Expanding Tax Deferment for ESOPs: A Necessity for Startups
In 2020, the government introduced a tax deferment policy for Employee Stock Ownership Plans (ESOPs) to alleviate financial burdens on startup employees and employers. This policy aimed to tackle two significant challenges: the immediate tax liability faced by employees receiving shares without actual monetary gains and the financial strain on startups due to tax deductions that often exceeded employees’ salaries. Despite its good intentions, the policy has had limited impact, affecting only a small percentage of startups. As employee attrition rates remain high, there is a growing call for the expansion of this policy to benefit a broader range of startups.
Understanding ESOP Taxation
Employee Stock Ownership Plans (ESOPs) are taxed at two key points: when the employee exercises the option and when the shares are sold. At the time of exercise, the difference between the Fair Market Value (FMV) on the exercise date and the exercise price is taxed as a perquisite. Employers are required to deduct Tax Deducted at Source (TDS) on this perquisite. The second taxation point occurs when the employee sells the shares. Here, the difference between the sale price and the FMV at the time of exercise constitutes capital gains, which is also subject to tax.
From the financial year 2020-21, employees receiving ESOPs from eligible startups can defer tax payments until certain conditions are met. The TDS on the perquisite is deferred until the earlier of five years from the year of allotment, the date of sale of the ESOPs, or the date of termination of employment. This change was intended to provide relief to employees who might otherwise face tax liabilities on notional profits without actual gains. However, the policy currently applies only to employees of 3,605 certified startups, representing a mere 2.5% of the over 143,000 startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT).
The Need for Policy Expansion
The limited reach of the current tax deferment policy has raised concerns among industry experts. High employee attrition rates in startups, estimated at over 40%, highlight the need for effective retention strategies. ESOPs serve as a vital tool for attracting and retaining talent by offering employees opportunities for wealth creation. However, the harsh reality is that 8 to 9 out of every 10 startups fail, rendering many ESOPs worthless. Employees often find themselves paying perquisite tax on notional profits without any real financial benefit.
Expanding the tax deferment policy to include all DPIIT-recognized startups could level the playing field, allowing smaller startups to compete with larger companies for talent. This expansion would create a more robust ecosystem that fosters entrepreneurship and drives economic growth. Concerns about potential tax avoidance appear unfounded, as ESOPs are non-cash perquisites with limited potential for abuse. Moreover, ESOPs are primarily offered by startups with scalable business models, making widespread misuse unlikely.
Recommendations for Effective Implementation
To enhance the effectiveness of the tax deferment policy, NASSCOM has put forth several recommendations. First, the eligibility for tax deferment should be extended to all DPIIT-recognized startups, separating it from the tax holiday under Section 80-IAC of the Income Tax Act. This change would allow a broader range of startups to benefit from the policy.
Second, adequate safeguards should be implemented to ensure that ESOPs are available only to Indian resident employees of DPIIT-registered startups. Uniform terms should apply to all employees receiving ESOPs, ensuring fairness and transparency. By adopting these recommendations, the government can empower startups to attract top talent, reduce attrition rates, and focus on growth rather than administrative burdens.
Addressing Taxation Clarity for Non-Residents
Another pressing issue related to ESOPs is the lack of clarity regarding taxation for non-resident employees. According to tax experts, Section 17(2) of the Income-tax Act provides for taxing stock award benefits as a perquisite. However, it lacks clear guidelines for non-resident employees who may have rendered services overseas during the grant period. This ambiguity often leads to disputes at the assessment stage, causing unnecessary hardship for taxpayers.
To resolve these issues, experts recommend that clear guidelines be established for the apportionment of benefits based on the grant-to-vesting period. Additionally, the place of service rendering should be the primary consideration for apportionment. By addressing these concerns, the government can create a more equitable taxation framework for all employees, regardless of their residency status.
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