ESOP Taxation in India: Complete Guide for Employees and Startups

ESOP basics: What you need to understand before taxes

An Employee Stock Option Plan (ESOP) gives employees the right to purchase company shares in the future at a fixed exercise price.

Until exercised, ESOPs remain options, not equity, and do not carry shareholder rights such as voting or dividends.ESOPs convert into actual shares only when the employee exercises vested options.

How does an employee stock option work?

Employee stock options follow a simple lifecycle. 

It begins with the grant date, when the company awards options to an employee; no tax is due at this stage. 

The options then vest over time according to a vesting schedule, and vesting itself does not create any tax liability.

Once the options have vested, the employee can exercise them by paying the exercise price to receive shares. This is the first taxable event, since the shares are typically acquired at a discount to their Fair Market Value (FMV) on the exercise date. 

Later, when the employee sells the shares, the sale triggers the second taxable event, and any gain relative to the FMV at exercise is treated as capital gains.

ESOP taxation stages: Why are ESOPs taxed twice

ESOPs are taxed at two separate stages: first when the employee exercises the options, and later when the shares are sold. This happens because each stage represents a distinct economic benefit. 

Stage 1: ESOP tax on exercise

When you exercise ESOPs, you buy shares at a price lower than their FMV. The difference between the FMV and the exercise price is treated as a taxable perquisite and added to your salary income.

Perquisite value = (FMV on exercise date − exercise price) × number of shares exercised

How TDS on ESOP works

Because ESOP perquisite is added to your salary, your employer must deduct TDS at your income-tax slab rate. This TDS is not an additional tax. It is simply an early payment toward the tax you already owe on the perquisite.

If your TDS covers the full tax liability, there is no extra tax to pay for this stage when you file your return. If TDS is less than required (e.g., due to other income), you may have to pay the difference later.

How is FMV at exercise determined?

• For listed companies: FMV is the market price on the stock exchange on the exercise date (Some companies may use the opening price, closing price, or an average price on that day, depending on their internal policy).
• For unlisted companies: FMV must be determined through a Category I merchant banker valuation.

Stage 2: Tax on the sale of ESOP shares

When you sell the shares acquired by exercising ESOPs, you must pay capital gains tax on any increase in their value since the exercise date.

Capital gain = Sale price − FMV on the date of exercise.

Capital gains tax rates

The rate at which capital gains are taxed depends on the holding period of the shares and whether they are listed or unlisted. 

For listed shares, short‑term capital gains (STCG) arising from a holding period of 12 months or less are taxed at 20% plus applicable surcharge and cess, while long‑term capital gains (LTCG) on shares held for more than 12 months are taxed at 12.5%. Under current law, the first ₹ 1.25 lakh of LTCG from listed equity (in a financial year) is exempt from tax. 

For unlisted shares, STCG on shares held for 24 months or less is taxed at your regular income‑tax slab rate, and LTCG on shares held for more than 24 months is taxed at 12.5% without indexation.

(Note: These thresholds and rates may be updated in Union Budgets. Always verify for the relevant financial year.)

Learn how taxation works for SARs and RSUs.

How to declare ESOPs in Income Tax Return (ITR)

You do not enter ESOP perquisite separately if your employer has correctly reported it.

The perquisite is already included in the “Income from Salary” figure in Form 16. In your ITR, you generally copy the salary details from Form 16, so ESOP taxation flows through automatically.

In cases of ESOP tax deferral, the perquisite is recognised and taxed in the year the deferral triggers. The corresponding Form 16 for that year should show it.

Note: If you exercised ESOPs but don’t see the perquisite in your Form 16, speak to your HR/finance team. 

Reporting the sale of ESOP shares under capital gains

When you sell shares acquired through an ESOP, the sale must be reported under the capital gains section of your income tax return. Begin by noting a few key details: the date of allotment or exercise, the FMV on the exercise date (which becomes your cost of acquisition), and the date and value of the sale. Based on the period between allotment and sale, and whether the shares are listed or unlisted, you can determine whether the gain qualifies as short-term or long-term.

In the capital gains schedule of your ITR, enter the FMV at exercise as your cost of acquisition, along with the sale consideration and the respective dates. The ITR utility will automatically compute the resulting gain or loss and the tax payable.

ESOP tax deferral for eligible startups (Section 192(1C))

Normally, the tax on ESOP perquisites is payable immediately upon exercise. For employees of startups without a liquidity event, this can create a significant cash-flow challenge. 

To address this, the Income Tax Act provides a tax deferral mechanism specifically for recognised startups. This allows eligible employees to defer payment of the ESOP perquisite tax until the earliest of: 48 months from the end of the financial year of allotment, the date they sell the shares, or the date they leave the company.

Access to this relief depends on three interconnected components.

1. DPIIT recognition‍

The company must first be recognised as a startup by the Department for Promotion of Industry and Internal Trade (DPIIT). DPIIT recognition is the first mandatory step; without it, the company cannot qualify as an “eligible startup” under the Income Tax Act.

2. Section 80-IAC eligibility‍

Once DPIIT-recognised, the company must also satisfy the criteria under Section 80-IAC, which require it to be incorporated as a Private Limited Company or LLP, have an incorporation date between April 1, 2016, and March 31, 2030, and maintain a turnover of less than ₹100 crore in any financial year.

3. Section 192(1C)‍

This section provides the practical mechanism for deferring ESOP perquisite tax. The deferral applies only if the employer is DPIIT-recognised, satisfies 80-IAC criteria, and opts into the deferral scheme.

Only when all these conditions are met does a company attain the status of an “eligible startup” under the Income Tax Act, which in turn enables employees to benefit from the ESOP tax deferral.

How the ESOP tax deferral works (Section 192(1C))

Even for eligible startups:

• The perquisite is still calculated on the date of exercise
• But the TDS and tax payment are postponed

The deferred tax becomes payable on the earliest of the following:

1. 48 months (4 years) from the end of the FY in which the shares were allotted
2. The date the employee sells the shares
3. The date the employee leaves the company

Section 56 exemption for startups: Changes after angel tax abolition effective April 2025

Until FY 2024–25, Section 56(2)(viib), commonly known as angel tax, applied when an unlisted company issued shares at a price higher than the FMV.

The “premium above FMV” was taxed as income in the hands of the startup. This rule caused significant friction in fundraising, especially for high-growth startups raising capital at valuations far above FMV.

Budget 2024 abolished angel tax for all classes of investors, effective FY 2025–26, removing Section 56(2)(viib)’s applicability to startup funding altogether.

So what does Section 56 exemption mean now?

Section 56 exemption was the earlier mechanism that protected DPIIT-recognised startups from angel tax. But now that angel tax is fully abolished for all companies and all investors, this exemption:

• Is no longer required for share issuances from FY 2025–26 onward
• Becomes irrelevant for future fundraising

How to calculate TDS on ESOP exercise? 

The process starts with determining the FMV on the exercise date. 

For listed companies, this is the stock market price on that day. For unlisted companies, FMV must come from a Category I merchant banker. The employer then refers to the exercise price specified in the ESOP grant letter.

Using the FMV and the exercise price, the employer calculates the perquisite value using the formula: Perquisite value = (FMV on exercise date − exercise price) × number of shares exercised

This perquisite is added to the employee’s total salary income for the year, which establishes the applicable tax slab and the TDS to be withheld under Section 192. The employer then applies the correct slab rate, including surcharge and cess where applicable, to compute the tax.

Once calculated, the TDS must be deducted and deposited with the government within standard payroll timelines. In the case of deferred ESOPs under Section 192(1C), the deposit is made in the year when the deferral ends.

The final step is to disclose the ESOP perquisite in Form 16 under "Salary perquisites" along with the TDS withheld. This ensures the employee can claim the tax credit (if applicable) when filing their income tax return.

When does TDS apply on ESOPs?

1. For regular (non-deferred) ESOPs

TDS becomes applicable at the moment of exercise, because that is when the perquisite arises.

Employers must deduct TDS:

• On the perquisite value: (FMV on exercise date − exercise price) × number of shares exercised
• As part of salary income, under Section 192
• At the employee’s applicable income-tax slab rate, after adding the perquisite to total salary income

How employers collect this TDS:

• They may deduct it from the employee’s salary for that month, or
• If the salary is insufficient, the employer must collect the shortfall directly from the employee before processing the exercise.

2. For eligible startups opting for ESOP tax deferral

Some startups qualify for a special ESOP deferral mechanism under Section 192(1C).

Under this mechanism:

• The perquisite is still calculated at the time of exercise
• But TDS deduction is postponed.

TDS (and the employee’s final tax payment on the perquisite) becomes due on the earliest of:

• 48 months from the end of the financial year in which shares were allotted
• The date the employee sells those shares
• The date the employee leaves the company

When the deferral ends:

• The employer deducts TDS in that year
• At the employee’s slab rate applicable in that year
• On the originally calculated perquisite amount

Can employers claim a tax deduction for ESOPs?

For companies, the “discount” given to employees at the time of ESOP exercise is treated as employee compensation. Indian courts have consistently held that this compensation is a deductible business expenditure, as long as the company follows proper accounting treatment and maintains supporting documentation.

The accounting treatment is important because tax deductibility mirrors how ESOP cost is recognised in the books. Indian frameworks clearly prescribe how this should be done: companies reporting under Ind AS follow Ind AS 102 (Share-Based Payments), while those under traditional Indian GAAP follow the ICAI Guidance Note on Accounting for Share-Based Payments (2020).

Under both standards, the company determines the fair value of options on the grant date and recognises that value as an employee compensation expense over the vesting period, reflecting when the employee earns the economic benefit. This accounting recognition forms the basis of the tax deduction later claimed by the company.