The government introduced a tax deferment policy for Employee Stock Ownership Plans (ESOPs) in 2020 to address two key challenges faced by startup employees and employers:
- Immediate tax liability on employees receiving shares without actual monetary gains.
- Strain on startups’ finances due to tax deductions often exceeding employees’ salaries.
ESOPs are taxed in 2 instances:
- At the time of exercise, there is a tax on perquisite value: When the employee has exercised the option, the difference between the Fair Market Value (on exercise date) and the exercise price is taxed as perquisite. The employer deducts TDS on this perquisite.
- At the time of sale, there is a tax on capital gains: When the employee sells the shares, the difference between the sale price and Fair Market Value as on the date of exercise constitutes the capital gains, which is subject to tax.
From the financial year 2020-21, an employee receiving ESOPs from an ‘eligible’ start-up need not pay tax in the year of exercising the option. The TDS on the ‘perquisite’ stands deferred to earlier of the following events: Expiry of five years from the year of allotment of ESOPs; Date of sale of the ESOPs by the employee or date of termination of employment
While ESOPs are critical for attracting and retaining high-quality talent in startups, the policy has had limited impact. Currently, only employees of 3,605 startups certified by the Inter-Ministerial Board (IMB) under the Income Tax Act are eligible for tax deferment. This represents just 2.5% of the over 143,000 startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT), states NASSCOM, in its pre-budget memorandum.
The case for expanding tax deferment: Employee attrition in startups remains high, estimated at over 40%. ESOPs are a key tool to counter this, offering employees wealth creation opportunities. However, given that 8-9 of every 10 startups fail, many ESOPs end up worthless. Employees also face the risk of paying perquisite tax on notional profits without actual gains.
Expanding the tax deferment policy to all DPIIT-recognized startups could enable smaller startups to compete with larger businesses for talent, creating a robust ecosystem that fuels entrepreneurship and economic growth. Concerns about tax avoidance appear unfounded, as ESOPs are non-cash perquisites with limited abuse potential, explains NASSCOM.
Moreover, ESOPs are predominantly offered by startups with scalable business models, not traditional businesses where wealth creation is slower. Expanding the policy is unlikely to lead to widespread misuse or excessive issuance of ESOPs.
Recommendations for expansion
To ensure the policy’s effectiveness while maintaining safeguards, NASSCOM recommends:
- Eligibility for all DPIIT-recognized startups: Separate the ESOP tax deferment eligibility from the tax holiday under Section 80-IAC of the Income Tax Act.
- Safeguards for eligibility: Adequate safeguards can be built in. ESOPs should be available only to Indian resident employees of DPIIT-registered startups. Uniform terms should apply to all employees receiving ESOPs.
NASSCOM sums up by stating that a broader tax deferment regime for ESOPs can empower startups to attract top talent, reduce attrition, and focus on growth instead of administrative burdens. In turn, this would strengthen the overall startup ecosystem, driving innovation and economic progress.
Need for clarity on ESOP taxation for non-resident employees
Other issues also arise in relation to ESOPs which could be resolved in the coming
Budget 2025
.
According to Divya Baweja, tax partner at Deloitte-India, “Section 17(2) of the Income-tax (I-T) Act, provides for taxing stock award benefits as a perquisite in the hands of employees. However, the section lacks clarity regarding the taxation of stock awards in the case of Non-Resident employees who have rendered a part of services overseas during the grant period to vest. The principle that the benefit accrues over the vesting period is indicated based on court rulings and OECD guidelines.”
“However, in the absence of clear guidance, the claim of the taxpayers is denied at the assessment stage by the tax officer. While at the appellate level, claims are accepted, the taxpayers have to go through unnecessary hardship of litigation,” he adds.
Baweja suggests that clear guidelines stating rules for apportionment of this benefit based on the grant to vesting period should be provided. Further, only the place of rendering services should be considered for apportionment.
Allowability of ESOP expenditure to the employer
Bombay Chamber of Commerce and Industry (BCCI) in its pre-budget memorandum points out that present there is no express provision in the I-T Act about allowability of ESOP expenditure while computing taxable income.
SEBI guidelines prescribe method for charging of ESOP discount in the books of accounts of listed entities. Despite this, many times, in the absence of an express provision in the Act on allowability of ESOP expenditure as deduction while computing taxable income, tax authorities do not treat ESOP expense as deductible while computing the business income. This leads to litigation. There are Rulings from different courts / tribunals giving favourable views regarding allowability of ESOP expenditure. Since ESOP expenditure is employee compensation, the same should be allowed as revenue expenditure.
Recommendation for allowability of ESOP expenditure:
- ESOP expenses debited to profit and loss account should be an allowable expense for deduction for computing the business income.
- It is suggested that a specific provision be incorporated permitting ESOP expenditure to be allowed as revenue deduction in the computation of income. Such provision may also consider the quantum of expenditure to be allowed and timing of deduction for consistency across all types of companies.
