Indian startups had been anticipating changes to the tax regime for employee stock option schemes (ESOPs), and the Finance Bill 2020 has indeed proposed some tweaks.
The changes are required because the current regime for ESOPs, which trigger a perquisite tax on the exercise of the stock options at fair market value, makes the entire proposition of ESOPs unattractive.
As finance minister Nirmala Sitharaman rightly pointed out in her budget speech, ESOPs comprise a significant component of compensation for the employees and play an important role in attracting and retaining talent.
However, the budget doesn’t exempt or shift the tax charge to an event later than the time of exercise of the ESOP (that is, either allotment or transfer of the security to the employee) as it does not propose any change to the substantive provisions under section 17(2)(vi) of the Income-Tax Act, 1961.
All that the budget does is defer the payment of the perquisite tax by employees when any of these events happen:
- Expiry of 48 months from the end of the assessment year relevant to the previous year in which the ESOPs are exercised;
- Sale of such security by the employee; or
- Cessation of employment of the concerned employee with the employer which allotted or transferred such security to the employee under ESOP.
The perquisite tax is required to be paid within 14 days of any of these events taking place.
Thus, the provisions provide more time to the employee to liquidate his or her shares and arrange money to pay the perquisite tax incurred on the exercise of the ESOPs.
Although the deferral of the perquisite tax is welcome, it’s not without practical challenges given the conditions attached.
First, the employer has to be an eligible startup referred to in section 80-IAC of the Income-Tax Act. This section stipulates that the eligible startup should be incorporated on or after April 1, 2016; it should be notified by the Department of Promotion of Industry and Internal Trade (DPIIT) and certified by the inter-ministerial board (IMB); and that it should not exceed the turnover of Rs 100 crore (as proposed in the budget).
Thus, a startup set up before April 2016 will not qualify for the new ESOP tax regime even if it is notified by the DPIIT and certified by the IMB.
This restrictive qualification criteria means only a very small number of startups will be eligible for the new ESOP tax regime.
Second, the employer has to be an eligible startup when the employee exercises the ESOPs. So, if the employer qualifies as an eligible startup at the time of grant of ESOPs but breaches one of the conditions for eligibility at the time of exercise of ESOPs by employees, the employees will not benefit from the new regime. This may create undue hardship for the employees when the ESOPs are planned relying on the new tax regime.
Third, the trigger of payment of the perquisite tax on the cessation of employment is misplaced from a commercial standpoint. This is because companies often allow employees to continue to hold ESOPs even after leaving the job.
In such a case, employees who wish to continue holding their ESOPs after leaving their jobs may not be able to do so for want of cash needed to pay the tax. Thus, the termination of employment may force them to sell their ESOPs.
Inversely, this may also limit the mobility of an employee for better opportunities until he or she could fetch returns on the sale of securities received through ESOPs to pay the perquisite tax. Also, situations such as cessation of employment due to death or disability may need to be thought through carefully from the employee standpoint.
Additionally, there are situations such as stock or business transfers by way of mergers or demergers, slump sale, stock swaps and acqui-hires wherein businesses and/or employees are merged with or transferred to other entities. This results in transfer or exchange of shares received through ESOPs; or transfer of employees to other entities resulting into termination of employment with the startup which has allotted shares; or issue of options under new ESOP schemes; or a combination of any of the above.
The implications for these situations under the new ESOP tax regime require evaluation.
Overall, the new ESOP tax regime retains the earlier law, with a tweak of deferral, and misses the overarching principle of not taxing any notional income in the hands of a taxpayer.
This becomes more relevant when the finance minister considers ESOP as a significant portion of the compensation to the employees. Thus, unless a compensation is realised by an employee, the same should not be taxed.
Under the proposed context, even if the fair market value of a particular share or security falls at the time of sale, termination of employment or expiry of the 48-month period, the employee will have to pay the perquisite tax on the basis of the fair market value as on the date of exercise.
This provision must be amended to ensure that in case of a realization by an employee which is lower than the fair market value as on the date of exercise, then only the actual reduced gain should be taxed as perquisite.
To extend the logic further, if the sale of securities takes place below the exercise price paid by the employee, there should not be any perquisite tax implications in the hands of the employee.
To summarize, the implications under the proposed ESOP tax regime may need to be evaluated for various situations before framing any ESOP policy. The government should make changes to the proposed ESOP tax regime to smoothen the above issues and make it applicable to all startups notified by the DPIIT as well as to micro, small and medium-sized enterprises.
Yashesh Ashar is a chartered accountant.