Everything you need to know about taxation of ESOPs

multi asset portfolio image | Right Horizon

Employee Stock Ownership Plans(ESOPs) and Restricted Stock Units (RSUs) have been a great wealth creator for many employees who benefited from them.  It’s hardly surprising why it’s a hype – startup, or otherwise. However, it is important to understand the taxation, lest a good part of the gain is paid out in taxes.  Today, the pay cuts are all the more reason for you to squeeze out the best from your ESOPs. In this article, we’ll glaze over a few key terms and discuss the basics of ESOP taxation.

ESOPs terms-to-know:

  • The date your employer issues you ESOPs is the grant date.
  • The date you’re entitled to buy the shares is the vesting date.
  • And the time between the grant date and the vesting date is the vesting period.
  • After you’ve vested, the date you exercise the option is the exercise date
  • The exercise price is the amount at which you exercise the option, which is usually lower than the FMV (Fair Market Value is the price at which the share is traded for a listed company).

Simple enough. No doubt, you may choose to not exercise the option immediately. In which case no tax is payable till you exercise the option. 

There are two stages of taxation of ESOPs.  Let us see how they work:

  • On Exercise: the difference between the exercise price and the fair market value is added to income and taxed as a prerequisite.
  • On sale: The difference between fair market value and sale price is taxed as capital gains. Capital gains are taxed as follows: 
    • For Indian listed company shares: If held for a period of 12 months or less after exercise, this is treated as short-term capital gains, and taxed at 15%. After 12 months, the gains are called long term capital gains, and gains over one lakh are taxed at 10%. 
    • For unlisted company shares, ESOPs held for over 24 months are treated as long-term capital gains which are taxed at 20% with indexation; otherwise short-term capital gains are added to income.

Furthermore, if you own shares across borders, the taxation is the same as unlisted company shares.

This time of the year may also be a good time for you to think of these options within your company of employment. Since markets have done well in recent months, you may want to convert your paper profit into real profit!

Investing beyond India

Investing in Indian stocks and assets | Right Horizons

If you are investing in Indian stocks and assets, you might as well expand internationally. For three reasons: the prudence of forex diversification, participation in the growth story of markets, and a more lucrative outlook for your portfolio. Let’s see why it’s important in more detail.

Reasons why you should invest across borders:

  1. Currency diversification

A truly balanced portfolio of Indian and international stocks over the long-term has proven better risk-adjusted returns with lower volatility. Currency diversification can be influenced by your lifestyle and financial goals. Here’s how you do it. Understand the currencies that you’re exposed to and the ones that align with your habits and goals. Eg. You may be traveling frequently or looking to plan for your child’s overseas education.  You may look to diversify based on factors like outlook of various assets like equity, real-estate, bonds, commodities, etc; outlook of currencies, and how complementary it is with your current portfolio. Then decide what makes sense for you.

  1. The benefits of stocks in Global Markets

You can have access to global MNCs in sectors that are not represented in Indian exchanges.  Eg. The US stock market is home to some of the most desirable stocks in the world like Facebook, Google, Apple, etc; which opens up a more diversified investment avenue. One has the option of participating in global innovation and other themes from time to time.

  1. More options

Going beyond the US, you’ll find that different currencies and stocks perform differently at different times. Acquaint yourself with the indices, trends, and dynamics. Developed and emerging markets respond differently to economic turns. While many markets took a plunge, some recovered faster than others. For example, Libyan oil market was looking hopeful (subject to political volatility) and the Australian stock market saw a boom before the Wall Street sugar high in November.

Furthermore, it strengthens your portfolio, offers a wider horizon, helps manage risk better and can potentially enhance returns.

The pitfalls

It’s only fair if we discussed the downsides as well. Investing is tricky. Investing in multiple markets internationally gets trickier and more complex. Moreover, something that’s in hype currently may lose its momentum, and even deliver negative returns in the future. Before you head out there, ask yourself the following questions.

  • Does this align with my personal goals?
  • Which markets suit my lifestyle?
  • Can my wealth manager or myself track this investment decision with due diligence?
  • Am I aware of nuances like currency dynamics, trends, geopolitical correlations, etc?

Making the most of your global portfolio.

If you’re still contemplating your options, here’s a mental model to help you decide which assets and stocks will pay off for you. It’s called Warren Buffett’s “20-Slot” Rule.

In a lecture at a B-School he said,

“I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all.”

It’s quite evident that the winners usually are very selective. Selective focus helps you trim away good options and make room for great decisions. And, you can always consult a professional who has experience in global markets and whom you can trust when in doubt.