Navigating the Tax Considerations for Equity Grants in India
Written By:
Team Qapita
February 18, 2025
Equity grants play a pivotal role in aligning employee interests with startups' growth trajectories. For Indian companies domiciled in the US, equity grants are a key tool to attract and retain talent, incentivizing employees with ownership in the company. However, the taxation of these grants can be a challenging area for founders, often requiring careful navigation through complex international tax regulations.
Granting, exercising, and selling equity can have varied tax consequences, influenced by factors such as your company's structure, the recipient's residency, and applicable tax treaties. As a founder, understanding these nuances is crucial for structuring effective compensation plans that comply with both US and Indian tax laws while optimizing financial outcomes for all stakeholders.
This guide explores the taxation system for equity grants in India, providing actionable insights into the tax treatment of stock options, Restricted Stock Units (RSUs), and other equity instruments. Let’s start.
When and how are equity grants taxed?
For US-domiciled companies, tax implications for equity grants in India vary depending on the stage of the equity lifecycle.
Taxes at grant and vesting
The tax treatment of equity grants in India depends on the nature of the grant:
Restricted Stock Units (RSUs): RSUs are taxed at the time of vesting. When RSUs vest, they are considered a perquisite under the ‘income from salary’ head. The taxable amount is the Fair Market Value (FMV) of the shares on the vesting date, converted to INR. The taxable value of RSUs is reflected in the employee’s Form 16 and Form 12BA, which are used for income tax return filing.
Employee Stock Options (ESOPs):ESOPs are not taxed at the grant or vesting stage. Instead, taxation arises only when the employee exercises the options.
Employers must deduct Tax Deducted at Source (TDS) under Section 192 of the Income Tax Act on the FMV of the shares at vesting.
Taxes at exercise
The exercise of equity options, such as ESOPs, triggers a tax liability for the employee. Under Indian income tax laws, the difference between the FMV on the exercise date and the exercise price is treated as a taxable perquisite. This amount is treated as salary income and taxed according to the applicable income tax slab.
RSUs, however, do not involve an exercise stage since the shares are automatically transferred upon vesting. The tax liability for RSUs is already addressed at vesting, distinguishing them from ESOPs and other equity grants.
Fair Market Value
The determination of Fair Market Value (FMV) for equity grants in India is a crucial process governed by specific regulations. For unlisted companies, the valuation of shares must be conducted by a SEBI-registered Category I Merchant Banker, as stipulated by Rule 11UA of the Income Tax Rules.
This requirement ensures a standardized valuation approach, which is particularly important for tax compliance and regulatory purposes. The Category I Merchant Banker applies internationally accepted pricing methodologies to determine the FMV, considering various factors such as the company's financial performance, market conditions, and growth prospects.
The valuation report issued by the Merchant Banker serves as a critical document for several purposes, including:
Determining the taxable perquisite value of ESOPs at the time of exercise
Establishing the FMV for secondary transactions of unquoted shares
Ensuring compliance with regulatory requirements for equity-based compensation
Taxes on sale of shares
Tax liabilities on the sale of shares arise under the capital gains head in Indian tax laws. The tax rate and treatment depend on the holding period of the shares and whether the shares are listed or unlisted:
Short-term Capital Gains (STCG):
For shares listed on Indian stock exchanges: If sold within 12 months of vesting, gains are taxed at 15%.
For shares not listed on Indian stock exchanges: If sold within 24 months of vesting, gains are taxed at the employee’s applicable income tax slab rate.
Long-term Capital Gains (LTCG):
For shares listed on Indian stock exchanges: If sold after 12 months of vesting, gains exceeding ₹1 lakhs are taxed at 10% without indexation benefits.
For shares not listed on Indian stock exchanges: If sold after 24 months of vesting, gains are taxed at 20% with indexation benefits.
Here are some important points that you should know regarding taxation of equity grants in India
If applicable, employees can claim tax benefits under the Double Tax Avoidance Agreement by filing Form 67, in addition to Schedule TR in their ITRs.
When calculating capital gains from the sale of shares of a foreign company, the exchange rate on the date of sale is used to convert the proceeds to Indian Rupees.
Employees holding RSUs or ESOPs of foreign companies must disclose these under the Foreign Asset Schedule (FAS) in their Indian tax returns (ITR-2 or ITR-3 forms).
Cross-border taxation and double taxation relief
Double taxation occurs when two different jurisdictions tax the same income. For Indian employees of US companies, this could mean paying taxes on the same income to both Indian and US tax authorities. This situation arises due to the difference in the basis of taxation in both countries:
US tax system is based on citizenship and worldwide income.
Indian tax system is based on residency and source of income.
As a result, your employees’ income could potentially be taxed twice, once in each country.
Understanding tax credits and double taxation
To address this issue, India and the US have signed a Double Taxation Avoidance Agreement (DTAA). This treaty aims to prevent double taxation by providing clarity on where taxes should be paid. Here are its key provisions:
Foreign Tax Credit (FTC): Employees can claim credit for taxes paid in one country against their tax liability in the other. For instance, taxes paid in the US can be credited against Indian tax liability.
Exemption method: As specified in the DTAA, certain types of income may be exempt from taxation in one country if taxed in the other.
Reduced tax rates: The DTAA may provide for reduced tax rates on specific types of income, such as dividends, interest, and royalties.
Practical tips for filing taxes
Here are some useful tips for your Indian employees working in the US:
Determine residency status: Understand the tax residency rules of both countries. The DTAA's tie-breaker rules can help determine the country of residence for tax purposes.
Apply DTAA benefits: Use the appropriate DTAA articles to determine where each income type should be taxed. Claim Foreign Tax Credit (FTC) for taxes paid in the other country
Obtain a Tax Residency Certificate (TRC): Indian employees should obtain a TRC from US tax authorities to claim DTAA benefits in India.
File Form 67 in India: If claiming foreign tax credit in India, employees must file Form 67 along with their Indian tax return.
Utilize Form 8833 in the US: Report treaty-based positions on the US tax return using Form 8833.
Consider the timing of income recognition: When planning income recognition, be aware of differences in tax years between India (April-March) and the US (January-December).
File returns in both countries: In the US, they must file Form 1040NR for non-residents or Form 1040 for residents. In India, they must file ITR-2 or appropriate forms based on income sources.
Tax-saving strategies for equity holders
Here are actionable strategies for minimizing tax liabilities related to equity grants.
Timing the exercise of options: By exercising options when the taxable income falls in a lower tax bracket, your employees can minimize the perquisite tax calculated on the difference between the FMV and the exercise price. This strategy is particularly beneficial during years when personal income is lower due to career transitions, sabbaticals, or other reasons.
Selling shares strategically: Timing the sale of shares can significantly impact capital gains taxes. Holding shares for over 24 months qualifies for long-term capital gains (LTCG) tax, which is taxed at a more favorable rate of 10% for listed shares or 20% with indexation for unlisted shares. One common practice in companies which are on the path to an IPO is for employees to exercise pre-IPO and sell their shares post IPO (after holding for at least 1 year) for maximum tax savings.
Utilizing deductions and exemptions: Indian tax laws offer several deductions and exemptions that can help reduce taxable income. For instance, reinvesting proceeds from equity sales in specified instruments, such as Equity-Linked Savings Schemes (ELSS) or mutual funds under Section 80C, can provide tax relief while enabling long-term financial growth.Your employees can also benefit from deductions available for investments in infrastructure bonds or contributions to the National Pension System (NPS).
Consulting Tax Experts: Cross-border equity grants introduce complexities that often require expert guidance. Tax professionals can help your employees navigate valuation methodologies for calculating FMV, determining the most tax-efficient exercise timing, and understanding their obligations in both India and the US.
At Qapita, our experts specialize in equity management and valuation. We provide tailored advice on structuring equity grants, calculating tax liabilities, and aligning with global tax compliance standards.
Legal and compliance considerations for equity grants
Adhering to legal regulations is crucial for maintaining good standing with tax authorities in both countries and ensuring your equity program’s success.
US tax considerations
Reporting requirements: File Form 3921 for Incentive Stock Options (ISOs) and Form 3922 for Employee Stock Purchase Plans (ESPPs) with the IRS.Submit these forms by February 28 if filing on paper, or March 31 if filing electronically.
Withholding obligations: For Non-Qualified Stock Options (NSOs) and Restricted Stock Units (RSUs), withhold applicable federal and state taxes upon exercise or vesting.
Indian tax considerations
Perquisite taxation: The difference between the FMV of shares and the exercise price is taxed as a perquisite at the time of exercise for stock options.For RSUs, the FMV of shares at vesting is taxed as a perquisite.
Withholding requirements: Withhold Tax Deducted at Source (TDS) on the perquisite value at the time of allotment of shares.
Reporting obligations: Report details of equity grants in Form 12BA along with the employee’s Form 16.
Documentation and record-keeping
Company responsibilities: Keep track of exercise and sale transactions. Maintain detailed records of all equity grants, including:
Employee responsibilities: Keep copies of tax returns and supporting documents for at least seven years. Maintain personal records of:
Grant documents
Exercise notifications
Sale transactions
Potential penalties and how to avoid them
US penalties
Late filing of information returns: Penalties range from $50 to $280 per form, depending on how late the filing is made. Maximum penalty of $3,426,000 per year for large businesses.
Failure to withhold taxes: Penalties up to 100% of the unpaid tax, plus interest.
Indian penalties
Non-compliance with FEMA regulations: Penalties up to three times the sum involved in the violation, or Rs. 200,000 if the amount is not quantifiable.Additional penalty of up to Rs. 5,000 per day for continuing non-compliance.
Late filing of form OPI: Late fee of Rs. 7,500 per return.
To avoid these risks, it is important to:
Implement robust systems for tracking and reporting equity transactions.
Partner with qualified tax advisors to ensure compliance with local and international laws.
Provide employees with timely access to essential documentation and resources.
Overcoming tax issues with equity grants
Here are some common tax issues you might face and practical solutions to address them.
Key Challenges
Unclear tax rules: The complexity of tax regulations in both India and the US can lead to confusion. Variations in tax laws, frequent updates, and differing interpretations can make compliance difficult.
Double taxation: Employees may face taxation in both countries, leading to a higher tax burden. Understanding and applying the Double Taxation Avoidance Agreement (DTAA) provisions is crucial to mitigate this issue.
Valuation complexities: Determining the FMV of shares for tax purposes can be intricate. Different valuation methods and fluctuating market conditions add to the complexity.
Solutions
Seek professional advice: Engage tax professionals who specialize in cross-border taxation. They can provide guidance on interpreting tax laws, applying DTAA provisions, and ensuring compliance with both US and Indian regulations.
Leverage equity management platforms: Utilize platforms like Qapita to streamline equity management processes. These platforms offer tools for tracking grants, calculating FMV, and generating necessary documentation, reducing administrative burdens and minimizing errors.
Stay informed: Regularly update yourself on changes in tax laws and regulations. Subscribe to newsletters, attend webinars, and participate in industry forums to stay ahead of developments that may impact your equity program.
Implement robust record-keeping: Maintain comprehensive records of all equity transactions, including grant agreements, vesting schedules, and FMV calculations. Accurate documentation is essential for audits and resolving any tax disputes.
Educate employees: Provide training and resources to help employees understand their tax obligations related to equity grants. Clear communication can prevent misunderstandings and ensure compliance.
Conclusion
Understanding and managing equity grant taxation is crucial for startup founders who want to attract and retain top talent while navigating complex international tax regulations. By implementing strategic approaches to equity compensation, you can maximize the benefits for your company and employees while minimizing potential pitfalls.
At Qapita, we specialize in simplifying these complexities for startups like yours. Our comprehensive equity management platform, rated #1 by G2, offers solutions tailored to your needs, from cap table management and ESOP administration to valuation services and liquidity solutions. With our user-friendly interface and expert support, you can effortlessly track grants, calculate Fair Market Values, and generate necessary documentation, all while ensuring compliance with both US and Indian tax laws.
Don't let the intricacies of equity grant taxation hinder your company's growth.
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