ESOP Tales of Startups - Taxability Then and Now

Employee stock options (ESOP) are part of an Employee benefits program offered by Startups to engage the employees in a more effective manner. The ESOPs issued to the employees provide them the benefit or right to purchase the shares of the Employer company, at a predetermined price, in a future date. Widely considered as a means to retain, engage and create more wealth to the employees, the ESOPs were used in an effective manner by IT Companies like Infosys, Wipro etc.

How ESOPs work?

The Employer Company issues the rights (stock options) to an employee with a pre determined lock-in period, vesting period, number of options , exercise price(price on which the employee can purchase the shares of the company on a future date after the expiry of lockin) etc. Usually the options are given free while the exercise price is predetermined. Upon the completion of the lock-in period, the options are vested on the employee i.e the Employee can choose to exercise his ESOPs to purchase the shares at a predetermined price(exercise price) or to let his options expire (If the Fair market value of the share is significantly lower than the exercise price).

The taxable event in case of ESOPs arises on two occasions - 

1) When the options are exercised by the employee 

When the options are exercised, the difference between the Fair Market value and the exercise price are treated as perquisite, tax should be deducted by the Employer under Income from salaries and 

2) When the shares are sold at a profit

The difference between the exercise price and the Selling price is treated as Capital gains and the income is taxed under the head Capital Gains.Taxes were either short term (if the holding period is less than a year ) and long term (if holding period is above 1 year).

Here, we may observe that the tax on perquisite is paid on the same year as that of exercising the Stock option even though the Employee does not gain any monetary benefit unless he sells the shares at a profit. This means that the tax liability arises even before the gains are realized. 

Budget 2020 seeks to end this anomaly as follows:

• Taxability though arises on the date of exercise of Employee stock options, the payment of tax on such event is postponed at a later date up to a maximum of 48 months.
• Tax on perquisites income in respect to ESOPs shall be paid within 14 days 
• After the expiry of 48 months from the end of relevant assessment year in which the options were exercised or
• From the date of sale of such specified security/share by the employee or
• From the date on which the person ceases to be a full time employee whichever is earlier.

Note:

The amendments are applicable only for Startups as recognized in Section 80-IAC and are effective only from the Assessment year 2021-2022 onwards.

Conclusion:

The amendment, though restricted only to the Start up companies, will nevertheless help in increased participation and exercise of stock options by the employees.

Sources:

SEBI Guidance note on ESOPs, various sources online on ESOPs, Memorandum to direct taxes 2020 issued by Ministry of Finance.

The author can also be reached at arthaconsultingservices@gmail.com.