It’s one month since the Union Budget 2020, and what was supposed to be the key highlight for startups — the tax deferral on ESOPs by a maximum of five years — has now turned to be a big dud.
Recognising the double taxation issue in the case of ESOPs, the finance minister Nirmala Sitharaman had said in the parliament, “ Currently, ESOPs are taxable as perquisites at the time of exercise. This leads to cash-flow problems for the employees who do not sell the shares immediately and continue to hold the same for the long-term. In order to give a boost to the startup ecosystem, I propose to ease the burden of taxation on 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.”
However, going through the Finance Bill 2020, soon it became clear, that the ESOP-related announcement will benefit hardly 250 startups in the country in contrast to the 40K startups that are said to be currently operational in the country.
In other words, the announcement was merely a clickbait.
As we heard from stakeholders last time — “Budget 2020: The Curious Case of Deferring Tax On ESOPs And Impact On Startups” — startups and investors are not entirely happy with the double taxation. And here’s a deeper look at the international practices and how India missed a golden opportunity to lead by example.
Why Budget 2020 Measures Are Good For No One
The devil lies in the detail. In contrast to the finance minister’s speech, the Finance Bill 2020, has actually set the eligibility clause for startups to avail the tax deferral scheme. The eligible startups are the ones referred to in section 80-IAC, determined by a body called Inter-Ministerial Board set up under the department for promotion of industry and internal trade (DPIIT).
Till December 11, 2019, only 38 Inter-Ministerial Board meetings have taken place and just 247 startups have been granted exemptions under Section 80IAC of the IT Act
Currently, there are 29,017 startups registered under DPIIT. However, not all can claim tax exemption under Section 80-IAC. The eligibility is determined by the IMB based on the below criteria:
- The startup is incorporated on or after April 1, 2016 but before April 1, 2021
- The startup’s products or services or processes are undifferentiated, have potential for commercialisation and have significant incremental value for customers or workflow
Further, the deduction under Section 80-IAC is for only three consecutive years out of seven years from the year of incorporation of a startup.
Tax Deferral On ESOPs: The Govt’s Explanation
The ESOP taxation issue was recently raised by investors during a post-budget meeting with the finance minister. Speaking on behalf of startups, Aarin Capital’s TV Mohandas Pai called ESOP a classical example well-intentioned but badly-designed government policy. Pai also questioned the functioning of the IMB and said that the Board has almost sabotaged the startup policy reforms.
Requesting Pai to share a written paper directly with the minister, Sitharaman defended the Board,
“IMB is not a deterrent. I want that to be clarified. They are not stopping people from getting registered. IMB is a step forward to look into how things are working. If you suspect the opposite, please share a paper in this regard.”
The DoR secretary Ajay Bhushan Pandey stated that the step was taken after a slew of pre-budget meetings with stakeholders.
Pandey further added that the government has, in fact, studied the ESOP norms in China, the US, Singapore and other countries as well.
“We looked into the Silicon Valley scenario too which is a place where lots of startups have gone and this is the kind of balance that we have tried to bring in.”
While DoR secretary is partly right in this defence that there are no gold standards set. Each of these countries is grappling with its own policy-related issues. It also overlooks the fact that the exercising ESOPs in startups itself is a risky affair for employees.
What Are The Global ESOP Practices?
Bringing the international perspective on ESOPs in startups, Siddarth Pai, founding partner of 3One4 Capital wrote, “Countries such as China, Singapore or the US allow the Board to adopt the ‘liquidation value’ of the ESOPs as their fair market value or even defer taxation to point of sale. Employees of listed entities can sell their shares on the stock market, allowing them to pay their taxes from the liquidity generated. But employees of Indian startups aren’t afforded these considerations and the latest changes don’t add to this either.”
To promote ESOPs in startups, Singapore offers a dedicated equity remuneration incentive scheme (ERIS) for startups which provides a tax incentive to employees who derive gains from ESOP granted by their employers.
According to the scheme, one can enjoy tax exemption of 75% of the gains arising from ESOPs. Tax exemption is available for each year of assessment over a period of ten years, subject to qualifying criteria. The accumulative gains on which the tax exemption applies are capped at $10 Mn over the ten-year period and the gains must be derived on or before December 31, 2023, according to the Inland Revenue Authority of Singapore.
The US has a multi-layered tax structure with the federal tax structure at the top of the hierarchy. Unlike India’s double taxation policy on ESOPs in startups, the US model is quite simple. The tax is applicable depending on the nature of short term or long term capital gains, and is applicable only at the point of sale, Sanjay Swamy, managing partner at Prime Ventures Partners told Inc42.
In the case of China, Chinese employee stock plans cannot hold more than 10% of total company equity and the policy does not allow individuals to own more than 1% of company stocks. This limits the real impact of employee stock plans.
Why There’s No Gold Standard For Startup ESOPs
For startups, ESOPs are usually offered to attract, hire and retain top talents, while fighting the cash crunch on one end. However, while India’s ESOPs taxation remains ineffective, many of the global startup employees having exercised ESOPs have found themselves caught in the middle, completely off-guard.
Taxes aside, the issues with ESOP in startups in India is that once exercised, employees have no opportunity to liquidate its shares but to wait for either IPO or company’s cashback offers. However, here’s the rub. If the startup is doing well, which is rare, the employee does not want to sell the stock. And if the startup is not doing well, which is the most common scenario, the company does not want to buy back its shares by paying employees, so ESOPs are worthless in this situation. The startup can not go for the IPO and the employee thus simply can’t liquidate its shares at all.
The cashback offers too has its trades. Let’s take a look at some Silicon Valley examples. In July 2016, Airbnb offered its employees an opportunity to sell a percentage of their stock as part of a deal that let investors buy those shares. However, in exchange, the employees had to agree to several blanket restrictions imposed by the company.
Similar is the case with Elon Musk’s SpaceX. According to the company’s written norms, “any violation of its employee stock sale rules could result in the worker forfeiting the rest of his or her shares.”
Further, startup mergers and acquisitions are pretty common in India and abroad. In the case of listed stocks, while one is free to sell their shares at the time of their choosing, in the case of unlisted shares, there’s no such free will.
In September 2015, a mobile security startup Good Technology’s employees suddenly came to know that their startup was sold to Blackberry and the stock after the acquisition was valued at 44 cents a share, down from $4.32. The employees had actually paid more taxes on their stocks than the stock value they owned.
Taxes On ESOPs In Startups: What’s The Way Forward?
Swamy said that ESOPs are just one of the many policy-related issues that startups are currently facing in India. While tax deferral on ESOPs in startups by a maximum of five years is a positive move, there is much more to be done.
Given the huge risk involved in ESOPs in startups, Sitharaman must take another look at the government’s approach of double taxation or else the startup and ESOPs culture which is growing fast in India too will only backfire as employees shun stock offers
As been demanded by venture capitalists and other startup stakeholders, the finance minister must abolish tax on ESOPs at the point of exercise as this gives no guarantee of liquidation to the employees exercising it. Investors believe that tax should be levied based on the difference between the purchasing price and selling price at the point of sale, considering the nature of LTCG or STCG, avoiding the dangerous and hypothetical term ‘fair market value.’