ESOP Taxation in India: Exercise, Sale and the Valuation Rule

ESOPs are taxed twice, at exercise as salary and at sale as capital gains, and in an unlisted company both numbers depend on a merchant banker's certificate that must be less than 180 days old.

Last verified: 5 September 2026 · Applies to: Tax Year 2026-27

Contents

• Grant and vesting are not taxable events
• Exercise: the perquisite and the TDS trap
• The certificate founders forget to budget for
• Sale: capital gains and the four permutations
• Illustrative example: one employee, grant to sale
• The start-up deferral, and why it rarely applies
• Reporting and the paperwork trail
• Frequently asked questions
• How BVACA can help

Grant and vesting are not taxable events

Nothing is taxed when options are granted, and nothing is taxed when they vest. An employee who holds fully vested options and never exercises them has no Indian tax liability on them, however valuable the company has become.

That is the whole of the good news, and it is worth stating clearly because it shapes everything that follows: the employee controls the timing of the first tax event by choosing when to exercise. In an unlisted company, where there is no market to sell into, that choice is the single most consequential financial decision an ESOP holder makes.

Exercise: the perquisite and the TDS trap

Exercise is the first taxable event. The gain is taxed as salary, as a perquisite:

Perquisite = (FMV on the exercise date − exercise price) × number of shares exercised

It is taxed at slab rates, which works out to an effective 31% to 43% for most employees at start-up salary levels once surcharge and cess are counted.

Three mechanical points that cause more problems than the rate does.

The employer must deduct TDS in the month of exercise. This was section 192 of the 1961 Act; from 1 April 2026 it is section 392 of the Income-tax Act, 2025. The obligation is on the company, not the employee, and it arises in the month the options are exercised, not in the month cash appears.

Failure is expensive. A company that does not deduct is treated as an assessee in default under section 201, with interest at 1.5% per month, and it risks losing the deduction for the salary expense. Unlike most TDS defaults, this one compounds quietly: the exercise happened, the perquisite crystallised, and the company has no cash from the employee to deduct from.

There is no cash. This is the practical heart of it. In an unlisted company the employee pays the exercise price out of pocket, receives shares that cannot be sold, and simultaneously triggers a tax bill on a paper gain. The company has to deduct TDS on that paper gain from the employee's actual salary, which for a large exercise can exceed the month's take-home pay entirely.

The standard answer is sell-to-cover: the employee sells enough shares, usually back to the company or into a secondary window, to fund the exercise price and the tax. It requires a buyer and a liquidity event, which is precisely what an unlisted company does not routinely have. Companies that run a periodic buy-back or secondary window solve this; companies that do not end up with employees who cannot afford to exercise vested options.

The certificate founders forget to budget for

For a listed company, FMV on the exercise date is the exchange price on that date. Simple.

For an unlisted company, FMV must come from a valuation by a SEBI Category I Merchant Banker. This is mandatory under Rule 15 of the Income-tax Rules, 2026 (the successor to Rule 3(9)(ii) of the 1962 Rules), and the certificate must be no more than 180 days old as at the exercise date.

Three things follow, and each of them regularly goes wrong.

A chartered accountant's valuation will not do. Rule 15 names the SEBI Category I Merchant Banker specifically. This is narrower than the FEMA signatory list and different from the Companies Act requirement, and it is not a matter of professional standing but of the rule's wording. A company that has an IBBI Registered Valuer report and a CA certificate on file may still have no valid ESOP perquisite FMV.

The 180-day clock runs to the exercise date, not the grant date. A certificate obtained at the last funding round is not automatically available for an exercise eighteen months later. If exercises happen in waves, the certificate has to be refreshed, and a company that allows exercises on a rolling basis needs a rolling certificate schedule.

Rule 15 permits DCF; Rule 57 does not. This asymmetry is worth internalising. The merchant banker computing ESOP perquisite FMV may use discounted cash flow and typically will. The formula that fixes fair market value of unquoted equity shares for other income-tax purposes, Rule 57, which values unquoted equity shares on a different basis, excludes DCF. The same company can therefore have a Rule 15 FMV well above its Rule 57 figure on the same day, and both are correct because they answer different statutory questions. If DCF itself is unfamiliar territory, our primer explains how a DCF is actually built.

Sale: capital gains and the four permutations

The second taxable event is sale. The important structural point is the cost base:

Capital gain = sale price − FMV on the exercise date

The exercise-date FMV, on which the employee has already paid tax as salary, becomes the cost of acquisition. The exercise price paid does not. Employees who compute their gain from the ₹10 they paid rather than the ₹210 they were taxed on are paying tax twice on the same amount, and it is a common self-inflicted error in self-filed returns.

The holding period runs from the date of allotment on exercise, not from grant or vesting.

Surcharge and cess apply as usual on top. The unlisted short-term line is the one that hurts most: an employee who exercises and sells within 24 months of a private company's shares is taxed at slab on the perquisite and then at slab again on the capital gain.

Illustrative example: one employee, grant to sale

Illustrative example. Figures are invented for illustration and are not a client matter.

An employee of an unlisted Indian private company holds 10,000 vested options with an exercise price of ₹10 per share.

Step 1, valuation. The company obtains a Rule 15 certificate from a SEBI Category I Merchant Banker dated 20 May 2026, showing FMV of ₹210 per share.

Step 2, exercise on 15 September 2026. That is 118 days after the certificate date, comfortably inside the 180-day window, so the certificate is available.

• Exercise cost paid by the employee: 10,000 × ₹10 = ₹1,00,000
• Perquisite: (₹210 − ₹10) × 10,000 = ₹20,00,000, taxable as salary in Tax Year 2026-27
• The company must deduct TDS on that ₹20,00,000 under section 392 in September 2026 and deposit it by 7 October 2026

Step 3, sale in November 2029 at ₹640 per share.

• Holding period from 15 September 2026 exceeds 24 months, so the gain is long-term
• Capital gain: (₹640 − ₹210) × 10,000 = ₹43,00,000
• Tax at 12.5% without indexation: ₹5,37,500, plus surcharge and cess as applicable

Note what would have happened if the employee had computed the gain from the ₹10 exercise price: a gain of ₹63,00,000 instead of ₹43,00,000, and roughly ₹2.5 lakh of tax paid on income that had already been taxed as salary three years earlier.

Note also the cash timing. The employee funded ₹1,00,000 of exercise cost and tax on ₹20,00,000 of paper income in September 2026, and saw the first rupee of actual proceeds in November 2029.

The start-up deferral, and why it rarely applies

There is a relief, and it is narrower than its reputation.

A DPIIT-recognised start-up holding an Inter-Ministerial Board certificate under section 80-IAC of the 1961 Act, now section 140 of the Income-tax Act, 2025, may defer the perquisite tax on exercise. The mechanism was section 192(1C); from 1 April 2026 it is section 392(3) read with section 289(3).

The deferral runs until the earliest of three events:

1. Expiry of the deferral window
2. Sale of the shares
3. Cessation of employment

The window itself was extended:

Now the constraint. Roughly 3,700 of approximately 1.97 lakh DPIIT-recognised start-ups hold the section 80-IAC certificate the deferral requires. DPIIT recognition on its own does not qualify a company; the Inter-Ministerial Board certificate is a separate application with a separate approval. The great majority of Indian start-ups that believe they can offer deferred ESOP taxation to employees cannot, and discover this only when an employee exercises.

Two consequences worth acting on. If you hold the certificate, tell your employees, because the deferral changes exercise decisions materially. If you do not hold it and you intend to build a meaningful ESOP programme, the DPIIT recognition and the section 140 tax holiday route deserves proper consideration rather than an assumption.

Note that cessation of employment is a trigger. An employee who exercises under deferral and then resigns brings the deferred tax forward immediately, typically without a corresponding liquidity event. Exit planning and ESOP planning have to be done together.

Reporting and the paperwork trail

The documents a company should be able to produce for any exercise, without searching: the ESOP scheme and shareholder approval; the grant letter and vesting schedule; the Rule 15 merchant banker certificate covering the exercise date; the perquisite computation per employee; the TDS challan for the month of exercise; and the board resolution allotting the shares. That set answers almost every question a reviewing officer will ask, and assembling it after the fact takes several times longer than keeping it as you go.

Frequently asked questions

When is ESOP taxed in India?

Twice. First at exercise, as a salary perquisite equal to fair market value on the exercise date minus the exercise price, taxed at slab rates with TDS deducted by the employer in the month of exercise under section 392. Second at sale, as capital gains computed as sale price minus the exercise-date fair market value. Grant and vesting are not taxable events.

Who can value shares for ESOP purposes?

For an unlisted company, only a SEBI Category I Merchant Banker, under Rule 15 of the Income-tax Rules, 2026 (the successor to Rule 3(9)(ii)). A chartered accountant's certificate or an IBBI Registered Valuer report does not satisfy this rule. The certificate must be no more than 180 days old as at the exercise date.

How old can the ESOP valuation certificate be?

No more than 180 days as at the exercise date. The clock runs to exercise, not to grant, so a certificate obtained for a funding round is not automatically available for exercises many months later. Companies allowing rolling exercises need a rolling certificate schedule.

Can start-ups defer ESOP tax?

Only DPIIT-recognised start-ups that also hold an Inter-Ministerial Board certificate under section 80-IAC, now section 140. Deferral runs to the earliest of the window expiry, sale of shares or cessation of employment. The window is 48 months from the end of the relevant assessment year for allotments before 1 April 2026 and 60 months for allotments on or after that date. Roughly 3,700 of about 1.97 lakh recognised start-ups hold the certificate.

What is the cost of acquisition when I sell ESOP shares?

The fair market value on the exercise date, which is the amount already taxed as a perquisite, not the exercise price you paid. Using the exercise price instead inflates the capital gain and results in tax being paid twice on the same income.

What happens if the employer does not deduct TDS on exercise?

The company becomes an assessee in default under section 201, with interest at 1.5% per month, and it risks losing the deduction for the salary expense. Because the perquisite is a paper gain, there is often no cash to deduct from, which is why sell-to-cover arrangements are set up before an exercise window opens rather than after.

How BVACA can help

Bachhal Vijender & Associates advises unlisted companies on the full ESOP cycle: scheme design and shareholder approval, coordinating the SEBI Category I Merchant Banker certificate so it is current at each exercise window, computing the perquisite and the section 392 TDS per employee, and running the capital gains position for employees at sale. Because we also prepare Rule 57 workings and section 247 reports, we can flag early where the ESOP valuation and the transaction valuation will legitimately differ and document why, which is the question an assessing officer asks first. If your scheme is being designed alongside a funding round, our startup fundraise and cap table advisory work and our ESOP valuation and perquisite FMV certificates usually run together.

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Author box: CA Vijender Singh Bachhal, Managing Partner, Bachhal Vijender & Associates (FRN 028355N), Panchkula. About the firm

Disclaimer: This article is general information current as at 5 September 2026, not advice for a specific situation. Tax and corporate law in India changed materially on 1 April 2026; verify the position before acting. Illustrative examples are not client matters.