ESOP Taxation || Revised provisions for Eligible Start Up’s

ESOP Taxation || Revised provisions for Eligible Start Up’s

Employee Stock Option Plan (ESOP) has been an attractive tool to attract and retain key employees by an organisation and generally ESOP’s constitute a significant component of compensation for employees especially for Start Up’s.

ESOPs are taxable as perquisites at the time of exercise at fair market value (FMV) reduced by the consideration received from employees towards acquiring such ESOP shares u/s 17(2)(vi) of the IT Act, 1961 (The Act).

Further, when the employees transfer such ESOP shares, it leads to capital gain in the hands of such employees for the value at which the ESOP shares are sold reduced by the FMV of such shares at the time of exercise.

To illustrate with an example, if an employee receives 1000 shares under ESOP having a FMV of Rs.100/- per share from his employer company at the rate of Rs. 40/- per share (amount paid by the employee to acquire such shares), the value of perquisite subjected to tax u/s 17(2)(vi) shall be Rs. 60,000 [1000 ESOP shares X (100-40)].

Further, when such an employee sells the 1000 ESOP shares for Rs. 200/- per share, the capital gain to such an employee will be Rs.1,00,000/- {total sale consideration Rs.2,00000 (1000 ESOP shares @ Rs.200/- share) less FMV of the shares acquired under ESOP (1000 ESOP shares @ FMV at the time of exercise Rs.100/- share)}.

There is generally significant time gap between the time of exercise of ESOP by a employee and when he actually sells off these shares (if he ever sell). The employee is subjected to taxation on the notional gain which he earns at time of exercise as a difference between the FMV of share and the value at which is received by him. The employee may or may not have such salary to have deduction of taxes to pay for the tax on perquisite and even assuming that he has such salary wherefrom the TDS on perquisite could be deducted but this will mean less cash flow to the employee at the time of exercise of ESOP on the notional gain made by him.

Budget proposal for ESOP

The Budget 2020 has brought in an important change in the taxation of the perquisite value of shares received under ESOP of the eligible start up’s. Section 192 of the Act has been amended to insert sub-section (1C) requiring an eligible start up referred to in section 80-IAC, responsible for paying any income to the assessee u/s 17(2) of the IT Act 1961 in any previous year relevant to the AY 2021-22 or subsequent AY’s , deduct or pay, as the case may be, tax on such income within fourteen days —

  1. after the expiry of forty eight months from the end of the relevant assessment year;
  2. from the date of the sale of such specified security or sweat equity share by the assessee;
  3. from the date of which the assessee ceases to be the employee of the person.

whichever is the earliest on the basis of rates in force of the financial year in which the said specified security or sweat equity share is allotted or transferred.

Corresponding changes have also been carried out in section 191 (assessee to pay the tax direct in case of no TDS), section 156 (notice of demand) and section 140A (calculating self-assessment tax). All these amendments will take effect from 1st April, 2020.

This is an important change brought in taxation of perquisite because the current regime for ESOPs taxation , which trigger a perquisite tax on the notional gain on the exercise of the stock options at fair market value, makes the entire proposition of ESOPs unattractive.

The amendments however does not propose any change to the substantive provisions under section 17(2)(vi) of the Income-Tax Act, 1961. It only defer the payment of the tax on perquisite by employees to be paid within 14 days of any of these events which ever is earlier taking place, independently.

  1. Expiry of 48 months from the end of the assessment year relevant to the previous year in which the ESOPs are exercised;
  2. Sale of such security by the employee; or
  3. Cessation of employment of the concerned employee with the employer which allotted or transferred such security to the employee under ESOP.

In essence the provisions provide more time to the employee to liquidate his or her shares and arrange money to pay the perquisite tax incurred on the exercise of the ESOPs. Also the amended provisions address a very restricted group of assessee and the provisions is marred with certain shortcomings.

  1. The amended provisions deals only in respect of eligible start-ups - referred to in section 80-IAC of the Act. Under the said provision, 'eligible start-up' means a start-up having the Inter-Ministerial Board (IMB) Certification. It was desirable that the definition of a 'eligible start-up' should be aligned with the definition contained Notification G.S.R. 127(E) dated 19 February 2019 issued by the Department for Promotion of Industry and Internal Trade (DPIIT).
  2. Eligible start up’s are restricted by the period of incorporation of the entity i.e. should have been incorporated after 1st April 2016 and on or before 31 March 2021. The restriction will leave employees of many entities being left out the benefit of the new ESOP tax regime.
  3. The employer must be an eligible startup when the employee exercises the ESOPs. So, if the employer qualifies as an eligible startup at the time of grant of ESOPs but breaches one of the conditions for eligibility at the time of exercise of ESOPs by employees, the employees will not benefit from the new regime. This may create undue hardship for the employees when the ESOPs are planned relying on the new tax regime.
  4. The period of deferment is only for a period of 48 months - the employee would still be faced with the cash flow problem after 4 years, should he/she remain associated with the eligible start-up.
  5. The trigger of payment of the perquisite tax on the cessation of employment is also commercially misplaced as companies do allow employees to continue to hold ESOPs even after leaving the job.In such a case, employees who wish to continue holding their ESOPs after leaving their jobs may not be able to do so for want of cash needed to pay the tax and the amended tax regime kind of force employees to sell their ESOPs. This may also be read as the revised regime may limit the mobility of an employee for better opportunities until the employee could manage to get returns on the sale of ESOP shares to pay the tax on perquisite.
  6. The amended provisions also does not address the situation which may arise by way of mergers or demergers, slump sale, stock swaps wherein businesses and/or employees are merged with or transferred to other entities. This may results in transfer or exchange of shares received through ESOPs; or transfer of employees to other entities resulting into termination of employment with the startup which has allotted shares.
  7. It may have been appropriate to address the situation where the market value of the shares received under ESOP falls at the time of sale below the FMV at the time of excercise, the employee will still have to pay the perquisite tax on the basis of the fair market value as on the date of exercise. The benefit of reduced sale value could have been given on sale of such ESOP shares.

The amended ESOP tax provisions retains the charterer of the earlier law of taxation of the notional perquisite income in the hands of the tax payer, with a deferral on the payment of tax on perquisite value for a very limited entities being eligible start up’s.

 

Manava Prem

Partner