Union budget 2020 seems to have fulfilled several wishes of the small and medium enterprise (SME) sector. The start-up community, specifically, welcomed many of the budget proposals. The biggest of these was the proposal to defer the tax on employee stock options (ESOPs) that start-ups provide to their employees.
In her speech, finance minister Nirmala Sitharaman noted, "Currently, ESOPs are taxable as perquisites at the time of exercise. This leads to cash-flow problems for the employees who do not sell the shares immediately and continue to hold the same for the long-term. In order to give a boost to the start-up ecosystem, I propose to ease the burden of taxation on the employees by deferring the tax payment by five years or till they leave the company or when they sell their shares, whichever is earliest."
So, where start-up employees previously had to pay taxes on the ESOPs allotted to them, they will now no longer have tax deducted at source and can pay this tax after five years or when they decide to sell their ESOPs – whichever happens first.
Read Between the Lines
At first glance, the announcement looks like an excellent move to promote India’s start-up ecosystem. However, when one reads the fine print, the joy wanes somewhat – many who had hoped that ESOPs would become tax-free realised that the tax payment had merely been postponed.
Taxing ESOPs is a somewhat complicated affair. Basically, an ESOP is an option given to an employee to own equity in the company. If the employee exercises that option, depending on how the ESOP scheme is structured, the employer deducts tax at source. Since the employee is given the option to buy the shares at a lower rate than market value, the difference between the buying price and the market value is treated as a prerequisite and TDS is deducted on that.
Taxation rates are further affected based on when the employee decides to sell the shares, and whether the company is publicly listed or not. In case the company is listed, having bought shares under ESOP, the employee can decide to sell within a year, in which case a 15 percent short-term capital gains (STCG) tax comes into effect. If the shares are held for more than a year, then 10 percent long-term capital gains (LTCG) tax is levied. So, holding shares for more than a year could be beneficial.
However, in the case of unlisted companies, when the employee decides to sell within less than 24 months, the income from the sale is taxed according to the individual’s income tax slab. If the shares are sold after 24 months, LTCG tax applicable is 20 percent, which is much higher as compared to listed companies.
Great Move but There is Room for Improvement
So, what does the finance minister’s announcement really mean? It simply means that the employee can exercise the stock option without paying tax at the time of buying. However, the tax comes into effect when the employee decides to sell or leave the company. There’s also some confusion about which start-ups will qualify for this.
Deferring tax on start-up ESOPs doesn’t seem like much, so why are entrepreneurs praising this move? For one, it is a significant step for the government to acknowledge that start-up employees need different tax treatments compared to the rest of their peers.
However, when employees exit the company, their cashflows are generally not in a great position and burdening them with capital gains tax on ESOPs may not be a good idea. The government should instead look at taxing employees only when they liquify their shares.
Having said that, many are hopeful that deferring the TDS could pave the way for the entire removal of capital gains tax on the exercise of options – something investors have wanted for a long time.
Pushkar Mukewar, co-founder and co-CEO, Drip Capital.
First Published: Feb 5, 2020 6:05 AM IST
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