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In India, ESOP taxation under Section 17(2)(vi) has long been a structural pain point.
Employees are taxed on notional gains at the time of exercise, when shares are allotted, even though the shares may not be sold at that stage and no cash may be realised.
But for startups that are DPIIT-recognised and certified under Section 80-IAC, employees are permitted to defer perquisite tax on ESOP exercise and sweat equity shares until a genuine liquidity event, such as the actual sale of shares.
This allows equity incentives to function as true long-term incentives.
How ESOPs are taxed under Section 17(2)(vi)
Under Section 17(2)(vi) of the Income Tax Act, 1961, ESOPs and sweat equity shares are treated as perquisites.
At the time of exercise and allotment, the difference between the Fair Market Value (FMV) and the exercise price is taxed as salary income. When the shares are eventually sold, any further appreciation is taxed separately as capital gains.
A. How perquisite value is calculated
Perquisite value = (FMV on exercise date − exercise price) × number of shares
For example
- Exercise price: ₹50 per share
- FMV on exercise: ₹150 per share
- Shares exercised: 2,000
Perquisite value = (150 − 50) × 2,000 = ₹2,00,000
This ₹2 lakh is taxed as salary income in the year of exercise, despite no sale of shares and no cash realisation. Employers are required to withhold TDS on the perquisite at the time of exercise.
B. ESOP tax at sale
When the employee eventually sells the shares, a separate capital gains tax applies. The FMV used earlier for perquisite taxation becomes the cost of acquisition for capital gains purposes.
Learn how ESOP tax is calculated and disclosed in ITR.
ESOP and sweat equity perquisite tax deferral for eligible startups
To address cash-flow challenges, the Finance Act, 2020 introduced a tax deferral for employees of eligible startups under Section 80-IAC. The intent was to ease the immediate tax burden arising at exercise, particularly in early-stage companies.
What “tax deferral” actually means
For qualifying startups, the perquisite continues to be valued at the time of exercise, but the obligation for the employee to pay tax, and for the employer to deduct TDS, is postponed.
The tax becomes payable within 14 days of the earliest of the following events:
- Completion of 48 months from the end of the assessment year in which the shares were allotted
- The date on which the shares are sold by the employee
- The date on which the employee ceases to be employed by the company
Even though this framework does not fully eliminate timing mismatches, it shifts taxation closer to liquidity and gives employees additional time to plan for the tax outflow or access liquidity.
Who qualifies as an “eligible startup” for perquisite tax deferral?
The perquisite tax deferral applies only to employees of startups that qualify as “eligible startups” under Section 80-IAC of the Income Tax Act, 1961.
1. DPIIT Recognition
To be considered, a company must first be recognised as a startup by the Department for Promotion of Industry and Internal Trade (DPIIT). This recognition is based on factors such as:
- Incorporated as a private limited company, partnership firm, or LLP
- Engaged in innovation, development, or improvement of products or services
- Annual turnover does not exceed INR 100 crore in any of the previous financial years
- Classified as a startup for a period of up to 10 years from the date of incorporation
However, DPIIT recognition by itself does not make a startup eligible for perquisite tax deferral.
2. Certification under Section 80-IAC is mandatory
In addition to DPIIT recognition, the startup must obtain separate certification as an “eligible startup” under Section 80-IAC.
This certification requires approval from the Inter-Ministerial Board (IMB) and incorporation after 1 April 2016. Only startups that meet this requirement qualify for income tax benefits under Section 80-IAC, and perquisite tax deferral is available only to employees of such startups.
Extending perquisite tax deferral beyond Section 80-IAC
While well-intentioned, the current perquisite tax deferral framework applies to a limited set of startups.
As of April 2025, only about 3,700 startups have received Section 80-IAC certification, out of more than 1.9 lakh DPIIT-recognised startups.
Recent policy reporting indicates that the government is examining the possibility of extending perquisite tax deferral to all DPIIT-recognised startups, with the proposal under consideration ahead of the Union Budget 2026–27.
ESOPs play a central role in startup compensation, but taxation at the exercise stage continues to weaken their effectiveness. Expanding tax deferral beyond Section 80-IAC would materially broaden its impact and better align ESOP/sweat equity taxation with how equity compensation operates in practice.
