ESOPs are generally issued at a discounted price or at the fair market value (FMV) of the underlying share at the time of their grant. On satisfaction of the prescribed vesting conditions, employees get to exercise the ESOPs and receive shares of the company.
Typically, the employee pays a discounted price at the time of exercise (of the right to buy). This pre-fixed price, called exercise price, maybe a large cash outflow for the employee depending on the number of ESOPs exercised. The ESOP income is taxed as a perquisite (part of salary income) on the date of allotment/ transfer of shares on exercise.
The perquisite value is the difference between the fair market value of the shares allotted and the exercise price paid by the employee. TDS on perquisites is deducted from the salary of the employee at the income tax rate applicable on their salary. In a nutshell, at the time of exercise and allotment of shares, the employee pays exercise price and tax on perquisite from his pocket.
To be allotted shares of the employer company may seem to be a lucrative offer, however, the cash outflow (cost of buying shares and TDS) that it entails for the employee may reduce its appeal. This is especially true in the case of unlisted companies, whose shares cannot be easily sold in the stock market and therefore, remain as an illiquid asset in the hands of the employee with the possibility of its value going up or down in the future. To acquire the shares, the employee incurs cash outflow in terms of the exercise price and taxes. This has made ESOPs of unlisted companies unattractive.
To ease this concern partially, the Budget 2020 amended various sections of the Income-tax Act, 1961 permitting deferral of the timing of TDS deduction on ESOP perquisite from the employees. The amended Section 192(1C) allowed an “eligible start-up” as referred to in Section 80-IAC of the Income-tax Act to deduct or pay tax on the ESOP perquisite within 14 days of specified events as follows:
– Completion of 60 months from the end of the relevant financial year in which ESOP shares are allotted or transferred
– Date of sale of ESOP or sweat equity shares by the employee
– Date of cessation of employment of an employee with the relevant start-up
whichever is earlier.
“Eligible start-up” means a company, or a limited liability partnership engaged in an eligible business that fulfills the following conditions, namely:
a. It is incorporated on or after 1.4.2016 but before 1.4.2023
b. The total turnover of its business does not exceed Rs 100 crore
c. It holds a certificate of eligible business from the Inter-Ministerial Board of Certification as notified in the Official Gazette by the central government
Accordingly, the above benefit of deferral of payment of tax is available only for employees of ‘eligible start-ups’. At present, there are more than 88,000 start-ups recognised by the Department for Promotion of Industry and Internal Trade (‘DPIIT’), but only 993 are eligible under Section 80-IAC of the Act.
The current provisions of the Income-tax Act concerning taxation of ESOPs at the time of allotment/ transfer of shares create hardship for employees of all unlisted companies as employees suffer cash outflow on account of payment of both the exercise price and TDS at the allotment stage without immediate monetisation of gains. This hardship is further accentuated in the case of the start-up industry since a large part of the salary income of their employees is in the form of ESOPs. To pay the exercise price and tax obligations, many employees of such unlisted companies avail loans which adds to their financial burden and therefore, leads to ESOPs not being viewed favourably.
A supportive ESOP taxation policy in budget 2023 would allow a start-up or a privately held company to make ESOPs attractive to the employees as a mode of compensation. If the benefit of deferral of payment of tax is extended to all unlisted companies, it would go a long way in making ESOPs an attractive compensation proposition for the employees and help foster start-ups, in line with the government’s vision of encouraging innovation and entrepreneurship.
(Views expressed are personal. Vijayalakshmi PG, Senior tax professional, EY India contributed to this article.)