Two separate taxable events
ESOPs (Employee Stock Option Plans) are taxed in India at two distinct points, and it's easy to conflate them — but each has its own tax character, rate, and timing:
(FMV at exercise − exercise price) × shares is a perquisite, taxed assalary income at your slab rate, in the year you exercise.
(Sale price − FMV at exercise) × shares is a capital gain, taxed as STCG or LTCG depending on how long you held the shares after exercising.
The reason for this split is straightforward once you see it: the value you received "for free" at exercise (the gap between what the shares were worth and what you paid for them) is compensation from your employer, so it's taxed like salary. Any further appreciation between exercise and sale is investment gain, so it's taxed like any other capital asset. Your cost basis for the capital gains calculation is the FMV at exercise — not the exercise price you paid — because that FMV portion has already been taxed once as perquisite; taxing it again as a capital gain would be double taxation. This step-up in cost basis is protected in law under Section 49(2AA) of the Income Tax Act, which specifically deems the FMV already taxed as perquisite (under Section 17(2)) to be the cost of acquisition for capital gains purposes — the statutory basis for why the same rupee is never taxed twice.
Worked example
Say you exercise 1,000 ESOPs at an exercise price of ₹100/share when the FMV is ₹500/share. The perquisite is (₹500 − ₹100) × 1,000 = ₹4,00,000, added to your salary income. If your other taxable income for the year is ₹20,00,000 (new regime), this perquisite adds ₹1,04,000 to your tax bill — the actual difference the slab engine computes between tax on ₹24 lakh and tax on ₹20 lakh, not a flat percentage of the perquisite.
The Section 80-IAC startup TDS deferral
Normally, your employer must deduct TDS on the perquisite in the same month you exercise, even though the shares themselves may be illiquid and impossible to sell. For employees of startups specifically recognised as eligible under Section 80-IAC, the law allows this TDS collection to be deferred to the earliest of 5 years from the date of exercise, the date you sell the shares, or the date you leave the company. This is purely a timing relief on when tax is collected — it does not reduce, and does not change, the actual perquisite amount or the tax rate applied to it. You still owe the same total tax; you just don't have to fund it out of pocket the moment you exercise.
How FMV is determined for unlisted shares
For companies listed on a recognised stock exchange, FMV is simply the market price on the date of exercise. For unlisted companies — the situation most ESOP holders at Indian startups are in — FMV must be certified by a SEBI-registered merchant banker, following a valuation methodology (commonly discounted cash flow or comparable multiples) as of a date not more than 180 days before the exercise date. Your employer's finance or HR team typically obtains this valuation and uses it to compute the perquisite for your Form 16 — ask them for the certified FMV figure rather than estimating it yourself from the last funding round's valuation, which can differ meaningfully from the merchant banker's number.