ESOP Taxation After Exit: Why Perquisite Tax at Exercise and Capital Gains at Sale Creates Double Taxation by Stealth

Introduction

Employee Stock Option Plans (ESOPs) are among the most powerful instruments that Indian startups and companies use to attract, retain, and motivate talent. ESOPs give employees a stake in the company, aligning individual performance with long-term organisational success. In theory, an ESOP is a deferred financial reward that pays off when the company performs well. In practice, however, ESOP taxation in India turns what should be a straightforward reward into a complex process, where a single gain can be taxed at two points under two different heads of income, sometimes before the employee realises any cash.

This is not a quirk of tax administration. It is hardwired into the structure of the Income Tax Act, 1961, and it has real consequences — particularly for employees of private startups who exercise options in companies that have not yet gone public, leaving them to pay large tax bills on paper gains they cannot easily liquidate. Understanding how this works, why it is structurally problematic, what the law currently says, and what courts have held on connected questions is essential for anyone working in the Indian startup or corporate compensation space.

How ESOPs Are Structured: The Five-Stage Lifecycle

Before getting into the tax mechanics, it is worth mapping the lifecycle of an ESOP. The Karnataka High Court, in the context of a significant ruling on one-time voluntary payments made by parent companies to ESOP holders in India, described this lifecycle with clarity: ESOPs pass through five stages — issuance of options, vesting of options, exercise of options, issuance of shares, and sale of those shares [1]. Each of these stages has its own legal character, and tax arises not at every stage, but at two of the most financially significant ones.

At the grant stage, when an employer communicates that an employee is being awarded a certain number of options at a pre-determined exercise price, no tax arises. The employee has merely received a right, not a benefit. Similarly, at the vesting stage — when the option becomes exercisable after the employee satisfies service or performance conditions — no tax is triggered under current law for standard ESOPs. The taxable events arise at stage three and stage five: exercise and sale.

The First Tax: Perquisite at Exercise Under Section 17(2)(vi)

When an employee exercises a vested ESOP — meaning they pay the exercise price and receive shares — the Income Tax Act, 1961 treats the benefit arising at that moment as a “perquisite” falling under the head “Salaries.” The specific provision is Section 17(2)(vi) of the Act, which includes within the definition of perquisite “the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at concessional rate to the assessee.”

The taxable value of this perquisite is the difference between the Fair Market Value (FMV) of the shares on the date of exercise and the exercise price paid by the employee [2]. If an employee exercises 1,000 options at ₹100 per share when the FMV is ₹400, a perquisite of ₹3,00,000 arises and is added to that employee’s salary income for the year, taxed at whatever slab rate applies. This is straightforward enough on paper. The problem is that the employee has not sold a single share — they are now a shareholder, but there is no liquidity event. They have received an asset, not cash, yet they owe income tax immediately.

Employers are required to deduct tax at source on this perquisite value under Section 192 of the Act and report it in Form 16 and Form 12BA. For listed companies, FMV is the average of the opening and closing price of the share on the date of exercise. For unlisted companies, it must be certified by a Category I Merchant Banker, and the certificate cannot be older than 180 days from the date of exercise [3]. This valuation mechanism is particularly problematic for startup employees whose companies are private — the merchant banker valuation may reflect high future-growth-based projections, creating a large paper perquisite that translates into a significant tax liability, even though there is no market to sell the shares into.

The Second Tax: Capital Gains at Sale Under Section 45 Read with Section 49(2AA)

When the employee eventually sells the shares received upon exercising ESOPs, the transaction attracts capital gains tax under Section 45 of the Income Tax Act, 1961. The question of cost of acquisition is critical here. Section 49(2AA) of the Act provides that where capital gain arises from the transfer of specified security or sweat equity shares referred to in Section 17(2)(vi), the cost of acquisition of such security or shares shall be the Fair Market Value on the date on which the option is exercised by the employee [3].

This means the FMV that was already used to compute the perquisite is now reused as the acquisition cost for capital gains purposes, preventing strict double-counting of the same spread. The capital gain is computed as the difference between the sale price and the FMV at exercise. So if those same 1,000 shares are later sold at ₹600 per share, the capital gain is ₹2,00,000 (₹600 minus ₹400, multiplied by 1,000). This gain is then subjected to capital gains tax — either short-term or long-term depending on the holding period [2].

For listed shares held for more than 12 months, Long-Term Capital Gains (LTCG) tax applies at 12.5% on gains exceeding ₹1.25 lakh. Shares held for 12 months or less attract Short-Term Capital Gains (STCG) tax at 20%. For unlisted shares, the threshold for long-term treatment is 24 months, and the LTCG rate is 12.5% without indexation, while short-term gains are taxed at applicable slab rates [4]. Foreign ESOPs received by Indian residents are also taxable in India under the same framework, though Double Taxation Avoidance Agreements may provide partial relief.

ESOP Double Taxation in India: How Perquisite and Capital Gains Create Stealth Taxation

Critics of the ESOP taxation framework in India argue that the so-called “two-stage taxation” is effectively double taxation. The logic is simple: the total economic gain from an ESOP is the difference between the exercise price and the sale price of the shares. For example, if the exercise price is ₹100 and the shares are later sold at ₹600, the ₹500 gain is split arbitrarily at the Fair Market Value (FMV) on the exercise date — ₹300 taxed as a salary perquisite and ₹200 as capital gains. Both taxes apply to the same underlying gain, just divided at an intermediate point, creating a structural mismatch.

This becomes particularly acute in scenarios where the share price drops between exercise and sale. An employee who exercises at an FMV of ₹400 and pays perquisite tax on the ₹300 spread, only to sell later at ₹350, has suffered an actual economic loss relative to their position at the time of exercise. Yet that employee has already paid income tax at salary slab rates on ₹300 of notional gain that never materialised into cash. The capital loss on sale is not automatically set off against the salary income already taxed. The asymmetry is pronounced and, many argue, fundamentally inequitable [5].

The liquidity problem is equally severe. Unlike salary, which arrives as cash, the perquisite from an ESOP arrives as equity. Employees must either sell a portion of their shares to cover the tax bill — a “sell-to-cover” approach that reduces their stake — or find cash elsewhere. For employees of private startups, where there is no public market and secondary sales are restricted or non-existent, this can mean paying a tax of several lakhs of rupees out of their regular salary, which may itself be insufficient to absorb the burden [5].

The Regulatory Framework: SEBI and Company Law Dimensions

ESOPs are not purely a taxation matter. The grant, vesting, and exercise of stock options by Indian companies are also governed under the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (for listed companies) and the Companies (Share Capital and Debentures) Rules, 2014 (for unlisted companies). Under Rule 12 of the Companies (Share Capital and Debentures) Rules, permanent employees of the company, its subsidiaries, or associate companies — both in India and abroad — are eligible for ESOPs. Directors, whether whole-time or otherwise, are also eligible, though promoters and members of the promoter group are specifically excluded.

The accounting treatment of ESOPs adds another layer of complexity. Ind AS 102 (Share-Based Payment) mandates that companies recognise the fair value of ESOPs as an employee cost over the vesting period. This cost is recorded in the Profit and Loss Account and credited to an ESOP Outstanding Account under reserves. The FMV used for accounting purposes must be certified by a Registered Valuer under the Companies Act, 2013, and should align with the FMV used for tax purposes to avoid discrepancies during regulatory audits.

The Judicial Record: Key Case Law

Indian courts have had several opportunities to examine the mechanics and boundaries of ESOP taxation, and their rulings illuminate both the legislative intent and the structural problems in play.

The most significant case on the deductibility of ESOP costs for employers is CIT (LTU) v. Biocon Ltd. [2020] 430 ITR 151 (Karnataka High Court). Affirming the ruling of the ITAT Special Bench, Bangalore, the Karnataka High Court held that the discount on issue of ESOPs is an allowable business expenditure under Section 37(1) of the Income Tax Act, 1961. The Court held that Section 37(1) “permits deduction of expenditure laid out or expended and does not contain a requirement that there has to be a pay-out,” and that ESOP expense is “a definite legal liability” that must be debited to the books of accounts under the mercantile system of accounting [6]. This ruling confirmed that even though ESOPs do not involve a cash outflow, they generate a deductible expenditure for the employer.

The Delhi High Court took a similar position in the context of PVR Ltd., relying on Biocon. The Delhi High Court observed that the expression “expenditure” under Section 37 would include a loss, and that issuance of shares at a discount — where the company absorbs the difference between the market value and the issue price — constitutes expenditure incurred wholly and exclusively for the purposes of the business [7]. The Madras High Court had earlier reached the same conclusion in CIT v. PVP Ventures Ltd. [2012] 23 taxmann.com 286, confirming that ESOP expenses are allowable as revenue expenditure because their objective is retention and motivation of employees, not capital formation.

On the question of when a perquisite arises, the Karnataka High Court, in a separate matter involving one-time voluntary payments made by parent companies to compensate ESOP holders for diminution in value of unexercised options, reaffirmed that “the taxable event for ESOP perquisites under Section 17(2)(vi) of the Income-tax Act, 1961 is the ‘exercise’ of the option” [1]. In the absence of an exercise event, the statutory computation mechanism fails and no perquisite can be charged. This ruling has important implications for corporate restructurings, acquisitions, and ESOP cancellations where options are wound up without being formally exercised.

The Startup Relief: Section 192(1C) and the Finance Act, 2020

Recognising that the immediate perquisite tax creates a liquidity crisis for startup employees — who often hold equity in companies that are not publicly listed and cannot easily sell shares to cover their tax liability — the Finance Act, 2020 introduced a deferral mechanism specifically for eligible startups. The amendment to Section 192 of the Income Tax Act (introducing Section 192(1C)) allows eligible startups to defer the deduction of TDS on ESOP perquisites [8]. Under this mechanism, the tax on ESOP perquisites is deferred until the earliest of three events: 48 months from the end of the relevant assessment year, the date of sale of such shares by the employee, or the date on which the employee ceases to be in employment. Corresponding amendments were also made to Sections 191, 156, and 140A of the Act to align the direct tax payment and assessment framework with this deferral, effective from April 1, 2020.

However, this relief is not available to all startups. The deferral benefit under Section 192(1C) is available only to employers who qualify as “eligible startups” under Section 80-IAC. This requires DPIIT recognition, incorporation as a private limited company or LLP on or after April 1, 2016, and turnover below ₹100 crore in any financial year. The startup must additionally obtain separate certification from the Inter-Ministerial Board (IMB) under DPIIT [9]. As of early 2025, only approximately 3,700 startups had obtained this certification out of more than 1.9 lakh DPIIT-recognised startups — meaning the vast majority of startup employees in India cannot access the deferral and continue to face immediate perquisite taxation upon exercise.

The Structural Problem and the Policy Debate

The core tension at the heart of ESOP taxation in India is this: the law taxes a financial instrument at an intermediate stage — the exercise date — rather than at the final liquidation event. In most comparable jurisdictions, the tax is either deferred to the sale date or calculated only on the final economic gain. The Indian framework, by contrast, inserts a valuation-based perquisite tax at exercise that bears little relationship to what the employee will actually receive when shares are eventually sold.

The startup ecosystem has been vocal about this structural defect for years. Founders, investors, and industry bodies have called for ESOP taxation to be deferred to the point of actual sale across all DPIIT-recognised startups — not just the IMB-certified subset — and for the holding period to be calculated from the date of allotment rather than requiring a fresh clock at each exercise. The government’s reported consideration of expanding the deferral to all DPIIT-recognised startups ahead of the Union Budget 2026-27 reflects growing acknowledgment that the current regime does not serve the policy objective of incentivising long-term equity participation by employees [4].

Conclusion

ESOP taxation in India operates through a framework that is technically coherent but economically dissonant. Section 17(2)(vi) captures a notional gain at exercise as salary income. Section 49(2AA) then resets the cost of acquisition for capital gains, preventing the same spread from being taxed twice in a strict mathematical sense. But the overall effect — two tax events, two different heads of income, one underlying economic gain — creates a burden that is real, immediate, and often disproportionate to the liquidity available to the taxpayer. The perquisite tax is levied when the employee becomes a shareholder, not when they become wealthy. The capital gains tax is levied when they sell. Between those two events, the value of the shares may rise, fall, or become entirely illiquid.

The judicial record on ESOP taxation in India — spanning cases from Biocon Ltd. to PVP Ventures and the Karnataka High Court’s ruling on the exercise trigger — has helped clarify the legal boundaries of the framework. However, courts cannot amend the law; that remains the prerogative of Parliament. Until the Section 192(1C) deferral mechanism is extended more broadly, or the taxable event for ESOPs is definitively shifted to the sale of shares, startup employees and other ESOP holders in India will continue to face a system that taxes not on realised profits, but on promises that may only materialise much later.

References

[1] Nishith Desai Associates, Taxability of One-Time Voluntary Payment Received on Diminution of Value of ESOPs (Karnataka High Court — Section 17(2)(vi) exercise trigger, five-stage lifecycle): https://nishithdesai.com/NewsDetails/15377

[2] Treelife, ESOP Taxation in India — A Complete Guide (2025) (Perquisite computation formula, capital gains stages, LTCG/STCG rates): https://treelife.in/taxation/esop-taxation-in-india/

[3] ICMAI, ESOP — Income Tax Perspective (Section 49(2AA) cost of acquisition, FMV computation rules, merchant banker valuation for unlisted shares): https://icmai.in/TaxationPortal/upload/DT/Article/21.pdf

[4] Inc42, Centre Mulls Extending Tax Deferral On ESOPs For DPIIT Startups: Report (Policy background, LTCG/STCG rate update, 1.97 lakh DPIIT startups data): https://inc42.com/buzz/centre-mulls-extending-tax-deferral-on-esops-for-dpiit-startups-report/

[5] Vested Finance, ESOP Taxation Guide: Perquisite Tax & Capital Gains Explained (Liquidity problem at exercise, sell-to-cover mechanics, tax before cash): https://vestedfinance.com/blog/us-stocks/how-are-esops-taxed-a-complete-guide-to-stock-option-taxation/

[6] Cyril Amarchand Mangaldas Tax Blog, Karnataka HC Affirms Discount on Issue of ESOPs is a Tax-Deductible Business Expenditure — CIT (LTU) v. Biocon Ltd. [2020] 430 ITR 151 (Section 37(1) deductibility): https://tax.cyrilamarchandblogs.com/2020/12/karnataka-hc-affirms-discount-on-issue-of-esops-is-a-tax-deductible-business-expenditure/

[7] LiveLaw, Delhi High Court Allows Deduction To PVR On Difference Between Market Price & Issue Price Of ESOP (Section 37(1), PVR Ltd. ruling): https://www.livelaw.in/news-updates/delhi-high-court-income-tax-act-pvr-ltd-esop-207871

[8] TaxTMI, Deferring TDS or Tax Payment in Respect of Income Pertaining to ESOP of Start-Ups (Finance Act 2020, Section 192(1C) amendment, Sections 191, 156, 140A): https://www.taxtmi.com/tmi_notes?id=532

[9] EquityList, Section 80-IAC: Perquisite Tax Deferral for ESOPs and Sweat Equity (IMB certification criteria, 3,700 certified startups out of 1.9 lakh DPIIT-recognised): https://www.equitylist.co/blog-post/perquisite-tax-deferral-startups