These differences can have a material impact on cash flows, risk and eventual returns. Understanding how shares are acquired and taxed under each structure is critical before opting in, as tax liabilities often arise well before any actual cash gains are realised.
ESOPs: Tax before cash
Employee stock option plans, or Esops, allow companies to reward employees by giving them the right to buy shares at a fixed, discounted price in the future.
These are commonly used by startups or unlisted companies that may not offer high cash compensation but want employees to benefit from future value creation. Esops are not shares on day one; they represent a promise to offer shares at a later date.
Esops typically unfold in three stages: grant, vesting and exercise. At the time of grant, the company specifies the number of options and the exercise price, which is usually set at a discount to the fair market value of the shares on the grant date. Vesting refers to the period the employee must complete to earn the right to buy the shares. Once the vesting period ends, the exercise window opens—this is the time during which the employee can convert vested options into shares by paying the exercise price.
Consider the example of Ananya, who is granted 10,000 ESOPs by her employer, ABC Co, at an exercise price of ₹80 per share, compared with a fair market value of ₹200 on the grant date—a 60% discount. The Esops come with a vesting period of two years, meaning Ananya must remain with the company for that duration to earn the right to buy the shares. If she leaves before completing the vesting period, the Esops lapse and she receives nothing.
After completing two years, the options vest and the exercise window opens, which ABC Co has set at five years. Ananya must exercise her vested Esops within this period.
To convert all her options into shares, she must pay ₹8 lakh (10,000 shares multiplied by ₹80). Once this amount is paid, the company allots 10,000 shares in her name and she becomes a shareholder. At this stage, her first tax liability arises in the form of perquisite tax.
Assume that on the date Ananya exercises her Esops, the fair market value of the shares is ₹300. The difference between the fair market value and the exercise price— ₹220 per share or ₹22 lakh in total—is treated as a perquisite and added to her salary income for the year. This amount is taxed at her applicable income tax slab rate of 30%.
As a result, Ananya must pay ₹6.6 lakh in perquisite tax in addition to the ₹8 lakh exercise amount, taking her total out-of-pocket cost to ₹14.6 lakh to own shares that are valued at ₹30 lakh on paper.
Once she owns the shares, Ananya must wait for a liquidity event such as an initial public offering (IPO), acquisition or buyback to sell them. When she eventually sells the shares, she will be liable to pay capital gains tax on the profit. If the shares are held for more than 12 months, long-term capital gains are taxed at 12.5%.
In the case of ESOPs, therefore, tax arises at two points—at exercise and at sale. In both instances, the tax must be paid out of the employee’s own funds.
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RSUs: Vesting equals tax
Restricted stock units, or RSUs, are a form of equity compensation in which companies promise to grant employees actual shares in the future, subject to conditions such as continued employment or performance milestones. Unlike Esops, employees do not need to buy these shares or pay any exercise price.
The RSU process has two stages: grant and vesting. At the time of grant, employees are informed of the number of RSUs awarded and the vesting schedule. Vesting is the period the employee must complete to earn ownership of the shares and often occurs in instalments over time. If the employee leaves before the vesting conditions are met, unvested RSUs lapse and do not convert into shares.
Once RSUs vest, they automatically convert into shares and are credited to the employee’s demat account. There is no exercise window and no payment required. On vesting, the employee becomes the legal owner of the shares, with rights similar to those of any other shareholder.
Consider an example where Ananya works at a listed company, XYZ Ltd, and is granted 5,000 RSUs with a three-year vesting period. After completing three years, all 5,000 RSUs vest on a single date. On the vesting date, assume the market price of XYZ Ltd’s shares is ₹400. The full value of the shares— ₹20 lakh—is treated as salary income and taxed at her applicable slab rate of 30%, resulting in a tax liability of ₹6 lakh.
To recover this tax, companies commonly follow the sell-to-cover method, said Pallav Pradyumn Narang, partner at CNK. “In RSU vesting, the employer has to deduct TDS but since the employee receives shares instead of cash, the employer sells a portion of the vested shares to arrange the tax to be paid to the government.”
In Ananya’s case, XYZ Ltd sells 1,500 shares worth ₹6 lakh and credits the remaining 3,500 shares to her demat account. This sale is purely to meet the tax obligation and does not represent a purchase price paid by the employee.
Although the sale is executed by the employer, the shares are first legally allotted to the employee and the sale is deemed to be carried out on her behalf. This constitutes a transfer of a capital asset and attracts capital gains tax.
However, since the sale typically occurs on or close to the vesting date, the gain is usually negligible as the vesting price and sale price are identical. “Such gains are classified as short-term capital gains and must still be reported in the income tax return,” said Shilpi Jain, partner at Ved Jain and Associates.
After vesting, employees may sell the remaining shares immediately or choose to hold them. Any subsequent sale attracts capital gains tax on the difference between the sale price and the market value on the vesting date. For shares issued by an Indian employer, long-term capital gains on holdings exceeding 12 months are taxed at 12.5%, while short-term gains are taxed at 20%.
Jain noted that the tax treatment differs when RSUs are issued by the foreign entity of a multinational company. “Under Indian tax law, foreign RSUs are treated as unlisted shares. If these shares are sold within 24 months of vesting, the gains are considered short-term and taxed at the employee’s applicable income tax slab rate,” she said.
RSUs are most commonly offered by listed companies and are therefore typically liquid.
Narang added that, apart from equity-settled RSUs, companies also offer cash-settled RSUs. “Cash-settled RSUs, often referred to as phantom RSUs, do not involve share issuance and instead provide a contractual right to receive cash linked to share value. Liquidity in RSUs therefore depends on whether the settlement is in shares or cash and whether the company is listed. In private companies, both ESOPs and equity-settled RSUs may remain illiquid until a liquidity event occurs,” he explained.
ESPPs: Buy, then wait
Employee stock purchase plans, or ESPPs, allow employees to buy company shares directly, usually at a discounted price.
Unlike Esops and RSUs, ESPPs require an upfront payment and result in immediate share ownership. However, discounted ESPP shares are subject to a one-year lock-in mandated by the Securities and Exchange Board of India. If shares are issued to employees at the same price as the public issue, no lock-in applies, with the restriction intended to curb short-term trading.
The ESPP process is relatively straightforward. The company announces the offer, specifying the number of shares, the discounted purchase price and any lock-in or holding restrictions. Employees who choose to participate typically pay for the shares through salary deductions. Once allotted, the shares are credited to the employee, making them a shareholder from day one.
Bharath Reddy, partner at Cyril Amarchand Mangaldas, pointed out that ESPPs function more as a reward than a retention tool, as employees do not need to remain with the company for extended periods to benefit.
However, despite upfront ownership, immediate liquidity is often limited due to lock-in restrictions, Reddy added. Once the lock-in period ends, employees of listed companies can sell the shares freely on the stock exchange, subject to trading window norms.
ESPPs are more commonly offered by listed companies and multinational corporations and are relatively rare among startups. This is because ESPPs place employees on the cap table from day one, which can affect a company’s ability to raise capital and undertake certain corporate actions.
“Any matter requiring shareholders’ approval would also need the approval of such employees, and certain investors are wary of having many shareholders on the cap table, as the time and effort involved in undertaking corporate actions increase. On the contrary, with ESOPs, employees do not get on the cap table as shareholders and can time that to a later date, such as during an M&A or IPO,” said Reddy.
ESPPs are taxed in a manner similar to RSUs, with tax arising at two stages—when the shares are purchased and when they are sold after the lock-in ends. “For capital gains, the fair market value on the purchase date is treated as the cost of acquisition and the holding period for determining short- or long-term gains is also counted from the purchase date,” said Narang.
While ESOPs, RSUs and ESPPs all offer employees a route to equity ownership, they differ significantly in the timing of ownership, liquidity and tax impact. Understanding these distinctions is crucial, as tax liabilities often arise before actual cash gains, making the structure of equity compensation just as important as its headline value.
Ananya is a hypothetical case used for illustration purposes.
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