The Finance Bill 2020 proposed deferment of payment for Employee Stock Option Plan (“ESOP”) by a maximum of five years. Accordingly, the income of the assessee from ESOP who is employee of a startup recognized under Section 80-IAC, shall become payable within fourteen days:
after the expiry of forty-eight months from the end of the relevant assessment year;
from the date of the sale of such specified security or sweat equity share by the assessee; or
from the date of the assessee ceasing to be the employee of the employer who allotted or transferred him such specified security or sweat equity share, whichever is the earlier.”
Cause for Proposal
There was a long-standing demand from stakeholders including NASSCOM for a change in the taxation of ESOPs. Finance Minister, Nirmala Sitharaman in her budget speech also acknowledged the lacunae in the extant mechanism. She said:
“Currently, ESOPs are taxable as perquisites at the time of exercise. This leads to a cash flow problem for employees who do not sell the shares immediately and continue to hold the same for the long term. In order to give boost to the startup ecosystem, I propose to ease the burden of taxation of the employees by deferring the tax payment by five years or till they leave the company or when they sell their shares, whichever is earliest”
The extant law entails double taxation of ESOPs under S. 17(2) of the Income Tax Act, 1961. Firstly, at point of exercise ESOPs are treated as perquisites making employees liable to tax over the price difference between Fair Market Value (“FMV”) and exercise price. Secondly, employees become liable again to tax at the point of sale on capital gain, based on the difference between the selling price and FMV.
Capital Gains tax rates depend on whether it is for short term or long term. Notably, Capital gains tax on listed companies is at a maximum of 10%, whereas for unlisted startups, if ESOPs are held for 24 months or less, it is treated as short term capital gains and taxable per taxpayer’s slab rate. If it is held for more than 24 months, tax is levied at 20%.
However, the proposal leaves the liability unchanged, merely payment is deferred. Since the employee does not receive any income merely upon exercise of ESOP, tax incidence upon exercise is an unnecessary and burdensome requirement for the employee. Furthermore, Employee cannot leave startup without triggering payment of this tax, which leaves employee in a vulnerable position.
Notably, also, this change applies only to startups that have received inter-ministerial board’s recognition. This is a very small sub-class within the tens and thousands of startups recognized by the DPIIT. Most mature startups do not fall under this category. In fact, only about 200 startups are eligible under said Section 80-IAC.
What follows rationally is that exercise tax could be dropped altogether, while retaining taxation at the sale. It goes without saying that restricting the application of benefits to such a small number of startups leaves this proposal less effective. The scope of tax relief on ESOP should be extended at least to all startups approved by DPIIT.