ESOP Structuring & Tax Advisory India: Who Needs It and Who Does Not
Whether ESOP Structuring & Tax Advisory India applies to a given business is the first thing worth settling, and it is where most of the early questions land. The questions below are the ones raised most often in practice; the full scope of the service is on the ESOP Structuring & Tax Advisory India page.
What is the legal basis for ESOPs in India — which law governs them?
ESOPs for unlisted private companies are governed by Section 62(1)(b) of the Companies Act 2013, read with Rule 12 of the Companies (Share Capital and Debentures) Rules 2014. These rules specify the mandatory contents of the ESOP scheme, the shareholder approval requirements, the vesting period requirements, and the restrictions on who can be granted options. For listed companies, the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations 2021 apply in addition — these are more prescriptive and include detailed disclosure requirements. Both regimes require a minimum of one year between grant and vesting (for unlisted companies, Rule 12(6)); the SEBI regulations relax this only in limited cases such as death or permanent incapacity of the employee.
In practice: Many early-stage founders believe ESOPs are an unregulated contractual matter — they are not. A scheme that does not comply with the Companies Act requirements and the Share Capital Rules is non-compliant, and grants made under it are open to challenge until the position is regularised. Compliance must be built in from the moment the first grant is made.
Do we need shareholder approval to implement an ESOP scheme — or is a board resolution sufficient?
A Special Resolution of shareholders — requiring 75% or more of votes cast — is mandatory before any ESOP grants can be made. This is required by Section 62(1)(b) and Rule 12(1) of the Companies (Share Capital and Debentures) Rules 2014. A Board resolution alone is not sufficient. A separate shareholder resolution is also required under Rule 12(4) for grants to employees of a subsidiary or holding company, and for grants to identified employees that, in any one year, equal or exceed 1% of the issued capital (excluding outstanding warrants and conversions) at the time of grant.
In practice: This is the most commonly overlooked requirement in informally structured ESOPs. Founders grant options to early employees on the basis of a Board resolution without getting shareholder approval first — those grants are non-compliant and open to challenge until the position is regularised.
Can we grant ESOPs to promoters or directors of the company?
Generally not to promoters, and only to some directors. Under Rule 12, 'employee' includes directors (whole-time or not) but excludes independent directors, employees who are promoters or belong to the promoter group, and directors who (directly or indirectly) hold more than 10% of the company's outstanding equity shares. The exception is a DPIIT-recognised start-up, which may grant options to promoters and such directors for up to ten years from incorporation. For listed companies under the SEBI Regulations, options cannot be granted to independent directors or to any employee who is a promoter or belongs to the promoter group.
In practice: Investors sometimes want founder equity to be subject to vesting as a governance discipline. Outside the start-up exception, ESOPs are not available to promoters, so this is usually handled through reverse-vesting or similar contractual terms in the shareholders' agreement rather than an ESOP grant — check the structure against the Rule 12 exclusions before it is agreed.
What happens to an employee's unvested options if they resign?
The answer depends entirely on the ESOP Scheme document — which is why getting the scheme terms right matters. Standard treatment: unvested options lapse on the last day of employment. Vested but unexercised options are typically allowed a limited exercise window after resignation, the length of which is set by the scheme terms, for good leavers (employees who resign voluntarily in good standing). Bad leavers (employees terminated for cause — fraud, gross misconduct, breach of contract) may forfeit all options — both unvested and even vested but unexercised — depending on the scheme terms. Lapsed options are returned to the unissued option pool.
In practice: The good leaver / bad leaver definition and the post-termination exercise window are among the most negotiated provisions in ESOP scheme design. Employees understandably want a longer exercise window after leaving; the company wants to recapture the cap table efficiently. We help founders think through these terms before the scheme is approved — not after the first departing employee asks the question.
What is a phantom stock or shadow equity plan — and when would we use one instead of ESOPs?
A phantom stock plan is a contractual arrangement under which employees receive cash payments that mirror the value of company shares without actually receiving any shares. The payout is typically triggered by a liquidity event — acquisition, IPO, or secondary sale — and is calculated as the difference between the share value at the liquidity event and the value at the time of the phantom grant. Phantom plans are governed by employment contracts, not the Companies Act ESOP framework. They do not appear on the cap table and do not require shareholder special resolutions. However, the payout is taxed as salary income in the hands of the employee in the year of receipt.
In practice: Phantom plans are particularly useful for: LLPs and partnerships that cannot issue equity; international employees in jurisdictions where equity issuance to a foreign national is legally complex; and situations where the founder wants to offer upside sharing without giving actual equity or cap table dilution. The downside: no long-term capital gains treatment for the employee — it is all salary income. For equity-eligible employees in a growing company, real ESOPs are almost always better from a tax efficiency perspective.
What does 'fully diluted' mean — and why does the option pool affect it?
Fully diluted equity count is the total number of shares that would be outstanding if every convertible instrument were converted and every option were exercised — including issued shares, outstanding options (vested and unvested), convertible notes, CCPS, CCDs, warrants, and the unissued option pool. Investors compute their ownership percentage on a fully diluted basis — not just on issued shares. Because unissued options in the pool are included in the fully diluted count, creating a larger option pool before a funding round dilutes founders (and existing investors) rather than the new investors, who compute their ownership after the pool is included.
In practice: Pre-money versus post-money option pool placement is one of the most significant economic negotiating points in a term sheet. A pool placed pre-money is funded by existing shareholders' dilution; post-money, it dilutes the new investor as well. We model both scenarios in every pre-fundraise advisory engagement.
Can we offer ESOPs to independent contractors or advisors — not just employees?
The Companies Act ESOP framework under Section 62(1)(b) and Rule 12 applies specifically to 'employees' — defined in Rule 12 to cover permanent employees (working in India or abroad), directors other than independent directors, and such employees and directors of a holding or subsidiary company. Independent contractors (who provide services under a contract for services, not a contract of service) are not 'employees' for this purpose. Granting options to advisors or contractors under the ESOP scheme is technically outside the statutory framework. Some companies use a separate Advisory Stock Option or Consultant Equity plan — contractually structured — for non-employees. The tax treatment of non-employee option grants differs: it may not qualify as a salary perquisite (Section 17(2) of the Income-tax Act 1961, restated under the Income Tax Act 2025 from 1 April 2026) and could be assessed under other heads of income.
In practice: Advisor equity is a real need — many early-stage companies want to compensate advisors with equity. We structure separate advisory stock plans that are distinct from the employee ESOP scheme, with appropriate legal documentation and tax treatment analysis for each advisor's situation.
What is capital gains tax on sale of shares acquired through ESOP exercise?
When an employee sells shares they acquired through ESOP exercise, the gain is a capital gain for income-tax purposes. The cost of acquisition for capital gains is the FMV on the exercise date (which was already taxed as perquisite income). The holding period starts from the exercise date. If held for more than 24 months: Long-Term Capital Gain (LTCG) — taxed at 12.5% without indexation for transfers on or after 23 July 2024 (earlier, 20% with indexation). If held for 24 months or less: Short-Term Capital Gain (STCG) — taxed at the applicable income-tax slab rate. These are the rules under the Income-tax Act 1961, which governs income up to FY 2025-26; from tax year 2026-27 the Income-tax Act 2025 applies with renumbered sections and forms — confirm the equivalent provision.
In practice: The LTCG/STCG distinction is one of the key variables employees and founders consider when deciding when to exercise and sell. For unlisted company shares, the 24-month holding period from exercise date is the key threshold. PNPC advises employees on the tax implications of different exercise and sale timing scenarios — especially before a liquidation event.
What is a secondary sale — and can ESOP holders participate in one?
A secondary sale is a transaction in which existing shareholders (including employees who have exercised their ESOP options) sell their shares to a new investor or to the company itself, rather than buying newly issued primary shares. Secondary sales allow early employees to get liquidity without the company undergoing a full exit or IPO. For Indian companies, secondary sales by employees who are Indian residents are subject to capital gains tax. For transfers to foreign investors, FEMA Form FC-TRS must be filed through the AD bank within 60 days of the transfer of the shares or receipt/remittance of funds, whichever is earlier. For sales to the company itself (buyback), Companies Act Section 68 procedures apply.
In practice: Structured secondary sale programmes — often called 'tender offer' programmes — are increasingly used by growth-stage companies to provide partial liquidity to employees before an IPO. Advice on these transactions typically covers the FEMA compliance for foreign buyer transactions and the capital gains position for employees.
Where this sits in the wider engagement
ESOP Structuring & Tax Advisory India rarely arrives on its own. The statutory basis and the current requirements are set out on the ESOP Structuring & Tax Advisory India service page, and the related services are grouped under Business Setup.
What PNPC does
PNPC Global has practised since 1986 across India and the UAE. On ESOP Structuring & Tax Advisory India we take the work end to end — reviewing the facts, preparing and filing what is required, and dealing with the authority through to closure.