Employee Stock Option Plans (ESOPs) are an essential tool to encourage employees to participate in the growth of the company. Many startups and other companies award ESOPs to attract and retain talented employees for the long-term in the company. However, due to tax rules related to ESOPs, owning them may be onerous to the employees.
Under the present tax rules, ESOPs are taxed at two different levels in the hands of the employees. Firstly, at the time of allotment, ESOPs are taxed as a ‘perquisite’ forming part of the employee’s salary. The difference between the fair market value of the stock options and the exercise price paid by the employee is taxed as ‘perquisite’. In this instance, the employee has not received any money and yet has to pay tax on the prerequisite. These ESOPs are taxed again when sold. The employee pays a capital gains tax at the time of sale of the ESOPs. The tax payable on the ‘perquisite’ portion made the ESOPs unattractive to the employees since in many cases the employee would not have enough money to pay the tax.
Budget 2020 proposal
The Budget 2020 has brought in a change that allows deferment of the tax for ESOPs granted by ‘eligible startups’. As per the budget proposal, the ESOPs allotted on or after 1 April 2020 by an eligible startup would be taxed as a ‘perquisite’ in the hands of the employee after 5 years of allotment or on the sale of the ESOPs by the employee or termination of employment, whichever is earlier. The budget 2020 thus defers the tax on the ‘perquisite’ portion of ESOPs reducing the tax impact on the employees’ salary in the initial years of an ‘eligible start-ups’.
‘Eligible startup’ - Not all startups are registered with IMB
The budget proposal of the deferment of ESOPs tax does not apply to all types of startups. The proposal is beneficial only for employees of startups registered with the Inter-Ministerial Board (IMB) of Certification. While many startups are registered with the DPIIT (Department for Promotion of Industry and Internal Trade), very few of the start-ups have availed a certification from the IMB.
The certification from IMB is required only if the startup wants to avail income-tax holiday. Many start-ups have not obtained a certification from the IMB in view of their continued losses. Hence, many registered start-ups with DPIIT who face issues of liquidity will still not be able to avail of the tax benefits given to ESOPs.
Tax incidence on the ESOPs
The ESOPs granted are taxed twice in the hands of the employees, as ‘perquisites’ and as ‘capital gains’. Though the tax on ‘perquisite’ is deferred, the overall tax incidence remains the same. Only the timing of the tax dues arising on the allotment or exercise of ESOPs will be deferred.
Startups need to retain talent and manage liquidity. In certain cases, startups may take a long time before they start making profits. The period may be greater than 5 years. The deferment of ‘perquisite’ tax to 5 years from the date of allotment may not meet the objective of ESOPs, which may be required as a substitute to high salaries, which also help in addressing the liquidity concerns of startups.
Instead, the point of taxation could have been deferred to the date of sale of ESOPs by the employee or date of termination of employment, whichever is earlier. The employee may then be allowed to pay only the capital gains tax on the sale of ESOPs. Such ESOPs, which are unlisted attract long-term capital gains tax of 20% (plus cess) when held for more than two years. Note that the gains from listed securities are taxed at 10% (without indexation) if they exceed Rs 1 lakh. No such threshold is available for unlisted equities.