Most employees think of ESOP taxation as a single event. It isn’t. Exercising an option and having your shares bought back by the company are two separate taxable events, governed by two different provisions — and the rules around one of them changed materially with the Income-tax Act, 2025. Here’s how each stage works, and what’s changed.
Q1. What’s the difference between “exercising” an ESOP and a “buyback”?
Exercising is when you pay the strike price and convert your vested options into actual shares. A buyback is what happens after — the company offers to purchase those shares back from you (common in startups without a public listing, as a liquidity event between funding rounds). Exercise creates the shares; buyback is one way of exiting them.
Q2. How is ESOP exercise taxed?
As a perquisite under Section 17(2)(vi), taxed under the head “Salaries.” The taxable amount is:
FMV of the share on the exercise date − exercise price paid, × number of shares
This is added to your salary income and taxed at your slab rate. Your employer deducts TDS on it under Section 192, same as regular salary.
Q3. Is grant or vesting taxed?
No. Grant (being awarded options) and vesting (becoming eligible to exercise) are not taxable events. Tax arises only at exercise and again at sale/buyback.
Q4. How is FMV determined for unlisted companies?
Via a valuation by a merchant banker, as prescribed under the Income Tax Rules. This is why the exercise-date FMV certificate matters — it fixes both your perquisite tax and your future cost of acquisition.
Q5. Can I defer the perquisite tax if I work at a startup?
Yes, for eligible startups recognized under the DPIIT scheme. The tax liability (deduction/payment) can be deferred to the earliest of: sale of the shares, the employee leaving the company, or 48 months from the end of the relevant year — whichever comes first. The tax amount itself is still computed at exercise; only the payment timeline shifts.
Q6. Once I’ve paid perquisite tax at exercise, am I taxed again when the shares are bought back?
Yes — but only on the gain made after exercise, not the whole amount again. The FMV already taxed as a perquisite becomes your cost of acquisition for the second stage. Tax at buyback/sale applies only to (buyback price − that cost of acquisition).
Q7. How were ESOP buyback proceeds taxed before April 2026?
Between 1 October 2024 and 31 March 2026, buyback consideration was treated as a deemed dividend under Section 2(22)(f) of the 1961 Act. The entire buyback amount was taxed at your slab rate, with no deduction for cost of acquisition — the cost could only be claimed separately as a capital loss. This meant employees were effectively taxed on the full proceeds, not just the real gain.
Q8. How are ESOP buybacks taxed now, from 1 April 2026?
The Income-tax Act, 2025 (via the Finance Act, 2026) moved buyback taxation back to the capital gains regime under Section 69. The taxable amount is now:
Buyback consideration − cost of acquisition (FMV already taxed at exercise)
Only the real economic gain is taxed — the earlier dividend-style regime is gone.
Q9. Is this better or worse for employees than the 2024–26 rule?
Better, in almost every case. Under the dividend regime, you were taxed on the full buyback amount at slab rate with no cost deduction. Under the restored capital gains regime, you’re taxed only on the appreciation since exercise, and — depending on holding period — may qualify for the lower long-term capital gains rate instead of your slab rate.
Q10. Does the buyback holding period matter?
Yes. It determines whether the gain is short-term or long-term:
- Listed shares: long-term if held over 12 months
- Unlisted shares (typical for pre-IPO startup ESOPs): long-term if held over 24 months
The holding period is counted from the exercise date (when you became the owner of the shares), not the grant date.
Q11. What tax rate applies on the buyback gain?
For ordinary (non-promoter) shareholders on unlisted shares: long-term gains are taxed at the applicable LTCG rate; short-term gains at slab rate. Listed-share LTCG typically attracts 12.5%, STCG 20%, subject to the specific conditions in force at the time of the transaction — this is worth confirming with your CA at the time of the event, as rates are periodically revised.
Q12. Does the promoter surcharge under the new law apply to regular employee-ESOP holders?
No. The additional tax under Section 69(2) and the Finance Act, 2026 surcharge apply specifically to promoter shareholders participating in a buyback. Ordinary employees exercising and exiting ESOPs are not classified as promoters and are not subject to this extra layer.
Q13. What if the company sells shares on the secondary market instead of a formal buyback?
Same capital gains logic applies — sale consideration minus cost of acquisition (the exercise-date FMV), split into short-term or long-term based on holding period. A “buyback” and an “open-market/secondary sale” are taxed on the same principle; the buyback rules under Section 69 specifically govern the company-initiated repurchase mechanism.
Q14. Is there a risk of double taxation on the same rupee?
Not on the same rupee — the design intentionally avoids it. The perquisite tax at exercise covers the value up to the exercise-date FMV. The capital gains tax at buyback/sale covers only the increase in value after that date. Where employees feel “doubly taxed” is usually a liquidity problem, not a legal double taxation: perquisite tax is due even if you haven’t sold anything yet and have no cash from the shares.
Q15. What should employees do before exercising or before a company buyback offer?
- Get the exercise-date FMV certificate in writing — it fixes your future cost of acquisition
- Check if your employer qualifies for the startup deferral before triggering perquisite tax
- Track your exercise date carefully — it’s the clock-start for the 12/24-month holding period
- Model the TDS impact at exercise separately from the eventual capital gains impact at buyback, since they hit in different years and under different heads
Quick comparison
| Exercise | Buyback (from 1 Apr 2026) | |
|---|---|---|
| Tax head | Salary (perquisite) | Capital Gains |
| Provision | Section 17(2)(vi) | Section 69, Income-tax Act 2025 |
| Taxable amount | FMV − exercise price | Buyback price − FMV at exercise |
| Rate | Slab rate | LTCG/STCG rate based on holding period |
| TDS | Deducted by employer (Sec 192) | Deducted per applicable capital gains TDS rules |
Need help modelling your ESOP exercise or an upcoming buyback offer?
✉ ang@angca.com