How Tax Implications of ESOPs for Startup Companies Work In India?

by  Adv. Anamika Chauhan  

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A Guide to Minimizing ESOP Taxes for Your Indian Startup

As we all know, start-ups act as the backbone of an economy nowadays, and India’s growth is much more dependent upon their growth. Have you recently started a start-up and want to issue ESOPs to your employees but have no idea about the tax implications of the ESOPs for your start-up company?

In such a case, you need not worry. We have covered all the implications of taxation on ESOPs for your start-up. However, we first need to understand the concept of an ESOP. 

Introduction to ESOP

ESOP stands for Employee Stock Option Plan. By issuing ESOPs, a company provides a sense of ownership and belongingness to its employees. An ESOP is a kind of employee benefits program/plan that gives an employee the chance to acquire the company’s stocks or shares at a discounted price for a certain number of years. 

There are basically three types of ESOPs that are offered to the employees. These run as stock options, stock appreciation rights, and good old-fashioned shares. 

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What goals are achieved by the start-ups when implementing ESOPs?

 We have usually not seen a Start-up issue an ESOP to their employees, but over the course of years, this paradigm has been shifted, and with the huge response received in terms of the established start-ups in the country, issuing the ESOPs has also become a practice. The reasons for issuing the ESOPs are as follows:

  • Retention of Employees: The most important aspect of an organization is retaining its hardworking workforce. Retention is key because hardworking employees are very hard to find and harder to retain.

    ESOPs act as a retention force because they reward their continued service to the organization and give them a sense of belonging to it. 
  • Growth of the Organisation: There is a famous saying that a happy employee gives the best results. With the ESOP plan, employees feel highly motivated to work, and this motivates them to contribute to the growth of the organisation. Also, it limits the accessibility of the shares. 

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Advantages of Opting for the ESOP Plan

We have already discussed the goals that will be achieved by the issuance of an ESOP by a start-up. Besides the goals, there are also some advantages that provide more value to an organisation and these advantages are as follows:

  • Employee Benefit: The full form of ESOP states that it is an employee benefit plan or program. It gives an employee the right, not an obligation, to choose to opt for this plan under which a certain number of shares or stocks are issued to the employee at a discounted market price for a certain number of years. This factor allows the employee to be retained in the organisation. 
  • Fulfilling the Business Requirements: Funds are an organisation’s blood and lifeline. A business definitely needs funds to fulfil its business requirements. Therefore, issuing ESOPs not only provides the required funds to the organisation but also encourages employee retention, thereby accelerating the organisation’s growth in every possible manner. 
  • Taxation Benefits: ESOPs allow organisations to postpone taxation payments if the start-up is a Qualified Start-Up as per the requirements fulfilled by the Department for Promotion of Industry and Internal Trade. To become a qualified start-up, a start-up must fulfil all the requirements specified under Section 80-IAC of the Income Tax Act, 1961.

These are the benefits that allow a start-up organisation to issue ESOPs to run its business and grow and expand swiftly. 

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How does ESOP Taxation Work? 

From the organisation’s point of view, issuing ESOPs is a win-win situation at any given point in time. As per the Income Tax Act, 1961, ESOPs are taxed in two types. One kind of tax is levied upon the ESOP upon option execution, and the other type of tax is levied upon them at the time of the ESOP sales.

The next section of this article discusses in further detail how these types of taxes work on ESOPs. 

ESOP Taxation in a Nutshell

The taxation of the ESOPs is based upon various factors that must be taken into consideration when an employee chooses any of the above-mentioned options to dispose of their ESOPs. It can be either exercised or sold.

The taxation of ESOPs will be discussed at their disposal in the upcoming parts of this article. However, we need first to discuss the factors on which the tax treatment of the ESOP is based. These factors are as follows:

  • The type of the Issued to the Employee
  • The Option Used by the Employee and 
  • The time when the Employee has chosen to retire 

These factors constitute and contribute to determining the level of taxation imposed upon ESOPs. As we have discussed in the upper sections of this Article, there are two types of tax treatment for ESOPs. So, let’s understand the tax implications in more detail. 

  • ESOP Taxation at the time of the Exercise: The shares are allocated to the employee, in this case, after the expiry of the vesting period. When the employee exercises this option the difference in the Fair Market Value of the share at the date and price of the exercise is taken into consideration. This will be taxable under Section 17 of the Income Tax, 1961.
    The employer organisation will be liable to deduct the TDS on this employee’s exercise, and the employer is under an obligation to file on or before the 7th day of the next month. This amount of the ESOP will be reflected in FORM 16 as part of the total income of the employee.  
  • ESOP Taxation at the Time of Sale by the Employee: The employee is liable to pay capital gains taxes on the profits earned from the sale of the ESOPs. The difference between the Sale Price of the ESOP and its Fair Market Value on the date of the exercise will be taxed as Capital Gains Tax.

    Capital gains are of two types: a) Short-term Capital gain and b) Long-term Capital gain. Short Term Capital Gain is incurred when the ESOPs are being sold within 24 months of exercising either of the above options and the Long Term Capital Gain is incurred when the ESOPs are being sold after completing 24 months of exercising the above-mentioned options. 

Rules required to be followed while issuing the ESOPs

There are some factors that must be followed while an organisation issuing the ESOPs. The main factors and rules that an organisation should follow are the provisions of the Companies Act, 2013. These factors are jotted down as:

  1. Specifying the terms of the ESOP: The most crucial element of issuing the ESOPs is to specify its terms clearly. It may range from the strike price that an employee is required to pay for the ESOP to the vesting period of the ESOP and the date when either of the above-mentioned options can be exercised. 
  1. Growth of the Organisation: It is imperative to calculate whether the organisation has the potential to establish and grow in the market from the date of the ESOPs until 4 years later. 
  1. Acceptance of the proposal to issue an ESOP: The Board of Directors must approve the issuance of the ESOP, and the same resolution must be filed under MGT-14 with the Registrar of Companies.
  1. General Assembly: It is important that the stakeholders, directors, and auditors are informed of the meeting before 21 days. 

This is how the General Assembly will approve the Special Resolution thereby issuing the ESOPs to the various stakeholders, directors, and auditors of the start-up organisation. 

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Suggesting the best course of action while researching ESOPs

There are some suggestions for choosing the best course of action while researching the ESOPs and these are as follows:

  • Value of the ESOP: The loophole that organisations are using to befool their employees is quoting the ESOP as ‘at the money’. This condition is known as the strike price of the ESOP, which is equal to its market worth, and they treat it as money. Therefore, it is very essential to get a clear idea as to what an employer is providing through an ESOP.  
  • Comparing different types of ESOPs: It is never suggested that the ESOPs of different organisations be considered while choosing the best ESOP. This is advised because every company has different financial goals and is standing at a different level financially or in terms of the workforce. So, it is always advised not to look up the ESOPs of different companies. 
  • Choosing your needs according to your financial goal: It is always advised to choose the best course of monetary value that will benefit you and your family. You will be required to weigh the pros and cons of Financial Gain in terms of Cash and ESOPs, and whatever suits your financial goal in the long run, go for that option. 

What are the factors that are considered for ESOPs in terms of capital assets?

  • Gains on Long-term and Short-Term Income if Listed on a Recognised Stock Exchange: If the ESOP stocks are listed on a recognised stock exchange, they will be subject to 10% taxation, including any surcharge and cess. On the other hand, short-term capital gains are taxed at 10% of the gains plus any applicable surcharge and cess.  
  • Gains on Income if it is not listed on a Recognised Stock Exchange: If the ESOP stocks are not listed on a recognised stock exchange, they will be subject to 20% taxation plus any surcharge and cess. On the other hand, non-resident individuals are taxed on 10% of the gains plus any applicable surcharge and cess.  
  • Disclosures to be made under the Income Tax Act: Recent amendments to the Income Tax Act have added a more protective layer to the disclosures an individual is required to make to the Income Tax Authorities. The Employee is required to disclose their overseas organisation ESOP under Schedule FA of the Income Tax Return. 

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Example of an ESOP Taxation 

Let’s take Rakhi, a hard-working early Employee of an IT Start-up Organisation Beta Solutions, in the year 2013. She received 10,000 ESOP at the exercise price of Rs.50 per share. According to the organisation’s ESOP Policy, the option can only be exercised after 3 years of vesting. 

Therefore, in the year 2016, Rakhi exercised the ESOP. The Fair Market Value of the share in 2016 was Rs. 100. In the year 2017, she decided to sell the shares at Rs. 120 each share, and at the time of the selling of the shares, assuming she was falling under the 30% tax slab. The two levels of taxation that will be imposed upon Rakhi are as follows:

Tax Implication when Rakhi exercised her option 

In this case, the ESOP will be taxed as a Pre-Requisite. So, it will be as:

  • Prerequisite: INR (100-50)*10,000 = INR 5,00,000
  • TDS= 30%* 5,00,000 = INR 1,50,000 (surcharge and cess will be extra in such a case)

INR 5,00,000 will be part of Rakhi’s Salary and will be taxed in the year of the allotment of these shares. Additionally, the start-up will be liable to deduct the TDS. 

Tax Implication when Rakhi chooses to Sell her ESOPs

When she decides to sell the shares in 2017, she is required to pay the Capital Gains Tax. 

  • Capital Gains Tax = (120-100)*10,000 = Rs. 2,00,000

Rakhi’s vesting period is less than 12 months, so she will be charged normally as per the slab because the sale of the shares is a short-term capital gain. 

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Conclusion 

ESOPs are a smart way to retain the organisation’s employees. However, some factors must be taken into consideration to issue ESOPs smoothly and give the organisation’s core employees a sense of belonging. There are various methods under which an ESOP is taxed. The ESOP should be issued in conjunction with those in order to provide the best results. 

Frequently Asked Questions 

Q1. Is ESOP taxed for startup?

Ans1. The employee is not eligible to pay the tax on the ESOP in the year in which they exercise the option. 

Q2. What is the ESOP scheme for start-ups in India?

Ans2. Employee Stock Option plans are schemes run by organisations to retain and motivate their hardworking workforce.

Q3. What are the tax implications of ESOPs in India?

Ans3. The tax on ESOPs is based on whether the employee is exercising or selling them. Accordingly, if the ESOP is being exercised/sold within 24 months of issuance, a short-term capital gains tax will be levied, and if it is being exercised/sold after 24 months of issuance, a long-term capital gains tax will be levied.

Q4. What happens to ESOP after IPO? 

Ans4. There are some pre-approved IPO schemes that require confirmation from the Shareholders. Additionally, an employee will not be entitled to sell their share within one year of the IPO. 

Q5. What is the ESOP structure for startups?

Ans5. An ESOP structure provides the Employer with a tax benefit and allows them to dispose of their holdings properly.

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Adv. Anamika Chauhan

Adv. Anamika Chauhan

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Advocate Anamika Chauhan has been practising law independently for the last 5 years, during which she has gained extensive experience in handling cases. She offers legal consultancy and advisory services with a focus on achieving ethical and professional results. In addition, her excellent communication skills allow her to articulate arguments persuasively in both written and verbal forms.

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