It is an undisputed fact that employees perform better in an organization when they have a stake in the business. As a part of long-term incentive schemes, notably during the formative years, start-up companies grant Employee Stock Options (ESOPs) which is a key instrument to retain talented employees and make them participate in the equity growth of the company. Overtime, ESOPs have become instrumental in Indian corporate and start up ecosystem to encourage high-value employees and retain their talent.
The provisions of income-tax law have provided various incentives to start-ups. In order to further spur the start-up ecosystem, the Finance Minister Nirmala Sitharaman in her 2020 Budget Speech, proposed the deferment of incidence of tax liability arising on account of exercise of ESOPs by the employees of eligible start-ups. This article analyses the consequences of the proposed tax deferment benefit provided by the Budget and whether these benefits meet the expectations of stakeholders.
A comparison between the current provisions and the proposed amendments:
Currently, allottees of ESOPs have to bear the income tax incidence at the following two stages:
||When ESOPs are converted into shares upon exercise of options by the employees
||Taxable as perquisite under the head income from salary in the year of exercise
||When the shares allotted under ESOP scheme are transferred by the employees
||Taxable under the head capital gains in the year of transfer
Further, the employer has an obligation to withhold tax on perquisite arising to employee on account of issue of shares under the scheme of ESOP.
Under the prevailing tax law, payment of tax on perquisite arising in the year of exercise of ESOPs leads to undue hardship for allottees on account of outflow of cash. This predicament is further exaggerated in case of employees who do not intend to sell their shares immediately but continue to hold the same as long-term investments. As a consequence, in spite of the fact that the benefit accruing to employees on exercise of ESOPs is merely notional and does not entail any receipt of funds, the employees still have an obligation to pay tax on accrued benefit.
Taking into consideration the plight of employees exercising ESOPs, the Finance Minister has proposed an amendment in the income-tax law to provide the benefit of deferring the tax liability arising on ESOP perquisite which will have to be paid within 14 days of the earliest happening of any of the below mentioned events:
• expiry of 48 months from the end of the relevant assessment year of exercise of ESOPs (5 years after the expiry of year of exercise of ESOPs); or
• date of transfer of shares allotted under ESOP scheme; or
• date on which the employee ceased to be in employment
The aforesaid tax liability on ESOP perquisite has to be computed on the basis of rates in force for the financial year in which the ESOPs are allotted to the employees.
It is pertinent to note that the amendment with respect to deferment of tax liability provided by the Budget applies only to the employees of entities that are incorporated after 01 April, 2016 but before 01 April 2021 and qualified as eligible start-ups under section 80-IAC of the Income-tax Act, 1961 ('Act'). To be eligible for this benefit, the start-ups have to hold a certificate of eligible business from the Inter-Ministerial Board (IMB) of certification as notified in the Official Gazette by the Central Government. Such benefit of tax deferment provided by the Budget not only applies to ESOPs but also to other specified securities or sweat equity shares.
Consequential amendments have been proposed to defer the tax on perquisite to be withheld by the eligible start-ups arising on account of exercise of ESOPs. As per the proposed amendments, the eligible start-ups would be required to withhold tax on ESOP perquisite within 14 days of the earliest happening of the aforementioned events.
The tax liability in the hands of employees of eligible start-ups, is now deferred to 14 days from the date on which the employee has proceeds on account of transfer of shares or ceases to be in employment. In the scenario where the employee of eligible start-up continues to be in employment, a breather is given by prescribing a period of 5 years from the year of exercise of ESOPs.
It is expected that a clarification may be issued by CBDT detailing the manner in which the employees of eligible start-ups would be required to disclose the details of ESOP perquisite in their income-tax return with the corresponding reduction of tax liability arising on ESOP deferred to the later date.
The first impression is that it was a big win for the start-up economy when the Finance Minister proposed to allow deferment of tax liability on ESOP perquisite. A major hurdle faced by start-ups is the retention of highly talented personnel. The proposed amendments with respect to the deferment of tax liability would reduce apprehension on part of the employees for participation in ESOP schemes. In turn, this would further reduce the attrition prevalent in start-ups. It is therefore, commendable that the government has acknowledged the concerns around ESOP taxation by proposing a significant relief to the employees of eligible start-ups. This amendment is realistic and praiseworthy.
Considering the fact that the percentage of start-ups which qualify as eligible start-ups under section 80-IAC of the Act and holding the requisite certification from IMB is meagre, it would also be important to consider by the Finance Minister for extending the scope of the benefit of tax deferment to other start-ups not covered under section 80-IAC of the Act.
Furthermore, few stakeholders were left unimpressed and have raised the concerns that the Budget has skipped one among the key expectations with respect to removal of taxation on account of grant of ESOPs in two events (i.e. at the time of exercising of ESOPs and at the time of transfer of shares allotted under ESOP scheme).
It has been a long-standing appeal from the business community to modify the taxation rules for ESOPs, which represents that the employees have to pay tax only on capital gains arising at the time of transfer of shares. Though, the amendment defers the tax payment for a particular class of employees, it does not address a similar issue faced by other class of employees who perhaps may be going through the similar pain of payment of taxes on notional income. Notably, the current proposal does not alter the tax regime for employees but only defers the tax liability on ESOP perquisite to a later date.
CA Amit K and CA Piyush Mohan Thakur (with inputs from CA Sai Tejeswar Reddy)