ESOP taxation; on Real(ised) income, not on No(tional) income

The Employee Stock Option Plans (ESOPs) have been used as an incentive to hire and retain talent by many organisations, for a long time. 

This is particularly so in the case of start-ups, where they compete to hire and retain talent vis-à-vis big brands and higher compensation offered by large corporates and multinational corporations.  
 
Currently, as per the Income-tax Act, 1961 (IT Act), the ESOPs are taxed at two stages in the hands of the employees:-

• At the point of exercise - The difference between the fair market value (FMV) on the date of exercise and the exercise price is taxed as perquisite i.e. part of salary 
• At the point of sale - The difference between the sale price and the FMV on the date of exercise is taxed as capital gains  

The taxation at the first stage i.e. at the time of exercise of options often leads to cash flow issues for the employees, as it is only a paper conversion of the options into shares, while there may not be any avenue to liquidate the shares at that time especially in case of unlisted companies. 

As is the nature of the beast in case of the startup ecosystem, it is said that eight out of ten startups fail or are not able to scale up.     

• This effectively means that the tax paid on ESOPs at the time of exercise by the employee may be a dead cost, in case the start-up ceases to exist before the employee gets an opportunity to sell his shares.  
• Similarly, it is seen that the valuation of start-ups varies considerably over time. In some cases, it could go up and down by millions of dollars in just a few quarters.  
• Thus, if the valuation goes down, the employees may suffer for no fault of theirs, in case they had exercised the options at higher valuation while they sell the shares at a much lower valuation later. 

Due to these challenges, representations were made by start-ups before the government to tax ESOPs only at the point of sale. 

These recommendations were considered and partially accepted by the government. Accordingly, an amendment was made by the Finance Act, 2020 wherein the tax deduction at source (TDS) with respect to perquisite income on ESOPs of eligible start-ups was deferred. 

Accordingly, an option was provided to the eligible start-ups to deduct tax on perquisite income on exercise of ESOPs within 14 days of the following, whichever is earlier:

• After the expiry of 48 months from the end of the relevant assessment year; 
• From the date of sale of shares; or  
• From the date the taxpayer ceases to be an employee of the eligible start-up 

This provision, however, does not address the cash-flow issue of the employees in totality. It merely defers the TDS liability by a few years. 

Further, an 'eligible start-up' has been defined to mean a start-up referred to in Section 80-IAC of the Act. Under the said provision, 'eligible start-up' means a company, or a limited liability partnership engaged in an eligible business that holds a certificate of eligible business from the Inter-Ministerial Board (IMB) of Certification. 

Additionally, an 'eligible start-up' should be incorporated by March 31, 2022. This requirement poses the following challenges: 

• Start-up incorporated after 31 March 2022 would not qualify as an 'eligible start-up' under the provisions of Section 80-IAC of the IT Act  
• Links the benefit to a start-up that holds a certificate from IMC. 

Way forward 

In order to address the cash flow issue faced by the employees, it may be better to shift the tax incidence to the time of sale only instead of two stages as at present - perquisite taxation and capital gains taxation. 

Additionally, the benefits should also be extended to ESOPs offered by all companies and not limited to eligible start-ups. This will help several companies which have been adversely impacted due to the pandemic and are facing challenges in retaining good talent. 

This will also streamline ESOP taxation in the hands of employees of both start-ups and mature companies.  

Recently Prime Minister Narendra Modi declared January 16 as the startups day and laid emphasis on the importance of start-ups in India's economic progress.  

Therefore, this year's budget may be an opportune time to consider the above recommendations favorably so that employees benefit in a true sense without any adverse out of pocket consequences vis-à-vis ESOPs. 

This article was originally published in Business Today.