Government Defers Tax On ESOPs By 5 Years: What Does It Mean For The Startup Community

The Union Budget 2020-21, presented on February 1, brought in a series of incentives for startups in India. Announcements such as the proposal to set up an investment clearance cell, relaxation of taxes levied on ESOPs and fresh tax cut for startups with a turnover of INR 100 Cr, among others were welcomed by all stakeholders of the community, including entrepreneurs, VCs and investors.

To ease the burden of taxation on startup employees, Finance Minister Nirmala Sitharaman proposed deferring the tax payment on Employee Stock Ownership Plans (ESOPs) by 5 years, or until they leave the company, or when they sell their shares – whichever is earliest. The announcement has sparked mixed reactions among startup founders, with many calling the move as a half-hearted attempt from the government.

Why ESOPs Are Important For Startups?

ESOPs serve as an important employee retention tool for startups, which often struggle to attract and retain top talent due to limited resources. They are granted to a permanent employee, director or officer to buy or subscribe to the shares of the organisation at a pre-determined price in the future. Typically offered as part of the employee benefit plan, ESOPs not only enable startups to preserve their cash outflow but also boost employee morale. Especially, early-stage ventures often give this option to their staff in lieu of a high salary.

The new amendment according to the Finance Bill, 2020

The draft Finance Bill, 2020, which proposes an amendment to Section 191 of the Income-Tax Act, says:

“For the purposes of paying income-tax directly by the assessee under sub-section (1), if the income of the assessee in any assessment year, beginning on or after the 1st day of April 2021, includes income of the nature specified in clause (vi) of sub-section (2) of section 17 and such specified security or sweat equity shares 28 referred to in the said clause are allotted or transferred directly or indirectly by the current employer, being an eligible start-up referred to in section 80-IAC, the income-tax on such income shall be payable by the assessee within fourteen days:

1. after the expiry of forty-eight months from the end of the relevant assessment year; or
2. from the date of the sale of such specified security or sweat equity share by the assessee; or
3. 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 earliest.”

As the startup community waits for the new changes to be implemented, here are the positive and negative takeaways from this initiative.

The Positives

Startups, especially the lesser-known find it extremely challenging to hire qualified, experienced employees. Given the cash crunch they face in the initial years, they tend to rely on ESOPs for onboarding the right talent. The 5-year deferment of tax payments on ESOPs will provide major relief to these startup founders as experts believe this is a great step to ensure the startup ecosystem has access to high-quality talent.

Additionally, the revised tax regime will enable startups to preserve cash on salary cost and rather utilize it to strengthen their technological framework, scale up operations and expand geographical reach. On the other hands, employees will now be exempted from paying taxes on ESOPs for five years.

The Negatives

While the latest move is expected to reduce attrition rates, a section of the startup community remains sceptical. Let us see why. At present, startup employees who opt for ESOPs are required to pay taxes twice – first when they sign up for ESOPs and then again when they redeem their shares. This creates a cash flow challenge for employees given there are no ready markets for selling the shares of startups, unlike listed companies.

Even though the five-year tax holiday on ESOPs is a positive step, dual taxation remains a major concern area. Moreover, only the startups recognised by the IMB (Inter-Ministerial Board) are eligible to avail this benefit. With no more than 250 IMB-registered startups, the majority will remain unaffected by the new tax regime.

The Road Ahead

The ESOP tax breather is certainly a step in the right direction, but there are certain limitations to it. To start with, the proposed changes should be applicable to all DPIIT-registered startups, thereby allowing every player to enjoy the benefits. Secondly, the double-taxation issues must be resolved and startup employees should only pay taxes at the time of sale. Finally, ESOPs for startups should not be taxed at a higher rate than listed stocks to create a level playing field.

Nevertheless, the Budget 2020-2021 is an indicator of the fact the government is listening to the demands of the startup ecosystem. There’s still a long way to go, but it’s certainly an exciting time for up-and-coming companies operating in the country.