Decoded! Taxation of employee stock options vis-à-vis start-ups

Book value instead of full market value should have been considered for taxation of ESOPs

By P Bhalerao, P Sharma, V AGARWAL & V Sadhale

The president gave his assent to the Finance Act, 2020 (Act) on March 27, thereby, effectuating amendments to the I-T Act 1968, inter alia, with respect to taxation of employee stock options (ESOPs) vis-à-vis start-ups.

The Act provides relaxation to certain start-ups through deferment of perquisite tax payable on exercise of vested ESOPs. As a result, the employees are not required to pay perquisite tax on ESOPs immediately at the time of allotment of shares consequent to exercise of vested ESOPs.

Section 17(2)(vi) of the IT Act defines perquisites to include the difference in fair market value (FMV) and exercise price (EP) at the time of exercise. With start-ups being unlisted, it resulted in employees paying perquisite tax even though there may not have been real monetary gain and liquidity at this stage. An important amendment was introduced to mitigate this, by enabling employees of the eligible start-ups, as defined under Section 80-IAC of the IT Act, to defer payment of perquisite tax on ESOPs. Section 156 of the IT Act, as amended, provides for deferment of perquisite tax liability. The tax payment is now required within 14 days of the earlier of:

i) Expiry of 48 (forty-eight) months from the end of the relevant assessment year in which the shares are allotted;
ii) Sale of such shares by the employee; or
ii) Cessation of employment with the employer who allotted/transferred the shares on exercise of vested ESOPs.
The above deferment applies to a start-up eligible under Section 80-IAC of the IT Act that meets the following conditions:
a) Incorporated on or after April 1, 2016, but before April 1, 2021.
b) Total turnover does not exceed Rs 100 crore in a year; and
c) Have obtained a certificate from the Inter-Ministerial Board of Certification (IMC) certifying that the entity is engaged in: (i) innovation; (ii) development or improvement of products, processes or services; or (iii) a scalable business model with high potential of employment generation or wealth creation.

A private limited start-up or a limited liability partnership that qualifies the criteria mentioned in (a) and (b) above, may make an application to IMC in Form 80-IAC along with documents specified therein for seeking grant of the certificate.

In addition to these conditions, DPIIT recognises an entity as a ‘start-up’ for 10 years from the date of incorporation. Therefore, an eligible start-up will be entitled to the benefit of tax deferment on ESOPs only until the expiry of 10 years from its incorporation.

ESOPs, at the first instance, are taxable under the head “salaries” by being perquisites as per Section 17(2) of the IT Act. The difference between FMV and EP of shares is taxed as income from salaries. When the ESOPs are ultimately sold, the difference is taxed as capital gains. Concepts of a period of holding and indexation operate to arrive at taxable gains.

As per Rule 3(8) of the Income Tax Rules, the FMV of an unlisted company shall be determined by a merchant banker on:
i) the date of exercise of ESOPs; or
ii) any date preceding the date of exercise of ESOPs not being more than 180 days earlier than the date of exercise.

The prerequisite tax, required to be paid on the allotment of ESOPs as per Section 192, shall be deducted as TDS. This will be in addition to the tax-deductible on other components of salary. The employer, therefore, has to identify a mechanism to track events that trigger payment of tax on ESOPs. The amount of tax shall be derived as per the relevant tax rate applicable to the employee. Alternatively, the employer may recover the perquisite tax amount from the employee at the time of allotting shares consequent to exercise of vested ESOPs.

These events are subject to the deferment under Section 156 (2).

The relaxation of deferral of perquisite tax is only available to eligible start-ups that fulfil the criteria detailed in Section 80-IAC. As of April 11, 30,877 start-ups are recognised by DPIIT. However, only 266 start-ups have successfully obtained IMC approval. So, only 266 start-ups could theoretically get the deferral benefit. Again, out of these 266, few start-ups could become ineligible on turnover criteria. Effectively, a plethora of start-ups will be deprived of the benefit of this relaxation. Resultantly, the relief measure employed may fail to create a valuable impact on account of limited outreach.

Further, the benefit of deferral of tax is available to an employee for the prescribed period only if he continues to be an employee of the company and holds the shares arising out of the exercise of vested ESOPs. Since an ESOP plan or scheme may allow employees to hold shares even after cessation of their employment, the shifting of incidence of taxation to the sale of shares is an ideal way to deal with this situation.

One could argue that if perquisite tax should be continued, can the basis of taxation be changed to the difference of book value and EP. This will ensure no or minimal tax at the time of share allotment and the actual gain, i.e., the difference could be taxed at the time of sale. This will ensure minimum cash outflow on the notional tax event at the time of conversion of option into shares, though in case of cashless/phantom ESOP, this may not be effective.

Another aspect that needs to be thought through is the cause of cessation of employment of the employee. Employment agreements generally contain provisions for the cessation of employment in various scenarios including death and disability. In principle, an employee shall be entitled to the benefit of deferral of tax till the time of sale in case cessation of employment occurs on account of death, disability, or other events out of the employee’s control. It would be disastrous if an employee (or his legal heirs) experiencing such difficulties also must fulfil his tax obligations. The exemption may not, thus, translate into actual benefit.

While the attempt and the intent seem to be correct, unfortunately, the end result takes away the real intended benefit. This has ended being a mere theoretical exercise.

Bhalerao is partner, I+B, Chartered Accountants, Sharma is legal advisor, Agarwal is co-founder, & Sadhale is co-founder, LegaLogic Consulting