What Does Tax Deferral on ESOPs Mean for a Startup?

Employee stock ownership plans (ESOPs) are attractive benefits part of the employee compensation package.

As companies understand the pain points of retaining talented staff, offering meaningful employee stock options makes more sense. And what’s more, your employees can now enjoy the benefits of ESOPs with the current tax deferral strategy, which allows them to pay taxes later.

This article provides an overview of tax deferral on ESOPs, weighing the cost and benefits and what this means for your employees.

Allocation of ESOPs and their benefits in India

The implementation of ESOPs is a complex undertaking. Most companies and start-ups are governed by the Companies Act 2013 in India. The Act enables the allotment of shares to employees under an ESOP at a future date and a predetermined price. Issuance and allotment of ESOPs can be done in cash, cashless, or cash on a concessional basis.

The benefits of ESOPs extend to all core constituencies, including the employees, employers, and shareholders. For companies, this means an opportunity to hire and retain talented individuals. For employees, ESOPs bring a sense of equity ownership. ESOPs also enhance shareholder liquidity and enable the transfer of ownership.

Taxation of ESOPs: When Does It Happen? 

Your employees receive ESOPs with the right to purchase a certain number of shares at a predetermined price. Depending on the vesting schedule, they may either choose to exercise and hold or exercise and sell.

The taxation of ESOPs happens on two occasions. These include:

1. At the time of exercise

The first levy occurs during the allocation of shares on the exercise date. The taxation depends on the fair market value (at exercise date) and exercise price. This taxable value is a prerequisite, which is deducted as deducting tax at source (TDS) by the employer.

Until recently, when employees chose to exercise their ESOPs and collected shares, they were subjected to income tax (30%+) on the entire value of the shares. But this has changed since the Budget for 2020 (more on that later).

Read more: What is the Right Time to Exercise Stock Options?

2. At the time of sale

The sale of the allocated stock triggers the second levy. The taxation depends on the difference between the FMV (at the exercise date) and the sale value. This value is taxable as capital gains.

Listed shares 

For instance, if the employee holds his ESOPs for fewer than 12 months, the gains will be taxed at 15% and treated as “short-term capital gains”.

If the employee sells his ESOPs after 12 months, the gains above INR 1,00,000 will be taxed at 10%. However, gains up to INR 1,00,000 are not taxable.

Unlisted shares 

If the employee sells his unlisted shares (holding more than 24 months), the gains will be taxed at 20% with indexation and treated as “long-term capital gains”.

If the holding period is less than 24 months, the gains will be taxable according to the slab rate of the holder. Therefore, the gains are considered short-term capital gains.

Read more: 6 Changes in the Revised ESOP Regulations

How Can Startups Enjoy the Benefits of Tax Deferral?

As mentioned already, employees had to pay perquisite tax (30%+) upon exercising their ESOPs. These startup shares, which were often illiquid, are expected to be worth much more in the future, but the tax applied on them was immediate.

The Union Budget 2020, presented by Nirmala Sitharaman, Finance Minister of India, on February 1, 2020, changed that. According to the amendment, employees from an eligible start-up can choose not to pay tax in the year of exercising the option, i.e., they can avail of tax deferral.

In this case, the TDS levied on the perquisite stands deferred to 14 days from any of the following events, whichever is the earliest:

• Date of termination of employment
• Date of sale of ESOPs by the holder
• Deferring the tax payment by five years from the year of allotment

Only employees from eligible start-ups can avail of these benefits. The criteria of eligibility include:

1. The start-up is incorporated on or after April 1, 2016, but before April 1, 2021.
2. The company’s total turnover did not surpass 25 crores from the period dated April 1, 2016, to March 31, 2021.

According to the Official Gazette by the Central Government, the startup holds a certificate of eligibility from the Inter-Ministerial Board of Certification. This strategy intends to attract and retain talented employees.

It is a big relief for employees even though the benefits last until they switch jobs. The step is to ease the rigidity since there were no cash benefits; rather, the employee had to pay additional taxes.

The current step of tax deferral on ESOPs is a positive initiative by the Indian government that aims to boost entrepreneurship and the start-up ecosystem by attracting new talent and avoiding employee liquidity issues.

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