Table of contents
- Key Takeaways:
- What Is an ESOP Trust and Why Do Companies in India Use One?
- Direct Route vs Trust Route: How Do the Two ESOP Implementation Models Differ?
- What Is the Legal Basis for an ESOP Trust Under the Companies Act?
- How Do You Set Up an ESOP Trust in India, Step by Step?
- Who Can Be Appointed as a Trustee, and What Are the Restrictions?
- What Is the SEBI 2% Cap on ESOP Trust Secondary Acquisition?
- What Other SEBI SBEB & SE Regulations Apply to a Listed Company's ESOP Trust?
- Do Unlisted and Private Companies Need to Follow the SEBI Cap?
- How Is an ESOP Trust Funded Without Breaching Section 67?
- How Are ESOP Trust Shares Accounted for Under Ind AS?
- Does the Trust Route Change How Employees Are Taxed on Their ESOPs?
- When Should Your Company Actually Use a Trust Instead of the Direct Route?
- Common Mistakes Companies Make With ESOP Trusts
- Closing Summary: The Trust Is a Structuring Choice, Not a Compliance Burden in Itself
- Frequently Asked Questions: ESOP Trusts in India
📖 Part of our ESOP advisory library: see our complete overview of ESOP structuring and compliance services for founders, CFOs and Company Secretaries. This article focuses specifically on the ESOP trust structure, when to use it, and the SEBI caps that govern it for listed companies.
📌 For Founders, CFOs & Company Secretaries: What You Must Know
An ESOP trust is not a separate legal requirement layered on top of a normal stock option scheme. It is one of two permitted implementation models under the Companies Act, the other being the direct route where the company allots shares straight to the employee. The trust route becomes mandatory the moment a scheme involves buying existing shares from the market, gifting shares, or offering a cashless exercise facility, and for listed companies it brings an entire additional layer of SEBI regulation with it, including a 2% annual cap and a 5% aggregate cap on how many shares the trust can buy from the secondary market.
This guide sets out exactly when a trust is required, when it is optional, how to set one up correctly under the Companies Act and, where applicable, the SEBI SBEB and Sweat Equity Regulations 2021, and how the trust route affects funding, accounting and tax outcomes compared with the direct route.
Most founders encounter the ESOP trust question at one of two moments. The first is when a fast-growing private company wants to let vested employees sell some shares back for cash without waiting for an acquisition or an IPO, and someone on the cap table team mentions that a trust could hold a buyback pool. The second is when a company is preparing to list, and its lawyers point out that its existing direct-allotment ESOP scheme cannot legally continue to acquire shares from the secondary market once the SEBI SBEB and Sweat Equity Regulations, 2021 start to apply. In both situations, the underlying question is the same: should the company keep allotting shares directly to employees, or route the scheme through an irrevocable trust that sits between the company and the employee.
The answer depends on the source of the shares being used, the company's listing status, and how much administrative and regulatory overhead the founders are willing to accept in exchange for the flexibility a trust provides. At Elite Valuation, we support founders and listed company boards with ESOP pool design, Rule 11UA and fair value reporting for grant-date pricing, and end-to-end trust structuring, so this guide reflects how the choice actually plays out in practice, not just the text of the regulations.
Key Takeaways:
- An ESOP trust is an irrevocable trust that holds shares for employees between grant and exercise; the alternative is the direct route, where the company allots shares straight to the employee
- The trust route is mandatorywherever a scheme uses secondary market acquisition of existing shares or gifting, under both the Companies Act and, for listed companies, the SEBI SBEB and Sweat Equity Regulations, 2021
- For listed companies, the trust's secondary market purchases are capped at 2% of paid-up equity capital per financial year and 5% in aggregate across all schemes combined, under Regulation 3 of the SBEB and Sweat Equity Regulations, 2021
- Shares acquired by secondary acquisition must be held by the trust for a minimum of six months before they can be transferred to an employee on exercise
- Trustees cannot be a director, KMP, promoter, or relative of one, and cannot beneficially hold 10% or more of the company's paid-up capital, under Rule 16(3) of the Companies (Share Capital and Debentures) Rules, 2014
- Trustees cannot exercise discretionary voting rights on trust-held shares, which is the single most misunderstood governance restriction in practice
- Unlisted and private companies can use the trust route entirely voluntarily under Rule 16, without the SEBI caps, most often to offer cashless exercise or internal liquidity
- Company funding of the trust is permitted under Section 67(3)(b) of the Companies Act as an exception to the general restriction on financial assistance for share purchases
- Choosing the trust route does not change how the employee is taxed; the Section 17(2)(vi) perquisite computation and TDS timing are identical under both routes
What Is an ESOP Trust and Why Do Companies in India Use One?
An Employee Stock Option Trust, generally called an ESOP trust or an employee welfare trust, is an irrevocable trust that a company settles for the specific purpose of administering its share-based employee benefit scheme. Instead of the company allotting shares directly to each employee at the moment their options are exercised, the trust sits in the middle. The company funds the trust, or authorises it to subscribe to freshly issued shares, and the trust holds those shares until the underlying options vest and are exercised. On exercise, the trust transfers the shares to the employee against payment of the exercise price, and uses that exercise price to repay whatever funding the company advanced.
The legal basis for this structure runs through two separate provisions working together. Section 62(1)(b) of the Companies Act 2013 is the general authority for a company to issue further shares to employees under an employee stock option scheme, pursuant to a special resolution. Where the scheme is implemented through a trust that buys or subscribes to shares using company money, Section 67(3)(b) carves out an exception to the general restriction on a company financing the purchase of its own shares, and Rule 16 of the Companies (Share Capital and Debentures) Rules, 2014 lays down the operating conditions that make that exception available.
📌 Why Companies Choose the Trust Route
- Secondary liquidity: the trust can buy back vested shares from departing or long-tenured employees, giving them an exit before a formal fundraise or listing event
- Cashless exercise: the trust can sell a portion of an employee's vested shares on their behalf to fund the exercise price and any tax withholding, so the employee never has to find cash upfront
- Warehousing forfeited options: shares that come back to the pool when an employee leaves before full vesting can sit in the trust and be recycled into future grants, instead of being cancelled and re-issued each time
- A single cap table line item: the trust appears once on the capitalisation table, rather than every individual optionholder appearing separately before exercise
None of this is available under the direct route in the same way, because the direct route only ever involves a fresh allotment from the company to the employee. There is no pool of already-issued shares sitting anywhere that could be resold to a departing employee or used to fund a cashless exercise. That distinction, more than any tax or accounting difference, is usually what actually drives the decision.
Direct Route vs Trust Route: How Do the Two ESOP Implementation Models Differ?
Structuring Decision Phase
Every ESOP scheme in India, whether the company is a private startup or a listed conglomerate, is implemented through one of these two models. The Companies Act does not treat one as the default and the other as an exception; it simply sets different conditions for each, and SEBI layers its own conditions on top for listed companies choosing the trust route.
| Feature | Direct Route | Trust Route |
|---|---|---|
| Legal basis | Section 62(1)(b), Companies Act 2013, read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 | Section 62(1)(b) plus Section 67(3)(b), read with Rule 16 of the Companies (Share Capital and Debentures) Rules, 2014 |
| Who holds shares before exercise | No one; shares are allotted only on exercise | The trust holds shares, either freshly subscribed or bought from the secondary market, from the funding date until exercise |
| Source of shares on exercise | Always a fresh allotment by the company | Either a fresh allotment to the trust followed by transfer, or existing shares the trust already holds |
| Secondary market purchases | Not possible under this route | Permitted, and for listed companies capped at 2% per year and 5% in aggregate |
| Cashless exercise facility | Difficult to offer without a third-party broker arrangement | Straightforward, since the trust can sell part of the employee's shares to cover the cost |
| Buyback or internal liquidity for employees | Not available through the scheme itself | Available, subject to the funding and valuation conditions in Rule 16 |
| Voting rights before exercise | Not applicable; no shares exist yet | Held by the trust but the trustee cannot vote them at its own discretion |
| Administrative overhead | Lower; only cap table and option register maintenance | Higher; requires a trust deed, trustees, separate trust bank account and books, and for listed companies a compensation committee and secretarial auditor certification |
| Typical user | Early-stage startups running a plain vanilla option pool | Growth-stage private companies planning liquidity events, and virtually all listed companies with an active scheme |
✔ When the Trust Route Becomes Mandatory, Not Optional
- Whenever the scheme involves acquiring shares from the secondary market rather than a fresh issue
- Whenever the scheme involves gifting existing shares to employees rather than granting options
- Whenever a listed company wants to offer a stock appreciation right or benefit scheme settled in shares that are not freshly issued at the point of settlement
Outside these situations, the choice is genuinely optional, and a large share of unlisted Indian companies with straightforward, fresh-issue option pools simply use the direct route because it is administratively lighter and there is no secondary liquidity need yet. The trust route earns its overhead once the company wants to do something the direct route structurally cannot.
Deciding Between the Direct Route and a Trust for Your ESOP Pool?
We help founders and CFOs map their liquidity plans, cap table structure and listing timeline to the right implementation model before the scheme is drafted, not after a problem surfaces.
What Is the Legal Basis for an ESOP Trust Under the Companies Act?
Three provisions of the Companies Act 2013 work together to make an ESOP trust legally possible, and it is worth separating them clearly because practitioners frequently blur them into a single generic reference to "Section 62."
Section 62(1)(b): Authority to Issue Shares to Employees
This is the enabling provision for any employee stock option scheme, whether implemented directly or through a trust. It authorises a company to issue further shares to employees under a scheme approved by special resolution, at a price determined in accordance with the scheme.
Section 67(2) and 67(3)(b): The Financial Assistance Exception
Section 67(2) prohibits a public company from giving financial assistance, directly or indirectly, for the purchase of or subscription to its own shares. Without an exception, this would make it impossible for a company to lend money to a trust to buy its shares. Section 67(3)(b) creates exactly that exception for schemes under which money is provided for the purchase of, or subscription for, fully paid shares in the company, to be held by or for the benefit of employees, provided the scheme is approved by special resolution.
Rule 16, Companies (Share Capital and Debentures) Rules, 2014: The Operating Conditions
Rule 16 is where the practical conditions actually sit. It requires shareholder approval by special resolution, mandates that purchases be made only through a recognised stock exchange if the company is listed, requires a registered valuer's valuation if the company is unlisted, sets out who cannot be a trustee, and prescribes board disclosure requirements where employees do not exercise voting rights directly.
For listed companies, the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 sit on top of this Companies Act framework rather than replacing it. Rule 16 continues to apply to a listed company's trust; the SBEB and Sweat Equity Regulations add the compensation committee requirement, the secondary acquisition caps, the minimum holding period, and the stock exchange filing obligations that are specific to listed entities.
How Do You Set Up an ESOP Trust in India, Step by Step?
Setup Phase
The mechanics differ slightly between a listed and an unlisted company, mainly in who approves the scheme and how the trust is funded, but the overall sequence is consistent.
1. Draft the Scheme and the Trust Deed
The board, acting through its Nomination and Remuneration Committee for a listed company or a compensation committee for an unlisted one, formulates the scheme terms, including eligibility, vesting conditions, exercise price mechanics, and the pool size, alongside a trust deed setting out the trust's objects, the trustees, and how the trust will be funded and wound up.
2. Obtain Shareholder Approval by Special Resolution
Rule 16(1)(a) makes shareholder approval by special resolution a precondition for the company to provide money to the trust. The explanatory statement accompanying the notice must disclose the objects of the trust, the number of shares to be acquired, the source of funding, and the percentage of secondary acquisition intended, among other particulars listed in Rule 16(2).
3. Appoint Trustees Who Satisfy the Eligibility Conditions
Trustees are appointed under the trust deed, and each candidate must be screened against the Rule 16(3) disqualifications, covering directors, KMPs, promoters, their relatives, and anyone beneficially holding 10% or more of paid-up capital. A listed company must appoint at least two trustees if it uses individual or one-person-company trustees rather than a corporate trustee.
4. Execute and Register the Trust Deed
The trust deed is executed, stamped in accordance with the applicable state stamp law, and, for a listed company, filed with every stock exchange on which the company's shares are listed, since the deed must comply with the format prescribed in Schedule I of the SBEB and Sweat Equity Regulations.
5. Fund the Trust
The company advances funds to the trust, typically as an interest-free or low-interest loan, under the Section 67(3)(b) exception. For an unlisted company, the shares the trust then acquires must be valued by a registered valuer under Rule 16(1)(c) before purchase.
6. Trust Acquires Shares
The trust either subscribes to freshly issued shares from the company, or, where secondary acquisition is intended and approved, purchases existing shares. A listed company's trust must route any such secondary purchase only through a recognised stock exchange, and stay within the 2% and 5% caps discussed below.
7. Grant Options, Track Vesting, and Process Exercise
Options are granted to eligible employees against the pool the trust holds. On vesting and exercise, the trust transfers the corresponding shares to the employee against the exercise price, and uses that consideration to repay the company's funding over time.
8. Maintain Ongoing Compliance and Disclosures
The company discloses, in its board's report, the names of employees who have not exercised voting rights directly on trust-held shares and the reasons for it, under Rule 16(4). A listed company additionally obtains an annual secretarial auditor certificate confirming the scheme has been implemented in line with shareholder resolutions and the SBEB and Sweat Equity Regulations.
Who Can Be Appointed as a Trustee, and What Are the Restrictions?
Trustee eligibility is the single most litigated-in-practice compliance point for ESOP trusts, because the disqualification criteria are deliberately broad and companies often default to appointing a convenient internal executive without checking them.
⚠️ Rule 16(3) Trustee Disqualifications. A person cannot be appointed a trustee of an ESOP trust if they are a director, key managerial personnel, or promoter of the company or of its holding, subsidiary, or associate company, or a relative of any such person, or if they beneficially hold 10% or more of the company's paid-up share capital. The purpose is to keep the trust independent of the very people whose compensation or shareholding the trust exists to manage.
Two further governance points sit alongside the eligibility test. First, where a listed company appoints an individual, or a one-person company, as trustee rather than a corporate trustee such as a scheduled bank or an SEBI-registered trustee company, it must appoint at least two such trustees, so that no single individual controls the trust unilaterally. Second, and this is the point most frequently overlooked, the trustee cannot exercise discretionary voting rights on the shares the trust holds. This restriction exists specifically to prevent promoters or management from routing shares through a trust as a way of controlling votes without the shares being formally attributed to them. Where the underlying employees do not exercise the voting rights directly themselves, Rule 16(4) requires the board to disclose, in its report for that financial year, the names of the employees concerned and the reasons the voting rights were not exercised directly.
What Is the SEBI 2% Cap on ESOP Trust Secondary Acquisition?
SEBI Compliance Phase
This is the provision that most often forces a listed company to restructure a scheme it inherited from its pre-listing days. Regulation 3 of the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 sets out the conditions under which an ESOP trust can undertake secondary acquisition, that is, buying already-issued shares from the market rather than subscribing to a fresh issue, and it caps that activity in two separate ways.
The Annual Cap: 2% of Paid-Up Equity Capital
Resets Every Financial Year
Measured Against Prior Year-End Capital
In any single financial year, the trust's secondary market acquisition under the schemes covered by the regulations cannot exceed 2% of the company's paid-up equity share capital as at the end of the immediately preceding financial year. This limit resets annually and is not a lifetime allowance for that year alone; it recalculates against the prior year's closing capital each time.
The Aggregate Cap: 5% of Paid-Up Equity Capital
Cumulative Across All Schemes
Separately from the annual limit, the total number of shares the trust holds through secondary acquisition, across every scheme the company operates put together, cannot at any point exceed 5% of the company's paid-up equity share capital. If the company expands its capital through a preferential allotment or a qualified institutions placement, the trust's holding is measured against the enlarged capital base to maintain this 5% ceiling.
The Six-Month Minimum Holding Period
Applies Before Transfer to Employees
Under Regulation 3(13) of the SBEB and Sweat Equity Regulations, 2021, shares acquired by the trust through secondary acquisition must be held for a minimum period of six months before they can be transferred, on exercise, to an employee. This prevents the trust from being used as a rapid pass-through vehicle for short-term market transactions.
📌 How the Caps Apply in Practice
Take a listed company with 10 crore shares of paid-up equity capital at the end of the preceding financial year. Its ESOP trust can acquire up to 20 lakh shares (2%) from the secondary market in the current financial year. If the shares trade at around Rs. 250, that ceiling represents roughly Rs. 50 crore of secondary purchases the trust can execute in that one year, funded through the company's Section 67(3)(b) advance. Regardless of how the annual number moves, the trust's total secondary-acquisition holding across every scheme it runs cannot exceed 50 lakh shares (5%) at any time, so a company cannot simply keep buying every year without limit; the aggregate ceiling eventually binds.
⚠️ Fresh Issue Is the Release Valve Once the Caps Bind. Once secondary acquisition headroom under the 2% or 5% caps is exhausted, or where the company would rather not deploy further cash into market purchases, the regulations permit a fresh issue of shares to the trust instead, once the options already granted exceed what the trust could otherwise cover through secondary acquisition. Most listed companies with active, growing pools run a blended structure of secondary acquisition up to the cap and fresh issue beyond it.
What Other SEBI SBEB & SE Regulations Apply to a Listed Company's ESOP Trust?
The secondary acquisition caps are the headline requirement, but they sit inside a broader compliance architecture that a listed company's trust must operate within.
✔ Additional Trust-Specific Requirements for Listed Companies
- The Nomination and Remuneration Committee acts as the compensation committee responsible for formulating and administering the scheme
- Prior in-principle approval must be obtained from each stock exchange before shares are allotted to the trust or to employees under the scheme
- The trust deed must comply with the format in Part A of Schedule I of the SBEB and Sweat Equity Regulations, and must be filed with every stock exchange where the company's shares are listed
- A single trust may administer multiple schemes, provided it maintains separate books and records for each
- Where a scheme is wound up, any excess shares or money remaining with the trust may, with shareholder approval, be applied to a different scheme under the regulations on the recommendation of the compensation committee
- An annual secretarial auditor certificate must be placed before shareholders at the AGM confirming the scheme has been implemented in accordance with the regulations and the shareholder resolutions
A company can also change its implementation mode, moving from direct route to trust route or vice versa, but only with a fresh special resolution, and only where the change does not prejudice the interests of existing option holders. This matters for companies that ran a direct-route scheme before listing and now need to switch to accommodate secondary acquisition; the switch is permitted, but it is not automatic, and it requires the same shareholder approval process as setting up the scheme in the first place.
Do Unlisted and Private Companies Need to Follow the SEBI Cap?
No, and this is one of the most common points of confusion among founders who read about the SEBI caps online and assume they apply universally. The SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 apply only to companies whose shares are listed on a recognised stock exchange in India, as set out in Regulation 1(4). An unlisted public company or a private company implementing an ESOP trust operates entirely under the Companies Act and Rule 16, with no 2% annual cap, no 5% aggregate cap, and no statutory six-month holding requirement.
| Requirement | Unlisted / Private Company (Rule 16 Only) | Listed Company (Rule 16 + SBEB & SE Regulations, 2021) |
|---|---|---|
| Shareholder approval | Special resolution under Rule 16(1)(a) | Special resolution under Rule 16(1)(a), plus fresh special resolution for any change in implementation mode |
| Valuation before secondary purchase | Mandatory registered valuer valuation under Rule 16(1)(c) | Market price on the recognised stock exchange applies instead of a separate valuation |
| Cap on secondary acquisition | No statutory cap under the Companies Act | 2% per financial year and 5% in aggregate under Regulation 3 |
| Minimum holding before transfer | No statutory minimum, though good governance practice mirrors the listed norm | Six months, under Regulation 3(13) |
| Trustee eligibility | Rule 16(3) disqualifications apply | Rule 16(3) disqualifications apply, plus the two-trustee minimum for individual or OPC trustees |
| Compensation committee | Not mandated by name, though a designated approving body is good practice | Nomination and Remuneration Committee mandatorily acts as compensation committee |
| Stock exchange filings | Not applicable | Trust deed and scheme filed with every exchange the company is listed on |
In practice, this means a growth-stage private company can set up a trust purely to offer employees an internal secondary sale window, perhaps once a year around a fundraise, without worrying about annual percentage ceilings. The discipline the caps impose is a listed-market investor protection tool, designed to stop a trust from becoming a vehicle for large-scale, undisclosed accumulation of a listed company's stock; it is not a general principle the Companies Act imposes on every company using the trust route.
How Is an ESOP Trust Funded Without Breaching Section 67?
Funding Mechanics
Section 67(2) of the Companies Act prohibits a public company, whether listed or unlisted, from giving financial assistance for the purchase of or subscription to its own shares, precisely to stop companies from artificially propping up their own share price or capital base using their own money. An ESOP trust would be impossible to fund without an exception to this rule, since the entire structure depends on the company advancing money for the trust to buy shares.
Section 67(3)(b) supplies that exception for schemes where the money is provided for the purchase of, or subscription for, fully paid shares to be held by or for the benefit of employees, subject to the conditions in Rule 16. In practice, the company typically extends an interest-free or low-interest loan to the trust, the trust uses that loan to subscribe to or purchase shares, and as employees exercise their options and pay the exercise price to the trust, the trust uses that inflow to progressively repay the company's advance. The loan is disclosed in the company's financial statements as a related-party or intra-group receivable, and the shares the trust holds are not treated as an asset in the company's own standalone or consolidated balance sheet, for reasons covered in the accounting section below.
✔ Rule 16 Conditions on Trust Funding
- The scheme must be approved by special resolution before any money is provided
- If the company is listed, the trust's share purchases must be made only through a recognised stock exchange, never by private arrangement
- If the company is unlisted, the purchase price must be based on a valuation by a registered valuer
- The explanatory statement to the shareholder notice must disclose the class of employees covered, the trustees, the sources of funding, and the extent of secondary acquisition contemplated
Private companies get an additional layer of relief. Since Section 67(2) already applies only to public companies on its own terms, a private company is outside that particular restriction by default. The separate MCA exemption notification of June 2015 provides private companies conditional relief from Section 67(1), the restriction on a company buying its own shares, provided the company has no body corporate shareholder, its borrowings from banks, financial institutions, or any body corporate are less than twice its paid-up share capital or Rs. 50 crore, whichever is lower, and it has no subsisting default in repayment of such borrowings.
⚠️ Consequence of Non-Compliance. Providing financial assistance to an ESOP trust without the special resolution, or in breach of the Rule 16 conditions, is not a mere technicality. The transaction is liable to be treated as void, and the company and every officer in default can be penalised under Section 450 of the Companies Act for a contravention with no separately prescribed penalty elsewhere in the Act. Correcting a defective funding arrangement after shares have already been allotted to employees is significantly harder than structuring it correctly at the outset.
How Are ESOP Trust Shares Accounted for Under Ind AS?
The accounting question that trips up first-time CFOs is whether shares sitting in the trust should appear as an investment asset on the company's balance sheet, since the trust is technically a separate legal entity from the company. The answer, under the framework the Institute of Chartered Accountants of India applies, is no.
The ICAI's 2020 revision to its Guidance Note on Accounting for Share Based Payments treats an employee benefit trust that a company effectively controls, in the sense that the company established it, funds it, and directs its activities for the sole benefit of its own employees, as an extension of the company itself for accounting purposes, rather than as an independent third party. Shares the trust holds are accordingly deducted from the sponsoring company's equity, in the same way treasury shares would be, rather than being recognised as an investment asset. The loan the company advanced to the trust to fund the purchase is eliminated on consolidation rather than shown as a receivable from an outside party.
The Ind AS 102 charge for the fair value of the options granted is unaffected by which route is used. The company recognises the cost of the options as an expense in its profit and loss account, spread over the vesting period, with a corresponding credit to equity, regardless of whether shares will ultimately come to the employee through a fresh company allotment under the direct route or a transfer out of the trust under the trust route. If the market price of the shares the trust already holds declines after acquisition, this can require the sponsoring company to recognise the impact through equity, since the trust's holding is treated as the company's own treasury position rather than a separate investment subject to its own impairment logic.
📌 What This Means for Financial Statement Presentation
- The trust's shareholding does not inflate the company's reported investment assets
- The company's effective outstanding share count, for earnings-per-share purposes, typically excludes shares still sitting unallocated in the trust
- The inter-company loan to the trust is eliminated on consolidation, not disclosed as a related-party receivable from an external counterparty
- Auditors specifically test whether the trust meets the control criteria for this treatment; a trust structured with genuine independent beneficial control by parties outside the company's direction could, in principle, be assessed differently
Need Ind AS 102 Accounting or a Registered Valuer's Report for Your Trust?
We prepare grant-date fair value reports under Rule 11UA for unlisted company trust purchases and support the Ind AS 102 expense computation across the vesting schedule.
Does the Trust Route Change How Employees Are Taxed on Their ESOPs?
Tax Treatment Phase
No, and this is worth stating plainly because it is the question founders most often ask when a trust is first proposed to them. The taxation of an employee's stock options under the Income Tax Act depends on the fact that shares were allotted or transferred to them at a concessional rate as part of their employment, not on which corporate mechanism delivered those shares.
Under Section 17(2)(vi) of the Income Tax Act, the difference between the fair market value of the shares on the date the option is exercised and the exercise price the employee pays is taxed as a perquisite under the head "Salaries," and the employer must deduct TDS on this amount under Section 192. When a trust transfers shares to an employee on exercise, that transfer is treated the same way as a direct allotment would be for the purpose of this computation; the trust route neither defers nor accelerates the point of taxation, and it does not change the fair market value that must be used.
📌 The Startup TDS Deferral Still Applies Under Either Route
An eligible DPIIT-recognised startup can defer, not eliminate, the employer's obligation to deduct TDS on the ESOP perquisite under Section 192(1C), regardless of whether the direct route or the trust route delivers the shares. The deferral runs until the earliest of 48 months from the end of the relevant assessment year, the date the employee sells the shares, or the date the employee ceases to be an employee of the company.
On a subsequent sale of the shares, the employee's capital gains are computed with the fair market value already taxed as a perquisite treated as the cost of acquisition, and the holding period runs from the date of allotment or transfer, whether that transfer came from the company directly or from the trust. Judicial precedent has also settled the question of whether the company itself can claim a tax deduction for the ESOP discount as a business expense where a trust is involved. The Karnataka High Court, in its ruling in the Biocon matter, and the Delhi High Court, in Commissioner of Income Tax v. Lemon Tree Hotels, both held that the discount between market value and the price at which shares are made available to employees under a scheme is an allowable business expenditure under Section 37 of the Income Tax Act, recognised over the vesting period, even where the shares passed through a trust structure rather than a direct allotment.
✔ GST Treatment of Trust Share Transfers
- The transfer of shares or securities is excluded from the definition of both goods and services under the CGST framework, so the trust's transfer of shares to an employee on exercise does not itself attract GST
- Where a foreign holding company's shares are routed to Indian subsidiary employees and the domestic entity reimburses the parent on a strict cost-to-cost basis, CBIC Circular No. 213/07/2024-GST, dated 26 June 2024, clarifies this reimbursement is not a supply of services and does not attract GST
- GST becomes payable, on a reverse charge basis, only on any additional fee, markup, or facilitation charge the foreign entity levies over and above the cost of the shares themselves
When Should Your Company Actually Use a Trust Instead of the Direct Route?
Stripping away the regulatory detail, the decision usually comes down to where the company sits on its growth and liquidity timeline.
Early-Stage Private Company With a Fresh-Issue Pool Only
Direct Route Usually Sufficient
If every option in the pool will be settled through a fresh allotment, there is no plan to buy back shares from departing employees, and the company is years away from a listing, the administrative simplicity of the direct route generally outweighs anything a trust would add. Most seed and Series A companies fall here.
Growth-Stage Private Company Planning Employee Liquidity
Trust Route Becomes Valuable
Once a company starts planning periodic secondary sale windows around funding rounds, wants to offer cashless exercise to reduce the cash burden on employees exercising large grants, or wants a clean mechanism to recycle forfeited options, a trust funded under Section 67(3)(b) with a Rule 11UA valuation backing each secondary purchase becomes the more efficient structure, even without any SEBI overlay.
Listed Company or a Company Preparing to List
Trust Route Effectively Required for Secondary Acquisition
Once a company is listed, any scheme involving secondary market purchases must run through a trust, and the SEBI SBEB and Sweat Equity Regulations, 2021 govern the caps, the trustee rules, and the disclosure obligations discussed throughout this guide. Companies preparing for an IPO with an existing direct-route scheme typically need to restructure into a compliant trust well before the listing, since retrofitting it under listing-day time pressure is one of the more common pre-IPO compliance scrambles we see.
📁 A Recent Engagement
B2B Technology Company
Pre-IPO Restructuring
ESOP Pool: 6.5% of Capital
A technology company preparing for a listing within 18 months approached us with an ESOP scheme that had been running for six years entirely under the direct route, with a pool equal to 6.5% of its paid-up capital spread across roughly 340 employees. The founders wanted to introduce a one-time secondary sale window ahead of the IPO so that long-tenured employees could realise partial liquidity, and separately wanted a cashless exercise facility for the large grants held by senior leadership.
Neither objective was achievable under the existing direct-route structure. We restructured the scheme into a trust route under Rule 16, drafted the trust deed to comply with the format the SBEB and Sweat Equity Regulations would require once the listing completed, screened and appointed two independent trustees who cleared the Rule 16(3) disqualification tests, and obtained the special resolution covering both the funding and the scope of secondary acquisition. Because the company was still unlisted at the point of the secondary window, the purchase price was anchored to a registered valuer's report rather than a stock exchange price, which also gave the founders a defensible reference point for the subsequent Rule 11UA compliance the fresh option grants required. The restructuring was completed roughly four months ahead of the draft red herring prospectus filing, avoiding the far more constrained timeline a post-filing scheme change would have imposed.
Common Mistakes Companies Make With ESOP Trusts
❌ Appointing a disqualified trustee
Companies frequently appoint a convenient internal finance or HR executive as trustee without checking whether that person qualifies as a KMP, or is a relative of a promoter or director, either of which disqualifies them under Rule 16(3).
Fix: Screen every proposed trustee against the Rule 16(3) criteria in writing before the trust deed is executed, and document the screening.
❌ Treating the 2% cap as a lifetime limit rather than an annual one
Some compliance teams calculate the 2% figure once at scheme inception and assume it applies for the life of the scheme, when in fact it resets every financial year against the prior year's closing paid-up capital.
Fix: Recalculate the annual headroom at the start of each financial year against the actual closing paid-up capital of the prior year.
❌ Allowing the trustee to vote unallocated shares
Trustees sometimes vote trust-held shares at general meetings as a matter of convenience, particularly on routine resolutions, without recognising that discretionary voting by the trustee is barred regardless of how minor the resolution appears.
Fix: Build an explicit voting abstention protocol into the trust deed and confirm it with the company secretary before every general meeting.
❌ Funding the trust before the special resolution is passed
Under time pressure, some companies advance money to the trust and only seek shareholder approval afterward, treating the resolution as a formality rather than a precondition.
Fix: Sequence the special resolution strictly before any funds are transferred, and hold the funding tranche until the resolution is on record.
❌ Skipping the registered valuer's valuation for an unlisted company's secondary purchase
Unlisted companies sometimes negotiate a secondary purchase price internally between the trust and a selling shareholder without commissioning the Rule 16(1)(c) valuation, treating it as unnecessary since there is no stock exchange price to defer to.
Fix: Commission the registered valuer's report before, not after, the purchase price is negotiated with the selling party.
❌ Assuming the trust route changes the employee's tax position
HR teams occasionally tell employees that trust-routed shares are taxed differently, or more favourably, than a direct allotment, which is incorrect and creates avoidable disputes at the time of exercise.
Fix: Communicate clearly to employees that the Section 17(2)(vi) perquisite computation and TDS obligation are identical under both routes.
Closing Summary: The Trust Is a Structuring Choice, Not a Compliance Burden in Itself
An ESOP trust is best understood as an implementation choice the Companies Act makes available alongside the direct route, not as an additional compliance obligation every company must shoulder. The trust route earns its administrative overhead once a company needs secondary liquidity, cashless exercise, or a mechanism to recycle forfeited options, and it becomes close to unavoidable once a company is listed and the SEBI SBEB and Sweat Equity Regulations, 2021 bring the 2%, 5%, and six-month rules into play. Getting the trustee eligibility, the funding resolution, the valuation, and the caps right at the outset is materially easier than correcting a defective structure once employees have already exercised options against it. At Elite Valuation, we help founders and boards decide whether a trust is the right structure in the first place, and build it correctly under the Companies Act and, where applicable, SEBI's framework, from the trust deed through to the first exercise cycle.
Setting Up or Restructuring an ESOP Trust?
Trust deed drafting → trustee eligibility screening → Rule 11UA valuation → SEBI SBEB compliance mapping → Ind AS 102 accounting support. One engagement, built for private companies planning liquidity and listed companies managing an active scheme..
Frequently Asked Questions: ESOP Trusts in India
CA Sagar Shah, Founder
Mr Sagar Shah is the Founder of Elite Valuation and leads the firm’s Valuation and Advisory practice. With over 15+ years of professional experience.
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