Union Budget 2019 India: Employee Stock Option Plans (ESOPs) are a popular way of rewarding employees. From an employer perspective, especially in start-ups, ESOPs provide an opportunity to attract high quality talent without significant impact on cash outflow for the employer. ESOPs also help in attracting, retaining and suitably compensating high performing talent while enabling employees to participate in the growth of the company.
Tax impact on individuals
Currently, the taxation of ESOPs is at two stages. The initial taxation is triggered at the point of exercise when shares are allotted to employees under the plan. The fair market value of shares on the date of exercise, less price if any paid by the employees, is considered as salary income in the hands of the employees. Further, when the employees sell these shares, tax implications in the form of capital gain is triggered. The difference between the sale price of shares and fair market value considered for salary taxation is considered as capital gain.
Let us understand this with an example. If at time of allotment of shares to employees, the fair market value is Rs 100 per share with no exercise price paid by the employee, the entire fair market value is considered as taxable salary. If the employee sells the shares at same time at a price of Rs 100, no capital gain would arise. However, if the employee holds the shares and sells at later point of time, at say Rs. 150, the additional amount of Rs 50 is taxed as capital gain.
Challenges
Meeting the tax obligations at the point of allotment could be challenging since taxes are required to be paid based on the fair market value of the shares which is not actually realised by the employee. The plans of most listed companies provide for sale of shares to the extent of taxes that are due to be paid to authorities. However, in the case of unlisted companies, the shares cannot be sold in the open market. This is where most start-ups face challenges while rolling out stock option plans, since employees feel the pinch of cash payout for taxes, without having avenues for liquidation of shares. The employees would need to wait for the listing of the shares through an initial public offering (IPO) or infusion of funds by PE investors. In an unfortunate event of downward revision of the valuation of the company, the employees would have to bear losses, having already paid the taxes at a higher valuation.
Prevalent practices on ESOP taxation
In terms of global practices, most countries do provide for taxation of shares allotted under an employee stock option plan, as taxable salary. However, exception for taxation of the same at the point of sale is provided for. In USA, for instance, while non-qualified stock options are taxed as salary at the point of allotment of shares, the point of taxation shifts to the point of sale if the scheme meets certain conditions, categorised as Incentive Stock Options (ISO). From a corporate tax perspective, the employer does not receive a tax deduction as well.
Even in India, the current practice of taxing stock options as salary at the point of allotment of shares has been in existence since 2009. Prior to this, during the period April 2000 to March 2006, shares allotted under an ESOP were taxed at the time of sale of shares, provided the employee stock option scheme was in accordance with the guidelines issued by the central government. Enabling the deferment of taxation to the point of sale would go a long way in helping start-ups roll out stock option schemes that are more attractive and help employees manage their cash flow challenges.
With the Department for Promotion of Industry and Internal Trade (DPIIT) having discussions with the finance ministry on taxing shares granted by start-ups under their employee stock option plan only at the time of sale, the expectation from the Budget is high on this count. The move to shift the taxation event at time of sale would ensure that the employees pay taxes at the time of actual income inflow and not at the time of occurrence of notional income. A favorable tax regime for ESOP would go a long way to reward talent and would also be a big boost to start-ups.
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