Income Tax 10 Feb,2020
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Untangling the new ESOPs taxation
Ritu GuptaAssistant Manager, Taxmann.com
DIPEN MITTALManager - R & D, Taxmann

1. Introduction

The Finance Minister, Smt. Nirmala Sitharaman, has presented the Union Budget 2020. Various amendments have been proposed in the Finance Bill to simplify and rationalise the provisions of the Income-tax Act. One of the major amendments proposed in the budget relates to the taxability of shares issued by a start-up to its employees under the Employee Stock Option Plan (ESOPs).

ESOPs are a significant component in the compensation of the employees of start-ups as it allows start-ups to employ highly talented employees at a relatively low salary amount with the balance being paid via ESOPs. The taxability of ESOPs arises in the hands of the employee at two stages. Firstly, when an employee exercises his right to apply for the shares under ESOPs and, secondly, when such shares are sold by the employee.

At the time of exercising the option for ESOPs, the difference between the fair market value of shares on the date of exercising the option and the amount actually paid by the employee for such shares is taxable as perquisite under section 17(2)(vi) of the Income-tax Act and chargeable to tax under the head salary. Consequently, the employer is required include the amount of perquisite in the salary of the employee and deduct tax thereon under section 192 in the year in which shares are allotted.

As employees do not get any immediate benefit from the shares allotted under the ESOPs, the deduction of tax thereon in the year of allotment itself was very burdensome for them as it reduces the cash flow in their hand. To reduce the burden of taxes, Section 192 (TDS on salary), Section 140A (self-assessment tax), Section 191 (direct payment of tax by the employee) and Section 156 (notice of demand) have been proposed to be amended to provide for the deferment of TDS and payment of tax on income in the nature of perquisites arising from ESOPs.

2. Deferment of TDS and payment of tax on perquisite arising from ESOPs

Section 192, which provides for deduction of tax by employer from salary of employee, is proposed to be amended to provide that an eligible start-up as referred to in section 80-IAC shall deduct tax from income arising in the nature of perquisites from ESOPs within 14 days from the happening of any the following events (whichever is earlier):

(a) On the expiry of 48 months from the end of Assessment year in which shares are allotted under ESOPs;

(b) From the date the assessee ceases to be the employee of the organization; or

(c) From the date of sale of shares allotted under ESOP.

For this purpose, the tax shall be deducted on the basis of rates in force for the financial year in which shares are allotted or transferred under ESOPs.

A similar amendment has been proposed to section 191 and section 156 to provide that if an employer does not deduct tax on perquisites arising from ESOPs then tax shall be payable by the employee directly within aforesaid period either voluntary or in response to a notice of demand.

As tax payment has also been proposed to be deferred in respect of perquisite arising from ESOPs, Section 140A is proposed to be amended to provide that tax on perquisite arising from ESOPs shall not be considered while computing the self-assessment tax at the time of filing of return.

3. Our Analysis

The amendments proposed in the Finance Bill 2020 with regard to deferment of TDS and payment of tax in respect of income arising in the nature of perquisite from ESOPs can be explained with the help of the following questionnaire:

Q 1. Would every start-up and employees be benefited from this proposal?

No, only an eligible start-up as referred to in section 80-IAC and its employees would be benefited from the proposal made in the Finance Bill 2020 with regard to deferment of TDS and tax payment on perquisite arising from ESOPs.

As per section 80-IAC, an eligible start-up can only be a company or limited liability partnership (LLP) engaged in innovation, development or improvement of products or processes or services or a scalable business model with a high potential of employment generation or wealth creation. Further, it has to satisfy the following conditions:

 1.  It must be incorporated on or after 01-04-2016 but before 31-03-2021;

 2.  Total turnover shall not exceed Rs. 100 crores in the previous year for which deduction under section 80-IAC is claimed; and

 3.  It must hold a certificate of eligible business from the Inter-Ministerial Board of Certification.

As on December 18, 2019, only 250 start-ups have been recognised by the Inter-Ministerial Board of Certification.

The meaning of an eligible start-up is defined differently in the notification issued by DPIIT and in Section 80-IAC, which has been explained in the below table.

Particulars Definition as per DPIIT Definition as per section 80-IAC
     

Incorporation

The start-up should be incorporated as a:

■  Company

■  LLP

■  Partnership Firm

The start-up should be incorporated as a:

■  Company

■  LLP

Date of Incorporation No condition as to the date of incorporation Should be incorporated between 01-04-2016 and 31-03-2021
Eligible Business Entity should be working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation. Same
Tenure An entity is considered as an eligible start-up up to a period of 10 years from the date of incorporation/ registration An entity is considered as an eligible start-up up to a period of 101 years from beginning from the year in which it is incorporated or registered
Total Turnover Turnover of entity for any of the financial years since incorporation/ registration should not exceed Rs. 100 crore Turnover of entity for any of the financial years since incorporation/ registration should not exceed Rs. 1002 crore
Reorganization The entity should not formed by splitting up or reconstruction of an existing business The entity should not formed by splitting up or reconstruction of an existing business except in a situation specified in section 33B
Second-hand plant or machinery No condition as to the status of plant or machinery purchased for the business Value of second-hand plant and machinery should not exceed 20% of the total value of plant and machinery used in the business
Benefit of deferment of TDS on perquisites arising from ESOPs Not allowed Allowed

Q 2. Whether perquisite arising from ESOPs would be included in the income of the employee in the year in which shares are allotted or transferred by the employer?

Yes, the difference between the fair market value of shares on the date exercising of option and the actual amount paid by the employee for shares allotted or transferred under ESOPs shall be chargeable to tax as perquisite in the hands of the employee in the year in which shares are allotted or transferred by the employer because no amendment has been proposed under section 17(2)(vi) which provides for taxability of ESOPs as perquisites. However, no tax shall be payable on such perquisites in the year of allotment due to the amendment proposed by the Finance Bill, 2020 in Sections 192, 191, etc.

Q 3. At what rate, the tax shall be computed on perquisite arising from ESOPs?

As the perquisite arising from ESOPs shall be taxable in the year in which shares are allotted or transferred by the employer to employees, the tax shall be calculated on the basis of rates applicable in the year in which shares are allotted or transferred.

For example

X Pvt. Ltd launched an Employee Stock Option Scheme for its employee in year 00 under which shares of the company would be allotted to employees at free of cost. Mr. A, one of the employees of X Pvt. Ltd., exercise his option to apply for the shares of the company in year 01. At the time of exercising of option by Mr. A, the fair market value of shares was Rs. 100. However, the company allots shares to Mr. A in Year 02. What shall be the amount of perquisite and in which year it shall be chargeable to tax in hands of Mr. A and at what rate?

Answer

In the above example, the amount of perquisite chargeable to tax in the hands of Mr. A shall be the fair market value of shares on the date of exercising of option, i.e., Rs. 100 and it shall be chargeable to tax in the year in which shares are allotted by the company, i.e., Year 02. Thus, tax on perquisite shall be calculated at the rate as applicable in Year 02.

Q 4. Whether perquisites from ESOPs shall be required to be disclosed by the employee in the return of income of the year in which shares are allotted?

Yes, as perquisites from ESOPs is treated as income of the year in which shares are allotted to the employee, same would be required to be disclosed in the return of income of that year itself. However, as neither employer nor employee would be required to deduct TDS or pay tax, respectively, in such year by virtue of amendment proposed to section 192 and section 140A, the perquisite value of ESOPs should not be included in the total income for the purpose of computing the tax liability of that year.

It is expected that new ITR forms and Tax audit report will be amended to require the following information in respect of ESOPs in the year which shares are allotted or transferred to the employee:

(a)  Date of exercising of option

(b)  Amount at which ESOPs were allotted

(c)  Fair market value of ESOPs on the date of exercising such option

(d)  Number of shares allotted under ESOPs

(e)  Date of allotment of shares

(f)  Income in the nature of perquisite arising from allotment of shares under ESOP (to be computed automatically)

Q 5. How would an employee be able to defer the payment of tax on perquisite from ESOPs considering the fact that such income shall be required to be disclosed in return of income of the year in which shares are allotted?

An employee may be required to disclose the value of perquisite from ESOPs in his return of income of the year in which shares are allotted. But due to the proposed amendment, he shall not be required to pay tax on perquisite arising from ESOPs in such year.

So, it is possible that the Government may provide for a mechanism for deferment of tax in such a case. One of the recommended mechanisms that will be the most appropriate one in such cases can be explained with the help of the following example:

Mr. A, working in a start-up company, has been allotted 100,000 shares at the rate of Rs. 10 per share under ESOP scheme in the Financial Year 2020-21. The fair market value of shares at the time of exercising of option by Mr. A is Rs. 100. Thus, the perquisite value of ESOPs taxable in the hands of Mr. A comes at Rs. 90 Lakhs [100,000 shares* (Rs. 100 – Rs. 10)]. The annual salary of Mr. A (excluding perquisite value of ESOPs) in that year is Rs. 40 Lakhs. He continues with the company even after expiry of 48 months from the end of the assessment year in which shares are allotted and he does not sell the shares even after expiry of said period. What shall be the mechanism for deferment of TDS and tax on perquisite value of ESOPs in such a case?

Assessment Year 2021-22

Mr. A would be required to disclose the perquisite value of ESOPs, i.e., Rs. 90 lakh in his return of income but he shall not be liable to pay any tax thereon in such year. The total tax liability for that year should be computed only on his annual salary of Rs. 40 lakh which shall be as follows:

Tax liability for Financial Year 2020-21 without including perquisite value of ESOPs under total income

Particulars Amount (in Rs.)
Total Income 40,00,000
Tax on Rs. 40 lakh as per slab rates applicable for Assessment Year 2021-22 as per old taxation regime 10,12,500
Add: Education Cess 40,500
Total Tax Liability 10,53,000

Assessment Year 2025-26

As Mr. A continues with the company even after expiry of 48 months from the end of the Assessment Year in which shares are allotted and he doesn't sell the shares even after expiry of said period, the liability to deduct tax or make payment of tax on perquisite value of ESOP will arise in the Assessment Year 2025-26, i.e., 48 months from the end of the Assessment year (2021-22) in which shares are allotted.

For the purpose of computing the tax liability in respect of perquisite value of ESOPs, the tax liability for Assessment Year 2021-22 shall be recomputed by including the amount of perquisite in total income, and, accordingly, the differential amount would be required to be declared in Assessment Year 2025-26.

Tax liability for Assessment Year 2020-21 after including perquisite value of ESOPs under total income

Particulars Amount (in Rs.)
Total Income before including perquisite value of ESOPs 40,00,000
Add: Perquisite Value of ESOPs 90,00,000
Total Income after including perquisite value of ESOPs 1,30,00,000
Tax on Rs. 1.30 crores as per slab rates applicable for Assessment Year 2021-22 as per old taxation regime 37,12,500
Add: Surcharge 5,56,875
Add: Education Cess 1,70,775
Total tax liability for Assessment Year 2021-22 after considering perquisite value of ESOPs 44,40,150
Less: Tax already paid at the time of filing of return for the Assessment Year 2021-22 10,53,000
Differential amount to be deducted or paid by the employer or employee in the Assessment Year 2025-26 33,87,150

In this regard, the Government may also amend the Income-tax return forms and include an additional field to show tax on perquisite value of ESOPs under Part B TI- TTI and, accordingly, tax deducted by employer shall be adjusted from such tax and if there is any shortfall then tax shall be required to be paid by the employee.

Q 6. Whether an employee shall be required to pay directly if no tax is deducted by the employer in respect of perquisite value of ESOPs.

Yes, if an employer does not deduct or could not deduct tax in respect of perquisite value of ESOPs then the employee shall be liable to tax directly within 14 days from the happening of any the following events (whichever is earlier):

(a)  On expiry of 48 months from the end of Assessment year in which shares are allotted under ESOPs;

(b)  From the date the assessee ceases to be the employee of the organization; or

(c)  From the date of sale of shares allotted under ESOP.

If an employee does not pay tax then Assessing Officer can also issue of notice of demand.

Q 7. What shall be the consequences if an employer does not deduct tax or employee does not pay tax on perquisite value of ESOPs?

Section 191 of the act provides that where a person who was liable for deduction of tax at source fails to deduct or after deduction fails to pay such tax to the credit of the central government, he shall be deemed as assessee-in-default. In such a case, the assessee shall be liable for payment of taxes directly. If he fails to make direct payment of such tax, he shall also be deemed as assessee-in-default.

Consequently, they could be liable for the following consequences:

Particulars Employer Employee
Interest 1% per month for failure to deduct tax or 1.5% per month for failure to pay tax [Section 201(1A)] 1% per month [Section 220(2)]
Penalty Amount of tax which he fails to deduct or pay (Section 271C) Up to the amount of tax in arrears (Section 221)
Prosecution For a period not less than 3 months but which may extend to 7 years and with fine (Section 276B) -

_____________________

 1.  The Finance Bill, 2020 proposed to increase the period from 7 years to 10 years.

 2.  The Finance Bill, 2020 proposed to increase the turnover limit from Rs. 25 crores to Rs. 100 crores.