Many employers have introduced stock options to tide over the immediate cash crunch in their businesses and to also be fair to employees
The COVID-19 pandemic has created unprecedented disruption and uncertainty for businesses. One of the key priorities for many companies is to conserve cash and ensure continuity. Many employers have introduced non-cash compensation components such as Employee Stock Option Plans (ESOPs) to tide over the immediate funds crunch and to also be fair to employees who may benefit when businesses return to normalcy in the future.
An ESOP is an option that is granted to an employee for purchasing the company’s shares at a pre-determined price, at a future date, upon completion of certain vesting conditions. These conditions may be performance (of the employer or employee) based or time-based. Upon fulfilling the vesting condition, the ESOPs vest to the employee, i.e., the employee gets an unconditional right to purchase the shares at a pre-determined price.
From an employee perspective, the benefit from ESOP is based on the future expected growth and valuation of the company. Hence, the ultimate gain may vary significantly depending on the company’s growth. At the time of granting options, the future growth and valuation expectations are all projections, making the ultimate gain uncertain.
Tax implication is also one of the key considerations. In the case of ESOPs, there will be tax implications at two stages – on allotment of shares and on sale of shares. On allotment, the difference between the Fair Market Value and Exercise Price, is taxable as a perquisite and the employer withholds the necessary taxes thereon at the slab rate applicable to the employee. The Fair Market Value is the average of the opening and closing price on the stock exchange in case of listed shares and for unlisted company shares, as determined by a Category I Merchant Banker.
Further, appropriate perquisite value and the tax thereon is reported in the salary certificate. Thereafter, on sale of shares by the employee, the difference between the selling price and the Fair Market Value (that was taken into account for the perquisite valuation) will be taxed as capital gains. The tax rate may vary based on how long the shares were held before the sale, i.e., whether the gain is a short-term capital gain or a long-term capital gain.
Taxation on notional gains
It is pertinent to note that, on allotment of shares, even though there is no cash flow to the employee, the allotment triggers tax and the employer is required to deduct tax at source. This causes cash flow issues for employees as they are required to pay tax on notional gains without actual receipt of cash. In case the employees are allotted shares of listed companies, they may sell a part of the shares allotted to meet the tax liability and ease the cash flow.
However, in case of an unlisted company, disposing the shares could be a challenge given their limited marketability. In such cases, the ESOP plan generally provides for specific exit mechanisms for employees, which could include selling to existing shareholders or to a special purpose vehicle. However, in the absence of a regulated market, selling the shares at a desired price may sometimes be challenging. This is especially true in the case of start-ups in which a large part of key employees’ compensation, comprises of ESOPs.
In order to ease such difficulties faced by start-ups, the Finance Act 2020 introduced provisions for deferring the tax payment on the exercise of ESOPs of specified start-ups, by five years, or until an employee leaves the company, or when he/she sells the shares, whichever is earlier. Further, it is worthwhile to note that the above mentioned relaxation in respect of ESOPs is available only to eligible start-ups that hold a certificate of eligible business from the Inter-Ministerial Board of Certification.
Employees of foreign multinational corporations may receive shares of foreign companies under an ESOP. Incorrect or non-reporting of options / shares of foreign companies or income from the same may have penal consequences not only under the Income Tax Act, but also under the Black Money (Undisclosed Foreign Income and Assets) Imposition of Tax Act, 2015. Further, compliance under Foreign Exchange Management Act (FEMA) also needs to be ensured. For example for a resident under FEMA, the sale proceeds upon sale of shares of foreign company allotted under ESOP, are to be repatriated to India within 90 days of sale of shares.
ESOP is an effective compensation tool. A prudently drafted ESOP plan can help an employer conserve cash during these challenging times, while at the same time letting employees share in the profits and growth of the company, when the good times arrive.(The writer is a Partner with Deloitte India. Mousami Nagarsenkar, Reena Poddar, and Yaseen Boxwala from Deloitte Haskins & Sells LLP also contributed)