned AY shall be covered under the scope of expression “other similar remuneration” which has been duly accepted by the OECD in its 2014 edition of commentary on Model Tax Convention and 2011 edition of UN Model Double Taxation Convention. India in its comments to the aforesaid commentary on the subject has not raised any reservations and/or objections to the ESOP benefits being covered under the expression ‘other similar remuneration’, thereby impliedly accepting the said scope of expression; (Copy of the said DTAA is attached as attachment 4)
The relevant extracts of Article 15 of DTAA are reproduced below for your record ready reference:
“Article 15(1).’………. salaries, wages land other similar remuneration (ESOP benefits) derived by a resident of a Contracting State (UAE) in respect of an employment shall be taxable only in that State (UAE), unless the employment is exercised in the other-contracting State (India). If the employment is so exercised, such remuneration as is derived there from may be taxed in .that other State (India)”
The expression ‘exercised’ has been Interpreted by OECD in its 2014 edition of Commentary on Model Tax Convention and 2011 edition of UN Model Double Taxation Convention, to mean a place where the employee physically rendered its services. India in Its comments to the aforesaid commentary on the subject has not raised any reservations and/or objections, thereby impliedly accepting the said scope of expression;
Therefore, as per Article 15(1) of India-UAE DTAA, the income from ESOP benefits shall be taxable only in UAE and the said income cannot be taxed in India;
Further, yourself would agree and appreciate that India is a signatory to the UN Model Double Taxation Convention and observer to the OECD Model Tax Convention. Further, India has provided its comments to both the commentaries of the respective Model Tax Conventions. The treatment of employee stock options has been explained in Para 12.1 to Para 12.15 to the 2014 Edition of Commentary on OECD Model Tax Convention and the UN has accepted the said treatment of employee stock-options. Further, India in Its comments to the aforesaid paras in the commentary on the subject, has not raised any reservations and/or objections, thereby impliedly accepting the tax treatment of employee stock options, provided therein. As, India has accepted the said position and In light of principle of contemporaneous exposition, it is binding on the Income-tax department to accept the treatment of employment stock-options;
The aforesaid proposition have also been accepted by the following Hon’ble High Court as well as Hon,ble Tax Tribunals upholding that income cannot be taxed in India if the employment services over the period from years of grant to years of vesting/exercise are rendered outside India.
- CIT vs Robert Arthur Keltz [ITA No. 57/2014 dated 23 July 2014] [Delhi];
- CIT vs Robert Arthur Keltz [59 SOT 2037 [ITAT- Delhi];
- Anil Bhansali vs ITO [53 taxmann.com 367] [ITAT- Hyderabad], etc
ITAT Observations and Decision
These observations, which we respectfully agree with, effectively emphasize the relevant legal stance regarding the accrual and arising of income. It is clear that the accrual or arising of income cannot be equated with the receipt of income. Both expressions – accrual or arising of income – represent a state prior to the time the income becomes receivable and convey an inchoate character of income. In the present case, regarding the ESOP benefit, while the income arose to the assessee in the current year, the related rights were granted in 2007 in return for services rendered by the assessee prior to the grant of rights, which were performed in India. Although the character of the income was inchoate at that stage, what is now being sought to be taxed under section 17(2)(vi) is a result of services rendered much earlier and the benefit, which is now a taxable income, accrued to the assessee in 2007. Section 17(2)(vi) only determines the timing of the income, but it does not change the fact that the benefit, which is now being sought to be taxed, had arisen earlier, i.e. at the time the ESOP rights were granted. On these facts, in our view, the income, even if it was inchoate at the time the options were granted, has accrued and arisen in India. The assessee is a non-resident in the current assessment year, but the benefit, for which the income is now being sought to be taxed, had arisen earlier in India. Therefore, the income in respect of the ESOP grant benefit accrued and arose at the time the ESOP rights were granted, even though the taxability of the same under section 17(2)(vi) has arisen in the current year. Additionally, the use of ESOP benefits as part of a compensation package to employees is a global practice and multilateral organizations such as the United Nations and OECD have extensively examined these aspects, albeit in the context of tax treaty law which we will discuss shortly.
It appears that the provisions of Article 15 allow for the taxation of Employee Stock Option Plan (ESOP) benefits, which are considered “other similar remuneration” and fall within the scope of the expression immediately following “salaries and wages”. If an individual receives ESOP benefits in the United Arab Emirates (U.A.E.) and exercises these options after returning to India, they will still have treaty protection for that income under Article 15(1). However, if they receive ESOP benefits while employed in India, they cannot benefit from Article 15. This is because Article 15(1) states that “salaries, wages and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State.” In this case, the employment was exercised in India, so the ESOP benefits cannot be protected by the treaty. This principle holds true for both salaries and wages as well as other benefits like ESOPs. The decisions in the cases of ACIT vs Robert Arthur Kultz and Anil Bhansali vs ITO, cited by the learned counsel, do not support the assessee’s argument and were found to be irrelevant to the present case. The assessee’s claim for treaty protection is therefore without legal merit and is rejected.
Unnikrishnan Vs Income Tax Officer, International Taxation 4(3)(1), ITAT Mumbai
Deputation refers to the act of sending or assigning an individual to represent a group or organization in a temporary assignment or posting, typically to another location or department. The individual is sent on deputation to perform specific duties, responsibilities or to gain experience. In the context of employment, deputation often refers to the temporary assignment of an employee from one organization to another, or from one department to another within the same organization, for a specific period of time.