Employee Stock Option Plans (ESOPs) have long been used as a compensation tool by companies to motivate employees by providing a sense of ownership and opportunity to be rewarded based on company’s performance.
While the possibility of benefitting from increasing share prices is a motivating factor for employees, the present income-tax mechanism is a dampener.
Taxability of ESOPs
As per present Income-tax provisions, taxability of ESOPs occurs at two stages. Firstly, at the time of allotment of shares and thereafter, at the time of sale of the shares. When employees exercise the options granted to them, they are allotted shares upon payment of an exercise price. The benefit arising from allotment of shares is taxable as perquisite in the hands of the employees. The value of perquisite will be the difference between (i) Fair Market Value (“FMV”) of the shares determined as provided in the Income-tax law and (ii) exercise price. The employer is required to withhold taxes on such perquisite and remit the same within timelines as applicable for salaries.
Thereafter, when employees sell the shares, gains from such sale is taxable as capital gains in the hands of the employees. The taxable capital gains will be the difference between (i) sale consideration and (ii) FMV of the shares used to determine the taxable perquisite at the time of allotment. The taxes on such capital gains are required to be remitted by the respective employees/ individuals.
Hardship to taxpayers in relation to taxation at the time of allotment of shares
Hardship to the taxpayers arise in relation to the taxation at the time of allotment of the shares. While there is no cash inflow to the employees at this stage, the employees have to pay the exercise price and taxes on the notional value of perquisite. This causes cash flow issues, particularly, where the FMV is high. In some cases, taxes on the notional value of perquisite may be higher than salary of the employees for the month of allotment, posing practical difficulties in withholding of taxes.The employees may not want to liquidate the shares at this point. Further, in case of shares of private companies, there may not be a market available to liquidate the shares, at the time of allotment.
Deferral of tax payment on ESOPs for eligible start-ups
The Finance Act, 2020 introduced provisions to defer tax payment on perquisite in relation to ESOPs of eligible start-ups. Eligible start-ups are required to withhold and remit taxes on perquisite in relation to ESOPs provided to their employees, within 14 days of (i) expiry of 48 months from the end of the assessment year in which the shares are allotted, or (ii) date of sale of the shares by the employee, or (iii) from the date the employee’s employment with the company ceases, whichever is earliest.
While this provides some relief to the employees of eligible start-ups, it needs to be noted that “eligible start-up” as per the Income-tax law means a company or limited liability partnership engaged in eligible business which fulfils certain conditions, namely:
a) Incorporation on or after 1 April 2016 but before 1 April 2025
b) Total turnover of its business does not exceed Rs 100 crore in the relevant financial year
c) Holding a certificate of eligible business from the Inter-Ministerial Board of Certification as notified in the official gazette by the central government
As per the #startupindia website of the Government of India, only 2,976 start-ups are eligible for Income-tax exemption. Hence, the relief provided to start-ups in relation to deferral of tax payment of ESOPs covers a very limited number of companies who may have granted ESOPs to their employees.
Changes the government may consider:
As a first step, the government may extend the deferral of tax payment on perquisite to all private companies instead of restricting the relief to eligible start-ups.
The government may also consider moving towards taxing ESOPs at one stage i.e. at the time of sale of shares, and doing away with taxation at the stage of allotment of shares.
Deferring the tax payment on ESOPs will ease the cash burden on taxpayers at the time of allotment of the shares and have a positive impact on acceptance and attractiveness of ESOPs as a compensation tool to enable companies to attract and retain talent.
Views expressed are personal