Here are ESOP taxation reforms Budget 2022 missed

Deepak Abbot 

In Budget 2020, taxation on exercise of employee stock ownership plan (ESOP) was removed under Section 191 of the Income Tax Act, 1961. While this was a welcome move in recognising the significance of ESOPs among startups, the devil lied in the detail.

This was applicable only for: one, startups incorporated after April 1, 2016 registered with the Department for Promotion of Industry and Internal Trade (DPIIT) under the Startup India initiative, and; two, those with an annual revenue of less than Rs 100 crore.

Half-baked Reforms

While point one would cover many startups, including most of the newly-minted unicorns, point two excludes most of these unicorns except few who were overvalued based on their future potential and not linked to their current traction. This clearly puts revenue-generating large startup employees at a huge disadvantage as they are being penalised for building a sustainable business.

However, this is not even the core of the problem of this half-baked ESOP reform. Other conditions made it even more difficult to implement: Eligible startups had to be approved by an inter-ministerial board separately, followed by approval from IT department under Section 80 of the Act. As a result, only 0.5 percent startups are eligible, which renders this reform useless.

Another rule which made it unattractive is that tax would be applicable if employees leave the startup. This is a huge sore point considering employees have not received any cash yet, but have to shell out significant tax upfront.

Tax On ESOPs

Coming to Budget 2022; startups were expecting all the above limitations to be relaxed in addition to bringing some tax parity between the listed and unlisted (ESOPs in this case). While the shortcomings of earlier reforms didn’t come through, the Finance Minister did bring the surcharge to 15 percent on long term capital gain (LTCG) of all kinds, from 37 percent earlier. This surcharge is similar to the surcharge on listed equities. While this brings the LTCG on unlisted equities to 23.92 percent from 28.5 percent earlier, it is not going to bring the taxation on ESOPs lower as assumed by some startup founders and finance professionals.

Here’s why it makes no difference to the on ground issues around ESOP taxation:

• ESOP would still be double taxed on exercising and liquidation,
• ESOP would still be taxed as per the income slab, where it could go up to 42.7 percent

Double Taxation On ESOPs

ESOP when exercised are taxed based on the Fair Market Value (FMV), and then taxed again at the time of buyback or secondary depending on the selling price at the time of selling, which could be higher than the FMV.

ESOPs Won’t Gain

In reality, a startup announces a buy back or a secondary round, and invites employees to sell their vested ESOPs — employees exercise it immediately, and then back-to-back sell it and get liquidity. This is classified as perquisite or ‘income’, and taxed as per the tax slab which could be as high as 42.7 percent (for above Rs 5 crore).

For employees to derive the benefit of this LTCG surcharge drop, they need to do the following:

• Exercise ESOPs when they are vested. Pay the strike price, and take it to their demat account
• Pay the tax on the difference between exercise price and FMV on that day
• Keep ESOPs in the demat account for two years, and then sell if there is a secondary or buy back
• only in this case tax is 23.9 percent (which was 28.5 percent earlier)

Many startups have announced regular ESOP buyback (twice a year in some cases) and some have even equated this with cash by allowing employees to sell every year when it vests. Through such policies, these startups are discouraging ESOPs to become ‘long term’ choices. Very few employees have the conviction or knowledge of taxation to avail LTCG benefits. In my interaction with numerous startup employees, I have never come across anyone who has exercised ESOP without any buyback. This is more of a cultural change that startups need to bring, but we have a long way to go.

Calculating Tax

Scenario 1: An employee has vested 100 ESOPs. The exercise price is Rs 10, but the FMV of the startup values each share at Rs 1,000. The employee exercises 100 ESOPs, and pays Rs 1,000 to the company. Here, the employee has to pay a tax on Rs 99,000 (100 ESOPs X Rs 1,000 (FMV) — Rs 1,000 paid for exercising). Depending on the employee’s tax slab, this tax could be as high as Rs 42,273.

In addition to the above, there could be three further scenarios here on:

Scenario 1a: The employee immediately sells it as part of the buyback arranged by the company. The buyback happens at exactly the FMV. There is no further tax liability on the employee.

Scenario 1b: The buyback happens at Rs 1,500 because the company's secondary round has been priced higher due to a huge demand. Here, the employee has to pay an additional tax of Rs 21,350 (due to additional gain of Rs 50,000).

(Note: If the above startup is among 0.5 percent approved under Section 80 of the Income Tax Act, then this employee has to pay a one-time tax of Rs 63,623 provided this employee continues to remain in service in that startup).

Scenario 1c: The employee doesn’t participate in the buyback or secondary upon exercising and payment of tax, but decides to benefit from the rising valuation of the startup. They keep the exercises shares in demat account for two years. After two years, there is a buyback event, and the share price of the startup has gone up to Rs 3,000.

Now the new provision under Budget 2022 kicks in, and the tax will look like this: The employee gets Rs 300,000 in hand (100 ESOPs X Rs 3,000 per share). The tax liability is Rs 71,700 (23.9 percent). The employee had paid Rs 42,273 tax at the time of exercising so now they have to pay remaining Rs 29,427. In this case the employee benefited from the LTCG, and overall paid much lesser tax.

Scenario 1c is a rarity in today’s environment where both startups and employees are maximising for the present.

So, to make ESOPs a real winner in India, we need to:

• Tax ESOPs only on exercising, and
• ESOPs should be taxed as per listed shares taxation which means 15 percent if sold in less than one year, and 10 percent if sold thereafter

Until then, ESOPs will remain tax unfriendly and employee unfriendly. One hopes that Budget 2023 will bring in the real reforms, reforms we all have been waiting for.

Deepak Abbot is co-founder, IndiaGold. Views are personal, and do not represent the stand of this publication.