Budget 2023 Expectations: Tax reforms, policy support to maintain ESOPs as critical talent retention tool for startups

Over the last few years, Employee Stock Ownership Plans (ESOPs) have emerged as a powerful tool in helping Indian startups achieve various organisational goals. This includes talent retention, employee motivation and ensuring that the staff aligns their interests with company objectives by having a stake in the business.

ESOPs are instruments that let employees buy a certain number of shares at a decided price. For instance, the Bengaluru-based food delivery platform Swiggy has a $40 million ESOP buyback programme over 2 years. In July 2022 and July 2023, employees are allowed to liquidate the ESOPs by selling them back to the company. On the other hand, ecommerce giant Flipkart is awarding a whopping $700 million one-time cash payout to 25,000 employees who are holders of employee stock options. According to Inc42 Plus data, Indian startup employees made over $335 million through ESOPs in 2021 alone.

Taxability of ESOPs

ESOP taxation has always been a contentious issue for startups and their employees. Typically, the employee pays a discounted price at the time of exercise. This pre-fixed price, called exercise price, is usually a large cash outflow for the employee depending on the number of ESOPs he exercises.

As per the Income Tax 1961, the tax on ESOPs is levied in two stages. First, at the time of exercise of the options and then on capital gains at the time of sale of the shares. Once the employee has exercised the option, the difference between the fair market value (FMV) of shares and exercise price of shares is computed and taxed as perquisite. Further, TDS is deducted on this perquisite as per the income tax rate applicable to the employee. Basically, the employee is paying the exercise price and tax on perquisite at the time of exercising the option and allotment of shares from the startup.

This puts a financial burden on the employees and they become liable to pay a potentially large amount of tax under an ESOP scheme even without realizing any profits. In such a situation either the employee needs to defer the exercise of ESOPs or in the absence of a provision, it lapses.

Budget 2020: Tax on ESOPs deferred for startups

In a welcome move, the Budget 2020 amendment had proposed to defer TDS on the perquisite and stated that startup employees need not pay taxes during the year of exercising the option. As per this, the tax on ESOPs exercise stands deferred to a time when the employees are able to sell the shares and pay the required tax from the proceeds. To sell the shares they have up to 48 months from the end of the assessment year when the ESOPs were exercised.

However, this tax benefit is only available to certain startups that fulfil the required eligibility criteria. The startup needs to be incorporated after April 1, 2016, and before April 2021, its total business turnover should not exceed ₹25 crore in any of the previous years beginning on or after April 1 2016, and ending on March 31, 2021. Most importantly, the startup should hold a startup certificate of eligibility from the Inter-Ministerial Board (IMB) of certification as notified in the Gazette of the Central Government. Since only a very small percentage of startups have received the IMB certificate, this tax benefit is not available to 99 percent startups.

Key expectations from Budget 2023

The startup community is expecting a more effective and supportive ESOP taxation policy from the government in the upcoming Budget. According to Budget 2020 provisions, which became applicable from April 1, 2020, in case of eligible startups, income tax on exercise would be payable by the assessee (i) within 14 days after the expiry of forty-eight months from the end of the relevant assessment year; or (ii) from the date of the sale of such ESOP shares by the assessee; or (iii) from the date the assessee ceases to be the employee of the ESOP allotting employer, whichever is the earliest.

While the first two provisions for deferment may stay, the third criteria is somewhere at conflict with the fundamental right of employees to change their jobs. In case the employee does not have funds to pay the taxes, either the ESOPs will lapse or they would need to continue working with the same employer against their wishes. This criteria must be done away with.

The other expectation of the startup community from the upcoming Budget is the relaxation in the eligibility criteria for startups. The most important demand for startups would be the relaxation of the IMB certification requirement, which will make a wider pool of startups eligible for the tax benefit.

If the benefit of deferral of payment is extended to all startups who give ESOPs to their employees or to all Department for Promotion of Industry and Internal Trade (DPIIT) registered startups, which is the primary level of registration, it will make ESOPs more attractive as a mode of compensation and retaining talent.

BM Singh is ESOP Expert & Managing Partner, BMSA