The Lifecycle of an ESOP Grant in India: From Board Approval to Employee Exit

Introduction

An ESOP grant in India passes through eight distinct phases, and each one is governed by a different combination of company law, income tax, accounting and, where foreign parties are involved, exchange control. Most of the expensive mistakes we see are not errors of law in any single phase. They are errors of sequencing: a valuation report that is 200 days old on the exercise date, a grant to a 2% recipient made without the separate shareholder resolution, an exit letter that lets vested options lapse when the scheme allowed a longer exercise window, or a deferral assumed for a start-up that never obtained its Inter-Ministerial Board certificate.

This article follows a single grant from the board meeting that designs the scheme to the employee's eventual exit and sale. It states the law as at 3 November 2026. That date matters more than usual this year. The Income-tax Act, 2025 (Act 30 of 2025) replaced the Income-tax Act, 1961 from 1 April 2026, the Income-tax Rules, 2026 replaced the 1962 Rules on the same day, and the Finance Act, 2026 changed the taxation of share buybacks with effect from the same date. An ESOP grant made in 2023 will therefore commonly see one exercise taxed under the 1961 Act and the next under the 2025 Act. Where a phase straddles the two statutes, both positions are set out.

The substance of ESOP taxation did not change on 1 April 2026; the section numbers did. The perquisite rule formerly in section 17(2)(vi) is now section 17(1)(d) read with section 17(4)(h); the employer's salary withholding formerly in section 192 is now section 392; the start-up deferral formerly in section 192(1C) and section 156(2) is now section 392(3) read with section 289(3); and the deemed cost rule formerly in section 49(2AA) is now Table entry 4 of section 73(1). Older transactions continue to be governed by the 1961 Act provisions in force when they occurred.

One caution on scope. Two significant legislative proposals are pending and are treated here as proposals only: the Corporate Laws (Amendment) Bill, 2026, which would extend section 62(1)(b) to RSUs, SARs and other schemes linked to share value, and has been reported on by a Joint Parliamentary Committee but not passed; and any further change to Rule 12 that may follow it.

The framework at a glance

Five bodies of law apply to an ESOP, and each looks at a different moment. Company law looks at authority and dilution. Income tax looks at the moment value passes to the employee (exercise) and the moment the employee realises it (sale). Accounting looks at the service period between grant and vesting. FEMA looks at whether either party is outside India. Contract and employment law, through the scheme document and grant letter, decide everything the statutes leave open.

The running case study

To keep the phases connected, one set of facts is used throughout. All figures are hypothetical and chosen for arithmetic clarity, not as market benchmarks.

• Company: Kaveri Analytics Private Limited, incorporated in 2020, DPIIT-recognised, not certified by the Inter-Ministerial Board. It is not a small company. It has voluntarily adopted Ind AS. Issued capital before the scheme: 20,00,000 equity shares of ₹10 each.
• Scheme: Kaveri ESOP 2023, pool of 2,00,000 options, approved in March 2023.
• Grantee: Meera, VP Engineering, resident in India, taxed under the new regime (section 115BAC of the 1961 Act; section 202 of the 2025 Act), not a promoter, holding no shares before exercise.
• Grant: 40,000 options on 1 April 2023 at an exercise price of ₹100. Vesting 25% a year on 1 April 2024, 2025, 2026 and 2027. Grant-date fair value ₹62 per option.
• Exercises: Lot A, 10,000 shares on 15 February 2026 (FMV ₹410); Lot B, 10,000 shares on 10 June 2026 (FMV ₹600); Lot C, 10,000 shares on 15 December 2026, after she has left (FMV ₹600).
• Exit: Meera resigns with effect from 30 September 2026. The fourth tranche lapses unvested. On 31 March 2028 Kaveri buys back all 30,000 of her shares at ₹900.
• Salary: ₹48 lakh in FY 2025-26; ₹52.5 lakh in tax year 2026-27 (six months at Kaveri plus six months at her new employer); ₹55 lakh in tax year 2027-28.

The case is deliberately built so that Lot A falls under the 1961 Act and Lots B and C under the 2025 Act, so that her exit interacts with the vesting and deferral rules, and so that the buyback produces both long-term and short-term gains.

Phase 1: Plan design and board approval

What the phase decides. The board fixes the size of the pool, who may participate, how options vest, how the exercise price is set, how long vested options remain exercisable, and what happens on exit. Almost every later dispute traces back to a choice made, or left unmade, at this stage. The board does not create the scheme; it recommends it. Authority to issue shares to employees comes only from the shareholders under section 62(1)(b).

Trigger. Usually a funding round (investors typically require a reserved pool on a fully diluted basis), a senior hire, or the need to replace cash compensation the company cannot yet afford.

Legal framework

Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 sets the outer boundary for unlisted companies. The points that most often drive design are these:

• Who is an "employee". A permanent employee working in or outside India; a director (whole-time or not) other than an independent director; and an employee or director of a subsidiary, holding company or associate company. Excluded are promoters and persons in the promoter group, and directors who, directly or through relatives or a body corporate, hold more than 10% of the outstanding equity.
• The start-up relaxation. For a start-up as defined in DPIIT notification G.S.R. 127(E) dated 19 February 2019, the two exclusions do not apply for ten years from incorporation. The relaxation was inserted in 2016 for five years and extended to ten years by the Companies (Share Capital and Debentures) Amendment Rules, 2019 notified on 16 August 2019. It requires DPIIT recognition only, not Inter-Ministerial Board certification; the IMB certificate matters for the tax deferral discussed in Phase 5. Founders should note the window closes on the tenth anniversary, not the tenth financial year.
• Exercise price. Rule 12(3) gives companies freedom to set the exercise price in conformity with applicable accounting policies. Face value, a discount to fair value, or full fair value are all permissible under company law. The tax and accounting consequences differ sharply (Phases 3 and 5).
• Minimum vesting. Rule 12(6)(a) requires at least one year between grant and vesting, with credit for time held under a predecessor scheme in a merger.
• Exit treatment. Rule 12(8)(f) requires unvested options to expire on resignation or termination, while vested options remain exercisable for the period the scheme specifies. On death, all options vest in the legal heirs or nominees (Rule 12(8)(d)); on permanent incapacity, all options vest in the employee (Rule 12(8)(e)). These are mandatory and override any contrary drafting.

For listed companies, the SEBI (SBEB & SE) Regulations, 2021 apply instead of Rule 12 (Rule 12(11)). They require a compensation (nomination and remuneration) committee to administer the scheme, also prescribe a minimum one-year vesting period, and regulate trust structures. Promoters remain ineligible for new grants, but Regulation 9A, inserted with effect from 8 September 2025, allows a founder later identified as a promoter in the draft offer document to retain and exercise options granted at least one year before that filing.

Process and execution

The board meeting typically approves: the scheme document; the explanatory statement and notice convening the general meeting; any increase in authorised capital; any amendment to the articles if they restrict issue of shares or require specific authority; and, if a trust route is chosen, the trust deed and funding arrangement. A board resolution approving the issue of shares under section 62 does not need to be filed in Form MGT-14 by a private company, but the subsequent special resolution of shareholders does.

The design questions that deserve explicit board minutes are: the pool size and whether it is measured on issued or fully diluted capital; the vesting schedule and any performance conditions; whether vesting accelerates on a change of control (single or double trigger); the post-exit exercise window, which should be stated as a number of days and should allow time to fund the exercise price and tax; whether the company may buy back or arrange a secondary sale; good-leaver and bad-leaver definitions; and what happens to options on a merger or demerger.

Direct or trust route

A company may allot fresh shares directly on exercise, or fund a trust under section 67(3)(b) and Rule 16 of the same Rules to acquire shares and transfer them to employees. The trust route requires a separate special resolution, is limited by the financial assistance cap in Rule 16, and is common in listed companies that want to source shares from the market. Most unlisted companies use the direct route because it avoids the trust's own tax and compliance profile. A trust holding unexercised shares can create a mismatch: the employee's perquisite under section 17(1)(d) includes securities "allotted or transferred, directly or indirectly", so a trust transfer is still taxed at exercise, but the trust's own income tax treatment needs separate advice.

Tax, accounting and compliance at this phase

No tax arises on approving a scheme. No accounting entry arises either; the expense begins only at grant. Compliance consists of the board minutes and the notice to shareholders.

Practical considerations

The most consequential design choice is usually the exercise price. A low exercise price is attractive to employees and is permitted, but it enlarges both the perquisite at exercise and the accounting charge. A price set near fair value reduces both, but may leave little upside for early employees if the valuation stalls. The second most consequential choice is the post-exit exercise window. A 30-day window is commercially convenient for the company but often impractical for an employee in an unlisted company, who must find the exercise price and the perquisite tax without any market for the shares.

In the Kaveri case, the board recommended a 2,00,000-option pool (about 9.1% of fully diluted capital), four-year annual vesting with a one-year cliff, an exercise price fixed at grant by the board, and a 90-day post-exit exercise window for vested options.

Common errors

• Granting to a founder after the ten-year start-up window closes, or to a 10%-plus director in a company that was never DPIIT-recognised.
• Drafting exit clauses that purport to forfeit vested options on resignation without stating an exercise window, which sits uneasily with Rule 12(8)(f).
• Treating the board resolution as sufficient authority to grant.

Transition. The board's recommendation, with its explanatory statement, goes to the shareholders.

Phase 2: Shareholder approval and scheme adoption

What the phase does. It converts a board proposal into legal authority to issue shares to employees without offering them first to existing shareholders. Without it, every later grant and allotment is exposed.

Which resolution

Section 62(1)(b) requires a special resolution. For private companies, MCA notification G.S.R. 464(E) dated 5 June 2015 modified section 62(1)(b) to substitute an ordinary resolution. Rule 12(1), however, still requires a special resolution and has not been conformed. The position is genuinely untidy: the exemption modifies the section, and a rule cannot override a section, but the rule also states the conditions on which a scheme may be offered at all. The practical position almost all advisers take, and the one we recommend, is to pass a special resolution. The cost is negligible and it removes the argument.

What the explanatory statement must contain

Rule 12(2) lists thirteen disclosures: the total number of options; the classes of eligible employees; the appraisal process for eligibility; vesting requirements and period; the maximum vesting period; the exercise price or formula; the exercise period and process; any lock-in; the maximum options per employee and in aggregate; the method the company will use to value its options; conditions under which vested options may lapse (for example, termination for misconduct); the time within which vested options must be exercised on termination or resignation; and a statement that the company will comply with applicable accounting standards. A scheme approved on an incomplete statement is vulnerable to challenge by a dissenting shareholder or investor.

Separate resolutions that are easy to miss

Rule 12(4) requires a separate shareholder resolution for (a) grants to employees of a subsidiary or holding company, and (b) grants to any identified employee, in any one year, equal to or exceeding 1% of the issued capital (excluding outstanding warrants and conversions) at the time of grant.

In the Kaveri case, Meera's grant of 40,000 options against issued capital of 20,00,000 shares is 2%. A separate resolution naming her was required in addition to the scheme resolution. Kaveri passed it at the same meeting in March 2023. Had the company relied on the scheme resolution alone, the grant would have been made without the authority Rule 12(4)(b) requires, and the defect would surface at the worst moment, typically in an investor's due diligence or on an IPO.

Investor consents

Shareholders' agreements usually give investors a veto over new share issues and often specify the pool size. The scheme, its size and any increase almost always need investor consent under the shareholders' agreement in addition to the statutory resolution. The statutory resolution does not cure a contractual breach, and vice versa.

Compliance

Variation later

Rule 12(5) permits variation of unexercised options by special resolution only if the variation is not prejudicial to option holders, and the notice must disclose the variation, its rationale and the beneficiaries. Extending an exercise window or accelerating vesting is generally beneficial; reducing a pool already granted, or tightening leaver terms for existing grants, is not.

Transition. With authority in place and filed, the company may begin issuing grants within the approved pool.

Phase 3: Grant of options

What the phase does. A grant is a contractual offer of a right, but not an obligation, to acquire shares at a fixed price after conditions are met. Nothing changes hands. The employee acquires no shares, no dividend rights and no votes (Rule 12(6)(c)). The options cannot be transferred, pledged or encumbered (Rule 12(8)(a) and (b)).

Trigger. A decision by the board or, if delegated, the compensation committee, followed by issue of a grant letter and, ideally, the employee's written acceptance.

Process

The grant letter should state the number of options, exercise price, grant date, vesting schedule and conditions, exercise window, leaver terms, and a reference to the scheme as the governing document. Particulars must be entered forthwith in the Register of Employee Stock Options in Form SH-6 (Rule 12(10)), authenticated by the company secretary or another person authorised by the board. Rule 12(7) allows an amount to be collected at grant, which may be forfeited if options are not exercised or refunded if they do not vest; this is rare in practice.

The grant date matters for accounting, not tax. Under Ind AS 102 it is the date the company and employee reach a shared understanding of the terms. A board approval followed by a grant letter issued three months later, and accepted a month after that, usually has a grant date at acceptance, with fair value measured then.

Tax

No income tax arises on grant, under either Act. Section 17(1)(d) of the 2025 Act, like section 17(2)(vi) of the 1961 Act, values the perquisite at exercise. That has been the position since the Finance (No. 2) Act, 2009 abolished fringe benefit tax with effect from assessment year 2010-11. Between 1 April 2007 and that change, the employer paid fringe benefit tax on ESOPs, measured with reference to fair market value on the vesting date (CBDT Circular 9/2007 dated 20 December 2007). Grants from that era that remain unexercised are now rare, but the history explains why some old schemes contain tax recovery clauses aimed at the employer's FBT.

Accounting

Under Ind AS 102, an equity-settled award to employees is measured at grant-date fair value, usually through an option pricing model, and charged to profit and loss over the vesting period with a credit to equity (commonly "share options outstanding"). Fair value is not remeasured for later movements in the share price. What is updated at each reporting date is the estimate of the number of options expected to vest, for service and non-market performance conditions. Where an award vests in instalments, each instalment is treated as a separate grant, which front-loads the expense.

Companies not on Ind AS follow the ICAI Guidance Note on Accounting for Share-based Payments (2020). It also requires a fair value approach for new grants. Some commentary states that the intrinsic value alternative available under the earlier guidance note remains available for certain grants; we have not been able to confirm the transitional scope from the primary text and companies relying on intrinsic value should verify it with their auditors.

Kaveri illustration. 40,000 options × ₹62 = ₹24,80,000 total fair value, ₹6,20,000 per tranche of 10,000. Treating each tranche as a separate grant over 1, 2, 3 and 4 years, and assuming at each year-end that all options will vest:

On Meera's resignation in September 2026, tranche 4 is forfeited because the service condition is not met. The ₹4,65,000 recognised for it in the first three years is reversed. The cumulative charge settles at ₹18,60,000, being three tranches of ₹6,20,000. Had she left after vesting but without exercising, no reversal would arise: Ind AS 102 does not reverse expense for vested options that lapse unexercised.

FEMA at grant

If the grantee is a person resident outside India, the grant is a foreign investment event under Rule 8 of the FEMA (Non-debt Instruments) Rules, 2019. The company reports it in Form ESOP on the RBI's FIRMS portal, through its authorised dealer bank, within 30 days of the grant. The grant must respect the sectoral cap and, where the grantee's country requires government approval, that approval. Late filing attracts a late submission fee, and RBI compounding orders show that delays in Form ESOP are a recurring contravention.

Common errors

• Issuing grant letters before the shareholder resolution, or above the per-employee maximum disclosed in the explanatory statement.
• Not updating Form SH-6, which then fails to reconcile with the cap table at diligence.
• Using the tax valuation (a merchant banker FMV) as the accounting fair value. They answer different questions: one values a share on an exercise date, the other values an option on the grant date.

Transition. From grant, the employee earns entitlement by continued service. Nothing further happens until each vesting date.

Phase 4: Vesting

What the phase does. Vesting converts a conditional promise into an exercisable right. Once vested, an option survives resignation for the exercise window the scheme allows (Rule 12(8)(f)), whereas an unvested option lapses.

Trigger. The passage of the stated service period, the satisfaction of any performance condition, or an acceleration event (death, permanent incapacity, or a contractual change-of-control trigger).

Legal points

The one-year minimum in Rule 12(6)(a) is measured from grant to the first vesting, not per tranche. Monthly vesting after a twelve-month cliff is therefore permitted. Accelerated vesting on a change of control is a contractual right, but acceleration cannot bring any vesting inside the first year, except for death or permanent incapacity, where Rule 12(8)(d) and (e) require all granted options to vest. Performance-based vesting is permitted; the explanatory statement must describe it.

A company should record each vesting event in Form SH-6 and confirm it to the employee. A board or committee should certify performance conditions where they apply, because the certification is the evidence if the employee later disputes whether a tranche vested.

Tax on vesting

For an employee, vesting is not a taxable event under either Act. That is the most commonly misunderstood point in ESOP communication, because RSUs granted by foreign parents are often settled automatically at vesting, which then is the exercise date for Indian tax purposes. For an ESOP that requires the employee to pay an exercise price, the tax point is exercise.

For the employer, vesting years are where the question of deductibility arises. The Special Bench of the Bangalore Tribunal in Biocon Ltd. v. DCIT (2013) held that the ESOP discount is employee cost, deductible over the vesting period and adjusted at exercise. The Karnataka High Court affirmed in CIT (LTU) v. Biocon Ltd., [2020] 121 taxmann.com 351; (2021) 430 ITR 151, holding that the discount is not a contingent liability but an ascertained cost of employee services deductible under section 37(1). The Delhi High Court (ITA 564/2012, 2022:DHC:3276-DB) and the Kerala High Court have since followed that reasoning. The Revenue's special leave petition in PCIT v. Lemon Tree Hotels Pvt. Ltd. on the same issue has been admitted by the Supreme Court and, as far as we have been able to verify, remains pending. The point is therefore well supported but not settled. Companies claiming the deduction should do so consistently, document the basis of measurement, and expect it to be raised in assessment.

Two cautions apply. First, the High Court decisions measure the deduction by reference to the discount (market value less exercise price), not the Ind AS 102 option fair value. The tax computation therefore usually needs a separate working rather than the book charge. Second, the 2025 Act has renumbered the general deduction provision; we have not traced any substantive change, but companies should cite the provision applicable to the tax year of claim.

Accounting

The Ind AS 102 charge continues through each vesting period (Phase 3 table). At vesting, the expected-to-vest estimate is trued up to actual. Expense already recognised for options that vest is not reversed if they later lapse unexercised; the balance in share options outstanding is typically transferred within equity.

Practical considerations

Vesting is when communication matters. Employees should be told, at each vesting, the number of vested options, the exercise price, the current tax valuation if one exists, the exercise window and the tax that exercise would trigger. In unlisted companies the absence of this information is the main reason employees either exercise without the cash to pay the tax or let vested options lapse on exit.

Kaveri illustration. On 1 April 2024, 2025 and 2026, Meera vests in 10,000 options each, giving 30,000 vested options by the time she resigns. Tranche 4, due on 1 April 2027, lapses on her exit.

Transition. Vested options remain dormant until the employee chooses to exercise within the scheme's exercise period.

Phase 5: Exercise

What the phase does. The employee pays the exercise price and becomes entitled to shares. This is the first tax point and, for most employees of unlisted companies, the most expensive moment in the lifecycle: tax is payable on value that cannot yet be sold.

Trigger. A written exercise notice within the exercise window, accompanied by the exercise price and, in most companies, the tax the employer must withhold.

The perquisite rule

Section 17(1)(d) of the 2025 Act includes in "perquisite" the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the current or former employer, free of cost or at a concessional rate. Section 17(4)(h) values it at fair market value on the date the option is exercised, less the amount actually paid by or recovered from the employee. The wording reproduces section 17(2)(vi) of the 1961 Act and its Explanation, as substituted by the Finance (No. 2) Act, 2009. The perquisite is salary income, taxed at slab rates, with surcharge and 4% health and education cess.

Three features of the rule matter in practice. The valuation date is the exercise date, not the allotment date, even if allotment follows weeks later. The rule covers a former employer, so exercise after leaving is still a salary perquisite, not a capital receipt. And the amount paid by the employee is deducted only once: if the company lends money for the exercise and later waives it, the waiver is a separate benefit.

Fair market value: Rule 15(6) of the Income-tax Rules, 2026

For exercises on or after 1 April 2026, Rule 15(6) of the Income-tax Rules, 2026 (notified 20 March 2026) prescribes the valuation. It carries forward Rule 3(8) of the 1962 Rules, which governs earlier exercises.

The "specified date" is the exercise date or any earlier date not more than 180 days before it. A company running quarterly exercise windows can therefore use one report for two windows, but a report dated 1 April cannot support an exercise on 15 October (197 days). The Rules define the merchant banker by reference to a Category I merchant banker registered with SEBI. SEBI overhauled its merchant banker regulations in December 2024; companies should confirm that their valuer's current registration fits the definition in the Rules. A registered valuer under section 247 of the Companies Act, or a chartered accountant, does not satisfy the rule for this purpose.

Withholding: section 392

The employer must deduct tax under section 392(1) (formerly section 192(1)) at the average rate on estimated salary for the year, including the perquisite. Because the perquisite is non-monetary, the deduction has to come from cash salary or from cash the employee provides. Most companies make allotment conditional on the employee paying the exercise price and the tax together. Section 392(2)(a) also allows the employer, at its option, to pay the tax on a non-monetary perquisite itself; the tax so paid has its own consequences and should be agreed with the employee in writing.

Where the employee has already left, as with Meera's Lot C, the former employer no longer pays salary from which to deduct. The perquisite is still the former employer's salary payment for TDS purposes, and the practical answer is the same: collect the tax with the exercise price before allotment and deposit it. Companies that allot first and chase the tax later routinely end up treated as assessees in default.

The start-up deferral: section 392(3) read with section 289(3)

An eligible start-up within section 140 (formerly section 80-IAC) deducts tax on the section 17(1)(d) perquisite at the rates in force for the tax year of allotment, but within the time section 289(3) gives the employee. That is fourteen days after the earliest of:

1. expiry of sixty months from the end of the relevant tax year;
2. the date of sale of the shares; or
3. the date the employee ceases to be employed by the employer that allotted them.

Under the 1961 Act (section 192(1C), section 156(2), section 191(2) and section 140A, inserted by the Finance Act, 2020 for perquisites from 1 April 2020), the first limb was forty-eight months from the end of the relevant assessment year. Some commentary describes the 2025 Act as extending the window from 48 to 60 months. It does not, in substance. An assessment year ends twelve months after the financial year it relates to, so forty-eight months from the end of the assessment year and sixty months from the end of the tax year fall on the same date. The change is drafting, required by the replacement of "assessment year" with "tax year".

Three conditions limit the relief. The employer must be an eligible start-up under section 140: DPIIT recognition is not enough; it needs the Inter-Ministerial Board certificate. The Finance Act, 2026 raised the turnover ceiling for eligibility from ₹100 crore to ₹300 crore with effect from 1 April 2026, aligning it with DPIIT's notification of 4 February 2026. The relief defers payment, not income: the perquisite is still income of the year of exercise and appears in that year's return. And cessation of employment ends the deferral, which in practice means the deferral is worth most to employees who stay.

Kaveri illustration: tax at exercise

Assumptions: new regime throughout; standard deduction ₹75,000; no other income or deductions; Kaveri is not an eligible start-up. Slab rates for FY 2025-26 under section 115BAC(1A) of the 1961 Act and for tax year 2026-27 under section 202 of the 2025 Act are the same: nil to ₹4 lakh, then 5%, 10%, 15%, 20% and 25% for each successive ₹4 lakh, and 30% above ₹24 lakh. Surcharge is 10% above ₹50 lakh and 15% above ₹1 crore. Cess is 4%.

Lot A, exercised 15 February 2026 (FY 2025-26; 1961 Act). Perquisite = (₹410 - ₹100) × 10,000 = ₹31,00,000.

Incremental tax from the exercise: ₹11,67,660, or 37.7% of the perquisite. Meera's cash outflow in February 2026 is ₹10,00,000 exercise price plus ₹11,67,660 tax, about ₹21.7 lakh, for shares she cannot sell.

Lots B and C, exercised 10 June and 15 December 2026 (tax year 2026-27; 2025 Act). Perquisite per lot = (₹600 - ₹100) × 10,000 = ₹50,00,000; ₹1,00,00,000 for both.

Incremental tax: ₹36,46,890, or 36.5% of the perquisite. The effect of crossing ₹1 crore is visible: the surcharge on her ordinary salary also rises from 10% to 15%. Marginal relief does not apply at either income level; it is relevant only for incomes just above a surcharge threshold, and we have checked that neither the ₹51.75 lakh nor the ₹1.5175 crore case falls within its range.

If Kaveri had been an eligible start-up. Tax on Lot B would be computed at tax year 2026-27 rates, but payable within fourteen days of the earliest of 31 March 2032 (sixty months after 31 March 2027), the sale on 31 March 2028, and her cessation on 30 September 2026. The cessation governs: tax due by 14 October 2026. The deferral would have bought four months. For Lot A under the 1961 Act, the forty-eight-month limb ran to 31 March 2031, but cessation again governs. Whether the deferral applies at all to Lot C, allotted after she had already ceased to be an employee, is a question the text does not answer cleanly; the conservative view is that it does not.

Funding the exercise

Section 67(3)(c) of the Companies Act permits a company to lend to employees other than directors and key managerial personnel, up to six months' salary, to buy fully paid shares to be held as beneficial owner. Private companies have a conditional exemption from section 67 under the June 2015 notification. Loans of this kind need board approval, documented terms and, for interest-free or concessional loans, attention to the separate perquisite for concessional loans under Rule 15. Many unlisted companies instead arrange a contemporaneous secondary sale or buyback so that employees can sell enough shares to fund the tax; the timing has to be engineered carefully because the sale, not the exercise, determines the capital gain.

Common errors

• Using a valuation report more than 180 days old, or one issued by a person who is not a merchant banker within the Rules.
• Assuming the deferral because the company is DPIIT-recognised.
• Failing to collect the tax before allotment, then being unable to recover it from a departed employee.
• Not telling departing employees that exercising after exit still produces a salary perquisite.

Transition. Exercise creates an obligation on the company to allot shares, and a stream of company law and, where relevant, FEMA filings.

Phase 6: Allotment and post-allotment compliance

What the phase does. It turns an exercised option into a share on the register. For the employee, the allotment date is the start of the capital gains holding period. For the company, it triggers a set of filings with short deadlines.

Trigger. Receipt of a valid exercise notice with the exercise price and the tax.

Process and filings

The Rule 9B point deserves emphasis. Companies that were not small companies on 31 March 2023 had to comply by 30 June 2025, after an extension notified on 12 February 2025. Companies that cease to be small later get eighteen months from the end of that financial year. An ESOP allotment in physical form by a company within Rule 9B is a non-compliant issue. Small-company status should be re-tested every year, because a funding round can increase paid-up capital past the limit.

A lock-in on shares allotted under the scheme is permitted (Rule 12(6)(b)) and, if disclosed in the explanatory statement, binds the employee. Transfer restrictions in the articles and shareholders' agreement (rights of first refusal, drag and tag) usually apply to ESOP shares in any event.

Accounting at exercise

The company receives the exercise price and transfers the related balance from share options outstanding. For Lot A (tranche 1, fully expensed at ₹6,20,000):

The tax perquisite (₹31,00,000) and the accounting charge (₹6,20,000) for the same lot bear no relation to each other. The first reflects the share price on the exercise date; the second reflects the option value at grant. Finance teams should not reconcile them; they should explain why they differ.

Kaveri illustration: valuation and cap table

Kaveri obtained merchant banker reports dated 31 December 2025 (₹410), 31 March 2026 (₹600) and 30 September 2026 (₹600). Lot A on 15 February 2026 relied on the December report (46 days); Lot B on 10 June 2026 on the March report (71 days); Lot C on 15 December 2026 on the September report (76 days). Each was within 180 days. After the three allotments, Meera holds 30,000 shares, about 1.5% of the 20,30,000 shares then in issue if no other options have been exercised.

Common errors

• Missing the PAS-3 deadline, a common default because allotments in exercise windows are frequent and small.
• Allotting in physical form after Rule 9B applies.
• Forgetting FC-GPR for an employee who had become non-resident by the exercise date.
• Omitting the Rule 12(9) table from the directors' report.

Transition. The employee is now a shareholder. Between allotment and exit, the shares are exposed to the company's corporate actions and the employee's own changes in circumstance.

Phase 7: Holding period and corporate events

What the phase does. Between allotment and sale the employee is an ordinary shareholder, but one whose cost base and holding period were fixed by the ESOP rules. Corporate actions during this period can change the number of shares, the identity of the issuer, or the value, and each has its own consequence.

The two numbers that carry forward

The cost of acquisition of shares acquired under the scheme is the fair market value taken into account for the perquisite: section 73(1), Table entry 4 of the 2025 Act (formerly section 49(2AA)). Not the exercise price. This prevents the same value being taxed twice, once as salary and again as capital gain.

The holding period runs from the date of allotment or transfer of the shares, not from grant or vesting. For unlisted shares the long-term threshold under section 2(101) of the 2025 Act is more than 24 months; for listed equity shares it is more than 12 months. These thresholds were set by the Finance (No. 2) Act, 2024 for transfers on or after 23 July 2024 and carry forward unchanged into the 2025 Act.

The consequence is that an employee who exercises early starts the holding clock early. The trade-off is that early exercise accelerates the perquisite tax and exposes the employee to a fall in value after paying tax on a higher FMV.

Corporate events

Payments for diminution in option value

The tax treatment of cash paid to option holders, without exercise, to compensate for a fall in value is unsettled, and the cases arose from the same event: a payment by Flipkart's Singapore parent to holders of its options following the separation of PhonePe.

• Delhi High Court, Sanjay Baweja v. DCIT, W.P.(C) 11155/2023 (May 2024): the payment to a former employee on unexercised options was not a perquisite, because no exercise had occurred; it was treated as a capital receipt.
• Madras High Court, Nishithkumar Mukeshkumar Mehta v. DCIT (July 2024), reported at 165 taxmann.com 386: the payment arose from employment and was a perquisite under section 17(2)(vi). The case is reported to be in appeal before a Division Bench.
• Karnataka High Court, Manjeet Singh Chawla v. DCIT, W.P. No. 20212 of 2023 (2 June 2025): the payment was a capital receipt not chargeable to tax and no TDS obligation arose; the court declined to follow the Madras reasoning.

The decisions are of co-ordinate High Courts and bind only within their territories. A company making such a payment should decide its withholding position knowing that the position may differ by the employee's jurisdiction, and should document whether the options are being cancelled (which is closer to a transfer) or retained with compensation for lost value (the fact pattern in all three cases). Reports indicate that a 2026 Tribunal decision treated an actual repurchase and extinguishment of options as a transfer giving rise to capital gains; we have not been able to read that order and do not rely on it.

Practical considerations

The scheme document is the only place where bonus, split and merger adjustments to unexercised options can be dealt with cleanly. Schemes that are silent leave the board choosing between an adjustment that may be challenged as a variation and doing nothing, which dilutes option holders. A short adjustment clause, approved with the scheme, avoids both.

Kaveri illustration. No corporate action occurs. Meera's three lots carry these attributes into the exit:

We have assumed allotment on the exercise date for simplicity. In practice a gap of a few days shifts the holding period by the same few days.

Phase 8: Employee exit

"Exit" has two meanings in an ESOP and they rarely coincide. The employee leaves the company, which decides what happens to options. The employee later sells the shares, which is the second tax point. The second may come years after the first.

8A. Cessation of employment

Legal position. On resignation or termination, unvested options expire, and vested options remain exercisable within the period the scheme specifies (Rule 12(8)(f)). The scheme may, and usually does, provide that all options, vested or not, lapse on termination for misconduct; Rule 12(2)(k) expects such conditions to be disclosed in the explanatory statement. Death and permanent incapacity trigger full vesting (Rule 12(8)(d) and (e)). Retirement is not mentioned in Rule 12 and is governed entirely by the scheme.

Good and bad leaver. These are contractual categories. A bad-leaver clause that forfeits vested options for reasons other than misconduct, or that gives the company a call option on allotted shares at cost, is common in investor-backed companies but should be read carefully against Rule 12(8)(f) and the explanatory statement. Disputes in this area are usually about whether the conduct alleged meets the scheme's definition, and the company's best protection is a clear definition and a contemporaneous board record.

Process. The exit letter should list vested and unvested options, the exercise window and its end date, the exercise price, the most recent tax valuation and its date, and the tax that will be collected on exercise. It should also state whether the start-up deferral (if available) ends on cessation, because it does.

Kaveri illustration. Meera resigns with effect from 30 September 2026. Tranche 4 (10,000 options) lapses unvested; the accounting reversal is shown in Phase 3. She holds 10,000 vested, unexercised options (tranche 3) and has 90 days. She exercises them as Lot C on 15 December 2026, day 76.

8B. Liquidity: the routes to sale

Buybacks after the Finance Act, 2026

Buyback taxation has changed three times in eight years, and the date of the buyback decides which regime applies:

Under the 2026 regime, promoters pay an additional income-tax under section 69(2) designed to produce an effective rate of about 30% for non-corporate promoters and 22% for corporate promoters. As enacted, the additional tax applies only to buybacks under section 68 of the Companies Act, and the 12% surcharge prescribed on it applies to the additional tax alone, as the Income Tax Department clarified in March 2026. Employees who are not promoters are outside it. Founders who hold ESOP shares and are also promoters, which the Rule 12 start-up relaxation makes possible, are inside it.

Kaveri illustration: the buyback

On 31 March 2028 Kaveri buys back Meera's 30,000 shares at ₹900 under section 68. The sale falls in tax year 2027-28. We have assumed that tax year 2027-28 rates are the same as tax year 2026-27; the Finance Act for that year has not yet been enacted, and the figures should be refreshed when it is. Her salary from her new employer is ₹55 lakh.

Long-term gain on unlisted shares is taxed at 12.5% without indexation under section 197. Short-term gain on unlisted shares is not within section 196 (which is confined to listed equity on which STT is paid) and is taxed at slab rates.

Incremental tax on the buyback: ₹29,48,140. The 15% cap on surcharge for capital gains is not binding at this income level, because the general rate is also 15%. Had the buyback happened about six weeks earlier, on 14 February 2028, Lot A would also have been short-term and taxed at slab rates.

If Meera had been a promoter, the additional tax under section 69(2) would apply on top. If the same buyback had taken place in March 2026, under the 2024 regime, the whole ₹2.7 crore consideration would have been taxed as dividend at slab rates, and her cost of ₹1.61 crore (₹41 lakh for Lot A and ₹1.2 crore for Lots B and C) would have been recognised only as a capital loss, usable only against capital gains.

The whole lifecycle, from Meera's side

The income column reconciles: 30,000 shares × (₹900 - ₹100) = ₹2.40 crore. The overall tax is 32.3% of the economic gain. Of the ₹2.40 crore, ₹1.31 crore was taxed as salary before she could sell a single share, and she funded ₹78.1 lakh of exercise price and tax out of her own resources between February and December 2026.

Transition. With the shares extinguished and the filings complete, the grant's lifecycle ends.

Cross-border dimensions

Foreign elements arise in two directions, and they are governed by different FEMA regimes.

An Indian company granting to people outside India

Rule 8 of the FEMA (Non-debt Instruments) Rules, 2019 permits an Indian company to issue options and shares to employees or directors resident outside India, including those of its holding company, joint venture or wholly owned overseas subsidiary, within the sectoral cap and with government approval where the sector or the grantee's country requires it. Each grant is reported in Form ESOP within 30 days and each allotment in Form FC-GPR within 30 days, both through the authorised dealer bank on FIRMS. Shares allotted on exercise of an option issued while the employee was resident in India are held on a non-repatriation basis even if the employee has since become non-resident (second proviso to Rule 8; Master Direction on Foreign Investment). A later transfer between a resident and a non-resident requires Form FC-TRS.

For tax, a non-resident employee's perquisite is taxable in India to the extent it is attributable to services rendered in India, and treaty relief may apply. The attribution method (typically by days worked in each country over the period from grant to vesting) is a matter of practice and treaty interpretation rather than express statutory rule; employers should agree a method and apply it consistently, because the withholding obligation follows it.

A foreign parent granting to Indian residents

Schedule III of the Overseas Investment Rules, 2022 permits a resident individual who is an employee or director of an Indian office, branch or subsidiary of the overseas entity, or of an Indian entity in which it holds equity, to acquire shares under its ESOP or employee benefit scheme. Where the holding is below 10% and carries no control, it is overseas portfolio investment. The value counts towards the individual's Liberalised Remittance Scheme limit. The Indian employer, not the employee, reports it in Form OPI through its AD bank within 60 days of each half-year ending 30 September and 31 March (Regulation 10(3), Overseas Investment Regulations, 2022). Before 22 August 2022 the reporting was an annual Form ESOP return; companies still filing the old form are filing under a regime that no longer exists.

The tax perquisite on foreign parent shares follows the same section 17(1)(d) rule. Rule 15(6) refers to shares "listed on a recognised stock exchange", which is defined by reference to Indian exchanges, so a share listed only on a foreign exchange falls literally within the unlisted limb requiring a merchant banker. Common practice uses the foreign market price, supported by a merchant banker certificate. Employees must disclose the shares in Schedule FA of their return, and claim credit for any foreign tax through the prescribed foreign tax credit form.

Where the Indian subsidiary reimburses its parent for the cost of the awards, the recharge raises three separate questions: transfer pricing (whether the charge is at arm's length), deductibility in India (generally allowed where the cost relates to services rendered to the Indian entity), and indirect tax on the recharge. We flag the GST treatment of such recharges as a point on which companies should take specific advice; it depends on how the arrangement is characterised and we have not undertaken a primary-source review of it for this article. Grants by an Indian employer to its own employees are not a supply for GST purposes, because services by an employee to the employer in the course of employment fall within Schedule III of the CGST Act.

Employees who change residence

An employee who exercises while resident, then moves abroad, remains taxable in India on the capital gain from Indian company shares under domestic law, subject to treaty relief. Withholding on payments to a non-resident seller applies, which changes the mechanics of any buyback or secondary sale. The FEMA consequence is the non-repatriation status noted above.

Common errors and risk areas

The errors listed under each phase share a small number of causes. Grouped by cause, they are easier to prevent.

Two risks deserve separate mention because they are often missed by both companies and employees. The first is liquidity mismatch. Exercise is taxed on value the employee cannot sell, and the Kaveri case shows the scale: ₹78 lakh paid out before any sale was possible. Schemes that allow exercise only on a liquidity event, or companies that arrange a sale window alongside each exercise window, remove most of this risk. The second is downside after exercise. If the value falls after exercise, the perquisite tax already paid is not refunded; the employee is left with a capital loss that can be set off only against capital gains.

Consolidated lifecycle and compliance overview

1. 1 Board approvalPool, price, vestingNo tax, no entry
2. 2 Shareholder voteSR; Rule 12(4) if 1%+MGT-14 in 30 days
3. 3 GrantSH-6; Form ESOP if NRInd AS 102 expense
4. 4 VestingAt least 1 yearNo tax for employee
5. 5 ExerciseSalary: FMV less priceTDS s.392; Rule 15(6)
6. 6 AllotmentPAS-3 in 30 daysHolding period starts
7. 7 HoldingCost = FMV taxedCorporate events
8. 8 Exit and saleCapital gainsBuyback under s.69

Tax event for the employee

Only two of the eight phases create tax for the employee; the other six are about authority, records and filings, and that is where most defaults occur.

Conclusion

An ESOP is usually discussed as a compensation decision. In practice it is a long-running administrative obligation that begins at the board meeting and ends, years later, with a buyback filing or a demat transfer. The legal content of each phase is not especially complex. What makes ESOPs go wrong is that eight phases fall under different statutes, are handled by different people (company secretary, finance, HR, the valuer, the employee) and occur years apart.

Three practical conclusions follow from the Kaveri case. First, design choices made at Phase 1, particularly the exercise window and whether exercise can be matched with a liquidity event, determine how much of the grant's value the employee actually keeps. Second, the start-up deferral is narrower than it is often presented: it requires the IMB certificate, it defers payment rather than income, and it ends on cessation. Third, the 2026 changes to buyback taxation have made company buybacks a materially more efficient exit route for non-promoter employees than they were between October 2024 and March 2026, which is worth revisiting for any company that has deferred a liquidity programme.

For transactions straddling 1 April 2026, the discipline is simple to state: identify the date of each event, apply the Act and Rules in force on that date, and cite the corresponding section. The substance has carried over; the citations have not.

References and points flagged for confirmation

Primary sources relied on

Cases

Case details are drawn from law-firm and law-report summaries (Trilegal, Nishith Desai Associates, TaxGuru on Biocon line) and the Delhi High Court order in ITA 564/2012. The full judgments should be read before reliance in any proceeding.

Points we could not confirm from primary text

• Section 289(3) wording. We relied on a reproduction of the enacted section.
• Finance Act, 2026 text. Buyback and section 140 changes are taken from professional summaries consistent with each other and with the Department's March 2026 clarification; the gazetted Act should be checked for exact section numbering.
• Tax year 2027-28 rates. The buyback illustration assumes the 2026-27 slabs, surcharge and cess continue.
• ICAI Guidance Note transition. Whether intrinsic value remains available for any grants.
• Merchant banker definition. Fit between the Rules' "Category I" wording and SEBI's December 2024 revision of the merchant banker regulations.
• 2026 Tribunal decision on repurchase of options. Reported, not read.
• GST on parent recharges. Not reviewed for this article.
• Lot C deferral. Whether section 289(3) can apply to shares allotted after cessation is not addressed by the text; we have taken the conservative view.

This article is general information on the law as at 3 November 2026 and is not advice on any particular transaction.