[2021] 123 taxmann.

com 332 (Article)

[2021] 123 taxmann.com 332 (Article)©

Date of Publishing: January 20, 2021

Deferment of tax on perquisite arising from ESOPs in case of start-ups

SARASWATHI KASTURIRANGAN VIJAY BHARECH YAMINI MODI

Partner, Deloitte India Senior Manager, Deloitte Assistant Manager, Deloitte

Haskins and Sells LLP Haskins and Sells LLP
With the economy grappling with the effects of the pandemic, the government is seeking ways to revive
growth. Start-ups can be integral to such recovery as they tap into young, skilled resource pool, apart from
bolstering the Make in India campaign. However, taxation issues and eligibility norms hinder such trend,
and the forthcoming Budget can be an opportunity to rectify this.

Measures to widen the scope of tax deferrals, as introduced in last year's Budget, can help start-ups.

Typically, Employee Stock Option Plans (ESOPs) have been a lucrative way to retain talent by employers. For
employees, it helps them be a part of the growth story through ownership of shares. For employers, stock
options enable the employer to motivate employees with lower cash flow impact.

Under ESOP, the grant of options entitles the employee to purchase shares of the company at a pre-
determined price upon vesting. When the shares are allotted, the employee can sell at prevailing prices and
make a profit if the share price is higher than the exercise price.

Taxation of stock options is in two stages – first on allotment of shares and second on sale of shares. On
allotment, the difference between the fair market value of share and exercise price is taxable as perquisite
and the employer needs to withhold the taxes at the slab rate applicable to the employee. On sale of
shares, the difference between the selling price and the fair market value (that was considered for the
perquisite valuation) is taxed as capital gains. The tax rate on capital gains may vary based on whether the
gain is a short-term gain or a long-term gain, which in turn is based on how long the shares were held after
allotment.

For an employee, the benefit of the incremental value since the date of grant, is notional unless the
employee sells the shares. Hence at time of taxation on allotment, the employees may not be able to fund
unless they sell the shares.
Further, the employee also reaps the benefit of the future expected growth and valuation of the company
from date of allotment to the date of sale which is treated as capital gains. Better the company
performance, more the gain the employee stands to make.

Start-ups widely use stock options to attract and retain talent. However, while employees may receive the
shares from their employers, in the absence of such shares being listed or marketable, the employees may
not have funds to meet the tax obligations at the point of allotment. In order to provide impetus to start-
ups and to ease the difficulties faced by employees of start-ups, the Finance Act 2020 had introduced
provisions for deferring tax payment that arises on the exercise of ESOPs to 14 days from the earliest of the
following events in case of an "eligible start-up" –

i. after the expiry of 48 months from the end of the relevant financial year during which shares
were allotted;
ii. date of the sale of such shares by the employee
iii. date of the individual ceasing to be an employee of the concerned employer.
Taxes would need to be withheld based on rates in force for the financial year in which the shares are
allotted.

However, the above relaxation came with riders.

The benefit is limited to "eligible start-up" defined under section 80-IAC of the Income Tax Act, 1961 (the
Act) to mean a company or a limited liability partnership engaged in eligible business which fulfils the
following conditions:

i. it is incorporated between 01 April 2016 and 31 March 2021,

ii. total turnover of its business does not exceed INR 100 crore annually, and
iii. it holds a certificate of eligible business from the Inter-Ministerial Board of Certification as notified
in the Official Gazette by the Central Government.
Eligible business means a business carried out by an eligible start-up engaged in innovation, development
or improvement of products or processes or services or a scalable business model with a high potential of
employment generation or wealth creation.

While the amendment was a welcome move, the employers who plan to avail this benefit do not seem to
sail through the tide because of the riders explained above. Even if the employer qualifies as an "eligible
start-up" at the time of grant of ESOPs, failure to meet any one of the conditions for eligibility at the time of
exercise of ESOPs will result in denial of the benefit to employees. The employer is also required to track
the tax trigger event during the four-year timeline as provided which adds to administrative burden.

The pre-requisite to have an Inter-Ministerial Board of Certification does not allow all the start-ups to avail
the benefit of deferral of taxation of ESOP perquisite. While an entity is considered as start-up if it is
recognised by the Department for Promotion of Industry and Internal Trade (DPIIT), adding this pre-
requisite reflects that not all have been able to avail this benefit. Till date, only more than 260 start-ups
have been recognised by the Inter-Ministerial Board of Certification. Clearly the relaxation introduced in the
last Budget is not serving the purpose for most start-ups. The relaxation provided in the last Budget should
therefore be extended to all start-ups with no pre-requisites attached.

With government's thrust on Make in India and employment generation, the deferral of point of taxation for
ESOP perquisite should be extended to all Indian companies whose shares are not listed in India.
For employees of a listed company, encashing shares on allotment of ESOP is simple as they are listed and
marketable. However, in case of an unlisted company, to encash the shares on allotment of ESOP,
employees need to wait for a future IPO, new investor, promoter buy-back etc. which also brings disparity
for these employees since capital gains on sale of unlisted shares are taxed at higher rates as compared to
shares which are listed in India.

Hence it is suggested that the government may consider going all out and address the challenge in respect
of Indian companies where the underlying shares are not listed by shifting the taxation trigger to the point
of sale.

The current pandemic has affected the business of start-ups. Although they have started leveraging their
available resources in response to the crisis, their growth and innovation potential are at risk; hence a relief
is required to ensure rapid recovery and growth.

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