Startup employees may have to effectively face a higher tax incidence on their employee stock option (ESOP) exits via buybacks from this year, as the Union Budget has proposed to treat share buybacks by companies like dividend income from October 1.
The move is expected to hurt the returns, net of taxes, from ESOP buybacks of promising and loyal early employees of startups who typically progress to higher management roles and get taxed at the higher income tax slabs.
“If the company is exiting employees by way of share buyback (which was earlier given as ESOPs), then the same will now be taxable in the hands of employees which earlier was taxable in the hands of the company,” said Anish Shah, Partner, M&A Tax and Regulatory Services, BDO India.
“As buyback will now be considered as a deemed dividend, it will now be taxed as per employee’s respective slab rates. Earlier it was taxable in the hands of the company at a flat rate of 20 percent (plus surcharge and cess),” he added.
Due to this change, ESOP liquidity programs will be taxed in the hands of the employee as ordinary income, whereas the employees had to pay nil taxes before. Although the employee may get the benefit of the capital loss later on the cost of acquisition of the shares, they still suffer a higher immediate tax during the ESOP buyback.
“If the company had Rs 125 to carry out a buyback earlier, they would pay Rs 25 of that as buyback distribution tax and pay the net Rs 100 to the employees. Today, if they do a buyback for Rs 125, the entire amount comes to the employees, who pay tax on it like dividend. If the employees are in the 30 percent slab, they will pay around Rs 36 instead of Rs 25. But, if the employees are in a lower slab they may pay a lower rate,” explained Ajay Rotti, founder and CEO of Tax Compaas, a boutique tax advisory firm.
In India, ESOPs are taxed twice — first when an employee exercises the options to acquire the shares in the company and then once again when the sale of shares happens. A longstanding demand of the startup ecosystem has been to rationalise this down to only one taxation event like advanced jurisdictions such as Singapore.
ESOP buyback is one of the most common liquidity events for ESOP holding staff of technology startups.
For example, initial public offer (IPO)-bound unicorn Swiggy is completing a $50 million buyback to reward employees even before the company hits the bourses.
Further, last year, Flipkart bought back ESOPs worth about $700 million from employees as a part of its move to separate full ownership of payments and financial services unicorn PhonePe, as the e-commerce giant looked to hire and retain talent at a time when most startups in the country have been undertaking layoffs due to the ongoing funding winter.
ESOP cashouts have led to $1.46 billion of wealth in the hands of startup employees between the beginning of 2021 and end of 2023, according to data from Qapita, signalling a change from the times when startup employees were not quite sure if the options would turn into a real shareholding and then into money.
At the time of the startup funding boom of 2021-22, there were stories galore of how employees were negotiating more ESOPs and less cash payments as part of their salary negotiations with tech startups.
“When you join a startup as an employee, you join for a significant multiplier of wealth and that multiplier is the ESOP. The salary is at best on a par with the market, but never really a differentiator. The challenge, of course, is that there is always an element of risk with ESOPs,” Harshil Mathur, founder and CEO of fintech unicorn Razorpay, told Moneycontrol earlier this year.
“We have seen people at our company create life-changing wealth through ESOPs. They would have never been able to do that with salary increases even over a decade,” he said.
Razorpay has done four ESOP buybacks in the last 10 years of its existence, with the latest taking place last year, when it bought back $75 million worth of shares from employees.
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