Startups are full of risks as they are taking a bet on the future. The team that believes in that future comes together with no guarantee of success. One indicator of success is considered as the rising valuation of a startup. Rising valuation helps not just investors & founders, it is a great way for employees to benefit directly through ESOPs (Employee stock ownership plan).
ESOPs are fast emerging as the most popular reward component among startups. The primary purpose of ESOPs is:
- Attracting the best talent
- Retaining the employees
- Compensate for less than market salaries
- Spread the wealth
While startups are doing their bit to make ESOP schemes attractive, the community has always expected some help from the government on this front.
Taking into account the need of the entrepreneurs and India’s burgeoning startup ecosystem, the Union Budget for 2020 had allowed deferring the tax payments on ESOPs by five years or till the employees leave the company or sell their shares, whichever is the earliest. It was a step in the right direction and we were expecting some more changes in Budget 2021 ( presented on February 1). However, the latest budget did not touch upon the issue.
But, given the challenges that India’s burgeoning startup ecosystem is facing in the post-covid business ecosystem, it would have been a great help if the government had incorporated the following wishlist in its just presented budget.
Treat ESOPs On Par With Listed Equities
ESOPs are treated like grants under Section 111a, hence attracting a different tax structure than listed equities. The first demand from the government is to exclude ESOPs under Section 111A of the Income Tax Act. Under the provisions of section 111A, tax on short-term capital gains, gains from the sale of equity shares which are not listed on a recognized stock exchange, gains from debt mutual funds, gains from government securities and gains from any other assets, which are not shares are taxed at a higher rate.
Here is a quick snapshot of the difference in tax treatment of ESOPs vs listed equities:
Clearly, ESOPs are taxed much higher, especially if sold (after exercising) within 2 years. ESOPs just like listed equities carry the same risk in my opinion and risk-reward ratio should be at par.
Tax ESOPs At The Time Of Actual Sale
Prior to 2020, ESOPs were taxed immediately at the time of exercising which means employees had to pay tax on the difference between grant price & FMV (fair market value) at the time of taking ESOPs to their demat. While the government improved the policy in Union Budget 2020, even that change wasn’t enough. Let me explain how tax payment works on ESOPs through an example:
- Employee A has been granted 1000 ESOPs in April 2021
- Grant price/Face value is INR 10
- ESOP vesting schedule is 25% each year
- By March 2022, 25% of 1000 ESOPs are vested, which means the employee can decide to exercise (buy) 250 ESOPs at INR 10 by paying INR 2500 to the company.
- At this stage an employee can decide to not exercise as she is still continuing with the employment.
- Let’s assume that in last 1 year, the valuation of this startup grew significantly and the FMV (the price which determines the market value of the unlisted share) has grown to INR 1000 per share
- While the employee bought the share at INR 10, the FMV is INR 1000.
- As per the income tax rules under Section 111A, employee A has to pay tax on the differential. But this is where it gets a little complicated. There could be multiple scenarios which will impact the tax implication on the employee.
Employee decides to leave after exercising 250 ESOPs. Now as per the income tax rules, Employee A has to pay the tax on the notional gain of INR 990 per share. In this case the notional gain is INR 2,47,500 (250 esops x INR 990). Assuming the employee is in the highest tax bracket, they would have to immediately pay a tax of INR 81000 approx. Please note that the employee has not made any real income (money in the bank) yet she has to pay this tax.
Employee believes that the future valuation of the startup would rise so she decides to exercise her option and convert the options to stocks while continuing with her employment. In this case, no tax is due at the time of exercise unlike scenario 1. She continues to exercise every year and by 4th year, she has exercised all the ESOPs. There is no tax due yet. But in the 5th year while the employee still works at the startup will have to pay a tax on the differential amount of 250 ESOPs bought 5 years ago. So assuming the FMV has now risen to INR 10,000, this employee will have to immediately pay INR 8.3 lakhs as tax and will continue to pay the tax on differential amount every year on the ESOPs exercised 5 years ago.
Employee doesn’t exercise for 4 years but then decides to quit after 4 years and before quitting, exercises all 1000 ESOPs. Assuming the FMV has now risen to INR 10,000, the employee has to pay approx INR 33 lakh tax at the time of leaving the company.
Above scenarios indicate the tax burden on the employees. This gets more burdensome when there are no liquidity events which means the employee never got an option to encash its exercised option.
Some startups now allow employees to exercise anytime even after quitting which effectively means no tax due as employees can exercise just before the liquidity event. But in this case, employees will lose out on the LTCG (check Table 1 above) benefit. Employees will have to pay tax as per their slab. If these tax rules were modified, employees could have exercised and taken ESOPs to demat and paid lesser tax.
While the government may take time to amend these rules, startups can do their bit by organizing frequent liquidity events for their employees. Having said that, not all startups are lucky to attract hot investors willing to shell out money for the secondary shares.
Allow Gains From ESOPs To Be Reinvested In Startups To Save Tax
In Budget 2020, the government made a very progressive rule, allowing LTCG (Long Term Capital Gains) from selling a house to be offset by investing in a startup. On similar lines, it will be a game changer if the government can offset any gains from ESOPs by letting it reinvest in other startups. This will spur the startup culture further and can be instrumental in reshaping the economy.
Tip: as an employee, if you have STCG from ESOPs, you can offset it against any short term loss from listed equities or MFs.
The next budget is full one year away, but we hope that the government would not miss to provide this much needed support to startups, when it presents its policies to promote the country’s economy on February 1, 2022.
Update | February 11, 2021, 16:25 | Previously, the tax after 2 years was mentioned as 20%, it has been recertified to reflect 27% including cess.