[Opinion] ESOP Taxation and TDS Mismatch | Need for Reform

Punit Agarwal – [2026] 185 taxmann.com 97 (Article)

1. Introduction

Employee Stock Option Plans (“ESOPs”) have emerged as a powerful tool for talent acquisition and retention, particularly in India’s burgeoning start-up and technology ecosystem. However, the income tax framework governing ESOPs creates a peculiar practical difficulty i.e. the perquisite arising on exercise of stock options is taxable as salary under Section 17(2)(vi) of the Income-tax Act, 1961 and the employer is obligated to deduct TDS under Section 192. The fundamental problem arises when the perquisite value is disproportionately large relative to the employee’s cash salary, leaving the employer with an insufficient salary pool from which to effect TDS recovery.

This article examines the legal provisions, practical challenges, and available solutions when an employer faces the classic question: “How do I deduct TDS of Rs. 30 lakhs when the monthly salary is only Rs. 3 lakhs?”

2. Taxability of ESOPs

ESOPs are taxed at two distinct points in time:

2.1 Stage 1—At the Time of Exercise (Perquisite Under “Salary”)

Under Section 17(2)(vi) read with Rule 3(8) and 3(9) of the Income-tax Rules, 1962, the difference between the Fair Market Value (“FMV”) of the shares on the date of exercise and the exercise price paid by the employee is treated as a perquisite taxable under the head “Salaries.” The employer is required to deduct TDS on this perquisite under Section 192 in the month of exercise.

For listed shares, the FMV is the average of the opening and closing price on the date of exercise on the recognised stock exchange. For unlisted shares, the FMV must be determined by a Category-I Merchant Banker as on the exercise date or a date not earlier than 180 days before the exercise date.

2.2 Stage 2—At the Time of Sale (Capital Gains)

On subsequent sale of the shares, capital gains arise with the FMV at the exercise stage serving as the cost of acquisition. For listed shares with STT, LTCG (holding period > 12 months) is taxable at 12.5% under Section 112A on gains exceeding Rs. 1.25 lakh, and STCG at 20% under Section 111A. For unlisted shares, the LTCG threshold is 24 months, taxable at 12.5% under Section 112, with STCG at slab rates.

3. The Core Problem

Consider the following scenario, which is increasingly common in Indian companies:

The employer’s dilemma is immediately apparent. Even if the employer were to withhold the entire remaining salary of the employee for the balance of the financial year (approximately Rs.33 lakhs), it would barely cover the TDS on the ESOP perquisite alone, leaving the employee with zero take-home pay for 11 months. This is neither commercially feasible nor practically sustainable.

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