Employee Stock Option Plan (ESOP) is a commonly used incentive mechanism to reward employees and most popular with start-up / unlisted companies that cannot afford to pay high salaries to attract talent, but are willing to share the future prosperity of the company.

Given the disruption the pandemic has created the priority of most companies is to conserve cash and ensure continuity and one of the alternatives to defer cash payments is ESOP.

Taxation of stock options

ESOPs are taxable on exercise as perquisite in the hands of employees, at the Fair Market Value (FMV) on the date of the exercise. The taxable benefit would be the difference between FMV and the exercise price. In case of listed companies, the value of the shares quoted on the stock exchange is FMV. As the employees do not receive any cash at the time of exercise, employees may choose to sell a part of the shares allotted, to meet the tax obligation.

In case of unlisted companies, including start-ups, as their shares are not marketable, the tax provisions mandate a merchant banker valuation. However in the absence of a ready market to sell shares employees may need to borrow funds to meet this obligation.

To address this challenge, a provision was introduced in 2020 that defers the tax on ESOPs of eligible start-ups. The law allows an employer of an eligible start-up to defer tax deduction on ESOPs for an employee for five years or when the employee leaves the company or when the employee decides to sell the shares, whichever is earliest.

The provision for deferment of tax is available only to shares of eligible start-ups and not to other Indian unlisted companies. The number of eligible start-ups when compared to the total of start-ups and unlisted companies in India, is only a handful and thus the beneficial provision has very limited applicability.

Challenges in implementation

It may be noted that employees of eligible start-ups (where stringent conditions are to be met) may still be put at an inconvenience despite the beneficial tax deferment provision on account of various factors:

• The employee may get taxed on higher value on exercise, in case the share price is higher at the time of allotment but dips at the point of tax withholding. In such case, the employee will still have to pay a perquisite tax on a notional gain as against the actual benefit.
• An employee may be forced to sell the shares awarded to him under an ESOP, to pay the taxes if he separates from the company. This will impact employees significantly in case the employment is terminated on account of disability or death.
• The employer would need to track the tax trigger event and keep track of events which trigge tax payment for the employee.
• The employer may qualify as an “eligible startup” at the time of grant of ESOPs but failure to meet any condition at the time of exercise of ESOPs may result in denial of deferment

Recommendations

Given the above challenges and the limited application, it is necessary that beneficial provisions be made more broad based to meet the desired objective of providing relief to employees by extending this provision to all unlisted Indian companies rather than only eligible start-ups. Further, the taxing point can be triggered only on sale rather than having multiple conditions attached which may defeat the purpose of deferment. Extension of deferral to the point of sale for all unlisted shares and taxation only of real gain will be a big relief to employees.

The author is Partner, Deloitte India