Tax paid by the employer on behalf of the employee: ESOPs, gross-up and the books
When TDS on an ESOP is more than the month's pay, can the company pay it? Tax paid by employer on behalf of employee: the s.392(2) route, gross-up and booking.
Last checked 6 min read
It usually happens in March. An employee exercises stock options, the perquisite runs into lakhs, and the TDS for the month is bigger than the salary. Payroll cannot deduct money that is not there. The question then becomes tax paid by employer on behalf of employee: is it allowed, what does it cost, and how do you book it?
The answer depends on one thing more than anything else: whether the benefit was given in shares or in cash.
Tax paid by employer on behalf of employee: three ways to handle a shortfall
The employer must deduct and deposit TDS on salary. If it does not, it is the employer who is in default. When a month's tax is more than the month's pay, there are three lawful ways out.
- Recover it later. Treat the shortfall as tax payable by the employee, or as an advance, and recover it from later salary. Total deductions must stay within the 50% cap in the Code on Wages, and the arrangement should be in writing.
- Collect it before the event. Ask for the tax before the shares are allotted, or sell some shares to cover it.
- The company bears it. This is the option most founders choose for ESOPs, and it is where the rules get interesting.
ESOP perquisite tax: the employer-pays route
Share-settled ESOPs and RSUs, and SARs settled in shares, are non-monetary perquisites. The employee receives shares, not money. For these, the Income-tax Act, 2025 lets the employer pay the tax itself.
- s.392(2)(a) (old s.192(1A)): the employer "may pay, at his option, tax on the whole or part of such income without making any deduction therefrom".
- s.392(2)(b) (old s.192(1B)): that tax is worked out at the average rate on the year's salary including the perquisite, and it is treated as tax deducted at source.
- Schedule III, Sl. No. 10 (old s.10(10CC)): the tax paid this way is exempt for the employee. No tax on tax.
- s.35(a)(ii) (old s.40(a)(v)): the company cannot deduct it as an expense.
Take Arjun, a product manager at a Bengaluru start-up. He exercises 4,000 options in March at ₹50 when the fair value is ₹500, so his perquisite is 4,000 × ₹450 = ₹18,00,000. The tax on that, at his average rate for the year, is far more than March's net pay. If the company elects to pay it under s.392(2)(a), Arjun's payslip does not show a giant deduction, his Form 130 shows the tax as paid for him and the same amount as exempt, and the company books a cost it cannot claim.
Two practical notes. The route covers only tax on the non-monetary perquisite, not tax on his regular salary. And it is an election by the employer, so record it: a board note or a written policy is enough.
Cash settled SAR tax is a different animal
Cash-settled SARs, cash RSUs and phantom stock pay the employee money. That makes the payout salary, or a monetary perquisite. Schedule III Sl. No. 10 does not apply.
If the company bears the tax on a cash payout, or on any cash salary, that tax is itself the employee's income. The Supreme Court said so in Emil Webber v. CIT (1993), and the 2025 Act carries the rule in s.17(1)(f): a sum the employer pays to meet "any obligation which, but for such payment, would have been payable by the assessee".
So the tax has to be grossed up. The question is how many times.
How to gross up salary for tax
Say the company promises a ₹50,000 Diwali bonus "net of tax" to an employee in the 30% slab, which is 31.2% with cess.
Multi-stage gross-up. Keep adding tax on tax until it settles. The gross is ₹50,000 ÷ (1 − 0.312) = ₹72,674, of which ₹22,674 is tax.
Gross up once. Courts have read the borne tax as a non-monetary perquisite: a payment to the government, not to the employee. On that reading the tax on ₹50,000 (₹15,600) is added to income once, and the tax on that ₹15,600 (₹4,867), paid by the employer at its option, is exempt. Total outlay ₹70,467. The ITAT Special Bench in RBF Rig (2007), the Uttarakhand High Court in Sedco Forex (2012) and the Delhi High Court in Yoshio Kubo (2013) went this way.
Multi-stage is lawful and can never be under-deducted, which is why many payroll teams keep it. It simply costs a little more, and the employee could claim the difference back in their return. The single-stage method needs the employer's election and a CA who is comfortable with the case law.
How to book it
The accounting follows how payroll reported it.
| What was paid | Payroll treatment | Books |
|---|---|---|
| Tax on a share-settled ESOP, employer's election | Deemed TDS, exempt for the employee | A separate expense account, not deductible (s.35(a)(ii)) |
| Grossed-up tax on cash salary, reported as a perquisite | Taxable salary | Salary cost, normally deductible as a business expense (s.34) |
| Single-stage: tax on the borne tax, under the election | Exempt (Sl. No. 10) | Not deductible |
Keep the non-deductible tax in its own ledger so the tax computation can add it back without digging. One open point for your CA: the 2025 Act's s.35(a)(i) disallows "tax paid on income" in wording that looks wider than the old section. Most readers think it still means the business's own tax, but nobody has ruled on it yet.
Forms that show it
- Form 123 (the old 12BA), item 23: (a) tax deducted from salary under s.392(1), and (b) tax paid by the employer under s.392(2)(a). ESOP tax under the election goes in 23(b). Grossed-up cash tax is ordinary TDS, so it goes in 23(a), with the borne amount in row 20, "other benefits or amenities".
- Form 130 (the old Form 16): the borne tax counts in TDS, and the Sl. No. 10 exemption shows as another exempt amount.
- Form 138 Annexure II, in Q4: the perquisite in column I, the exemption in column Q. We explain the return itself in the Form 138 FVU file post.
A short checklist
- Classify every equity plan as share-settled or cash-settled. Ask your CA only about hybrid plans.
- For share-settled plans, decide whether the company will elect to pay the tax, and write it down.
- For cash payouts, choose: recover later within the 50% cap, or gross up (multi-stage or once).
- Open separate ledgers for deductible and non-deductible borne tax.
- Check that Form 123 puts each amount in the right item.
Equity payouts also raise a PF and ESI question, since the Labour Ministry's FAQs leave ESOPs out of "wages". That sits in the 50% wage rule post.
Vatsin Payroll offers the employer-bears route for the perquisite part, recovery from later pay for the cash part, and a gross-up option, with separate journal accounts for each. Pick whichever matches what your CA signs off.