5.08Equity, ESOPs and compensation

ESOP tax: Indian perquisite tax and the deferral for DPIIT startups; US ISO and AMT

Stage: SeedIndia

1. The core idea#

The worst moment in an employee's equity journey is a tax bill on shares they cannot sell. That is the default in India and, for some option types, in the US: tax is charged when options are exercised, on the gap between the share's value and the price paid, long before any sale. A startup that designs its ESOP without planning for this ends up with employees who can't afford to exercise, or who let vested options lapse when they leave.

The three regimes in this library work very differently:

  • India: two tax events. At exercise, the gain is taxed as salary (a perquisite), with the employer deducting tax. At sale, any further gain is capital gains. Employees of a small group of eligible startups can defer the salary tax until they sell, leave or a long period passes.
  • US: depends on the option type. NSOs are taxed as income at exercise, like India. ISOs have no regular tax at exercise, and if shares are held long enough the whole gain is long-term capital gain, but the gain at exercise counts for the alternative minimum tax (AMT), which tightened from 2026.
  • UK: EMI options granted at market value usually mean no income tax at exercise and capital gains tax on sale, often at a reduced rate.

The company can't change the tax law, but it can choose instruments and schemes that work well, time exercises around liquidity, help with cashless exercise, withhold correctly, and explain it clearly. Mistakes in withholding are the company's liability.

Who this is for: founders designing ESOPs in India, the US or the UK; finance leads running exercises or buybacks; anyone explaining equity to employees.

Pairs with: 5.02 (plan design), 5.07 (valuations), 5.09 (leavers), 5.10 (buybacks), 5.11 (equity education), 5.18 (international employees).

This playbook summarises general rules. It is not tax advice; employees should get their own.

2. The rules#

India#

Stage 1, exercise: the perquisite is the fair market value on the exercise date minus the exercise price, taxed as salary at the employee's slab rate. For unlisted shares the FMV comes from a Category I merchant banker report no more than 180 days old (5.07). The employer deducts TDS through payroll. From 1 April 2026 the provisions sit in the Incometax Act 2025 (salary TDS under s.392); practitioners agree the substance is unchanged.

The startup deferral. Employees of an eligible startup can postpone the tax until 14 days after the earliest of: the end of the deferral period, the sale of the shares, or leaving the company.

  • Deferral period: 48 months from the end of the assessment year of allotment under the 1961 Act. For shares allotted from 1 April 2026, the 2025 Act sets it at 60 months from the end of the tax year of allotment (s.392(3) read with s.289(3)).
  • Who qualifies: the employer needs both DPIIT recognition and an Inter-Ministerial Board certificate of eligibility for the startup tax holiday (old s.80-IAC, now s.140). DPIIT recognition alone is not enough. As of April 2025 only about 3,700 of more than 1.9 lakh DPIIT-recognised startups held that certificate.
  • It is a deferral, not an exemption. Capital gains tax still applies on sale.

Stage 2, sale: the gain is the sale price minus the FMV used at exercise. For unlisted shares held more than 24 months, long-term capital gains are taxed at 12.5% (since July 2024) without indexation; shorter holdings are taxed at slab rates. Buybacks: from 1 October 2024 to 31 March 2026, buyback proceeds were taxed as dividend income. The Finance Act 2026 restored capital gains treatment for buybacks from 1 April 2026, with an additional tax only for promoters (5.10).

US#

NSO ISO
At grant No tax (if strike ≥ FMV) No tax
At exercise Spread taxed as ordinary income;
employer withholds for employees		 No regular tax; spread is an AMT
adjustment
At sale Further gain is capital gain (long-
term after one year)		 If held 2 years from grant and 1 year
from exercise, whole gain is long-
term capital gain; otherwise a
"disqualifying disposition" taxes
the spread as ordinary income
NSO ISO
Company Yes, equal to the employee's Only on disqualifying dispositions
deduction income

AMT from 2026. The One Big Beautiful Bill Act made the higher AMT exemptions permanent: $90,100 for single filers and $140,200 for married couples filing jointly in 2026. But it lowered the phase-out thresholds to $500,000 and $1,000,000 and doubled the phase-out rate to 50%. Inside the phase-out band the effective marginal AMT rate can reach around 42%, so large ISO exercises now produce bigger AMT bills than in 2025. Exercising and selling ISO shares in the same calendar year avoids the AMT adjustment, at the cost of ordinary income treatment.

Early exercise and 83(b). Exercising unvested options early and filing an 83(b) election within 30 days starts the holding periods and, at a low strike price, can mean little or no tax at exercise.

QSBS. For stock issued after 4 July 2025, the qualified small business stock exclusion is phased: 50% of the gain excluded after 3 years, 75% after 4, 100% after 5, with a higher $15 million cap and a $75 million gross asset limit for the company. Option holders' clock starts at exercise, not grant.

UK#

  • EMI granted at or above market value: no income tax or National Insurance at exercise. On sale, capital gains tax applies; Business Asset Disposal Relief (BADR) can apply if options were granted at least two years before the sale, at 14% for 2025–26 and 18% from 6 April 2026.
  • EMI below market value: the discount is taxed as income at exercise.
  • Unapproved options: the spread at exercise is income, usually through PAYE with employer and employee National Insurance if the shares are readily convertible into cash.
  • CSOP: no income tax at exercise if exercised 3 to 10 years after grant (or in some leaver and sale cases).

3. The method: what the company should do#

Step 1: Pick tax-efficient instruments#

  • US employees: ISOs where allowed; consider allowing early exercise with 83(b) for early hires when the strike price is very low.
  • UK employees: EMI granted at an HMRC-agreed market value.
  • Indian employees: options under an Indian scheme, and apply for the IMB certificate (old 80-IAC) if you may qualify, because it unlocks both the tax holiday and the ESOP deferral (4.04).

Step 2: Design around liquidity#

  • Exercise windows tied to liquidity events: buybacks, secondary sales, or a sale of the company, so employees can sell some shares to pay tax (5.10).
  • Cashless or "sell-to-cover" exercise where possible: the company or a buyer purchases enough shares to cover the strike price and tax.
  • Exit-only exercise (common for UK EMI and for some Indian schemes): options become exercisable only on a sale or IPO, when tax can be paid from proceeds. Tradeoff: employees can't start capital gains holding periods early.
  • Longer post-leaving exercise windows so departing employees aren't forced to pay tax without liquidity (5.09).

Step 3: Withhold and report correctly#

  • India: compute the perquisite using a valid merchant banker FMV; deduct TDS through payroll (or track the deferral and deduct within 14 days of the trigger); report in Form 16 and the quarterly salary TDS return; keep the IMB certificate on file if deferring.
  • US: withhold income tax and payroll taxes on NSO exercises by employees; report ISO exercises on Form 3921 by 31 January; report NSO income on the W-2 (employees) or 1099 (non-employees).
  • UK: run PAYE and National Insurance on taxable exercises where shares are readily convertible assets; file the annual employment-related securities return by 6 July.

Step 4: Explain it clearly#

Give each employee a one-page example with their own numbers (5.11) and point them to a tax adviser before large exercises.

Worked examples#

India, eligible startup. Priya holds 10,000 vested options at a ₹10 exercise price. She exercises when the merchant banker FMV is ₹310.

  • Perquisite: (₹310 − ₹10) × 10,000 = ₹30 lakh, added to her salary. At her income level, roughly a third of it would be tax, about ₹10 lakh.
  • Without the deferral: her employer must deduct about ₹10 lakh through payroll, although she can't sell the shares.
  • With the deferral (her employer holds the IMB certificate): no tax is deducted at exercise. The tax becomes due within 14 days of the earliest of her selling, leaving, or 60 months after the end of the tax year of allotment.
  • At sale three years later at ₹800: capital gain (₹800 − ₹310) × 10,000 = ₹49 lakh, longterm (held over 24 months), taxed at 12.5% plus surcharge and cess. The deferred perquisite tax is paid at the same time.

US, ISO vs NSO. Daniel exercises 20,000 options at $0.50 when the 409A FMV is $5.00, a spread of $90,000.

  • As NSOs: $90,000 ordinary income, with withholding.
  • As ISOs: no regular tax, but $90,000 is added to his AMT income. If he holds the shares at least one year after exercise (and two years after grant), the whole gain on sale is long-term capital gain. If the company's value falls after exercise, he may have paid AMT on a gain that disappeared. He exercises in two tranches across two years to limit the AMT.

UK, EMI. Amira's 10,000 EMI options were granted at £1.00, the HMRC-agreed market value. Three years later the company is sold at £10 per share. No income tax at exercise; capital gain of £90,000; BADR applies because her options were granted more than two years before the sale, so the rate is 18% (for disposals from 6 April 2026), about £16,200 before the annual exemption.

4. Cross-border and edge cases#

Indian employees with options in a foreign parent. The perquisite at exercise is taxed in India as salary, with TDS by the Indian employer, using an Indian-rules FMV. The startup deferral usually doesn't help, because it depends on the Indian employer being the eligible startup issuing its own shares. Employees must report the foreign shares in their tax return's foreign asset schedule every year. Gains on sale are taxable in India; foreign tax credits may apply if the other country also taxes.

US citizens or residents working in India. US citizens are taxed by the US on worldwide income; they may face both Indian perquisite tax and US income or AMT, with foreign tax credits. Get specialist advice.

Employees who move country between grant and exercise. Many countries apportion the gain by the number of days worked in each country during vesting. Track work locations. Leavers. In India, leaving ends the deferral, so tax becomes due within 14 days. In the US, ISOs not exercised within 3 months of leaving become NSOs. In the UK, EMI relief is lost if not exercised within 90 days of leaving. All of these push leavers to decide quickly; longer exercise windows and buybacks help (5.09).

Company deductions. In India, the company can generally deduct the ESOP expense for tax when shares are allotted, under court rulings and the accounting expense. In the US, the company deducts NSO income and ISO disqualifying dispositions. In the UK, a statutory corporation tax deduction is available when employees acquire shares, subject to conditions.

Sale of the company. In a cash acquisition, options are often cashed out: the payment is taxed as income (India, US NSOs, UK unapproved) or as capital gains for EMI shares exercised just before completion. Plan the mechanics with the acquirer (5.09, 5.20).

Changes are frequent. India's 2025 Act renumbered everything and lengthened the deferral; the US changed AMT and QSBS in 2025; the UK changed EMI limits and BADR rates in 2026. Review your equity guidance every year.

Scripts#

Explaining Indian ESOP tax in one paragraph:

"When you exercise, the difference between the share's value at that time and the price you pay is treated as salary and taxed. Because we are an eligible startup, that tax is postponed until you sell, leave, or five years pass, whichever comes first. When you eventually sell, any further gain is capital gains, taxed at 12.5% if you've held the shares more than two years."

Before a US employee exercises ISOs:

"Exercising ISOs has no regular income tax, but the spread counts for AMT, and the rules got tighter in 2026. Please model the AMT with a tax adviser before exercising more than [amount] in a year. We're happy to share the latest 409A and your grant details."

When announcing a buyback or liquidity programme:

"You'll be able to exercise and sell up to [x]% of your vested options. We'll withhold the tax due on exercise from the proceeds, so you won't need to fund it yourself."

Common mistakes#

  1. Assuming DPIIT recognition gives the deferral. It needs the separate IMB certificate.
  2. Using an out-of-date or wrong valuation for perquisite tax.
  3. Not withholding on NSO exercises or Indian perquisites, leaving the company liable.
  4. Forgetting Form 3921 for ISO exercises or the UK ESS return.
  5. Letting employees exercise ISOs without AMT warnings, especially after the 2026 changes.
  6. No liquidity plan, so employees can't afford to exercise.
  7. Ignoring the tax on leaving in India when the deferral ends.
  8. Using old Indian section numbers in documentation after April 2026.
  9. Giving tax advice rather than general information; point employees to advisers.
  • 4.04 DPIIT recognition and Startup India benefits
  • 5.02 ESOP plan design: India (Companies Act rules) vs US (ISOs and NSOs)
  • 5.07 Setting the strike price: US 409A and Indian valuations by a merchant banker
  • 5.09 Exercise windows and what happens when people leave
  • 5.10 ESOP buybacks and liquidity programmes
  • 5.11 Explaining equity to employees: offer letters and equity education
  • 5.18 Equity for employees in other countries

Sources#

← 5.07 Setting the strike price: US 409A and Indian valuations by a merchant banker5.09 Exercise windows and what happens when people leave →