PE, VC Funds Urge Govt to Tax Esops Only at Time of Sale

Top private equity houses and venture capital funds, which bankroll startups, have drawn the attention of Prime Minister Narendra Modi and finance minister Nirmala Sitharaman to the hurdles before these fledging outfits in compensating employees with stock options.

At the meeting with Modi and Sitharaman on December 17, some of the senior fund officials have said that the startup world-where a sizable slice of the payout to employee is in the form of stock options-would gar a leg up and find is a lot easier to hire talent and grow if employee is allowed to pay tax at the point they actually sell the shares, two persons who attended the meeting told ET.

At present, a startup employee who received a grant of options from the firm under the employee stock ownership plan (Esops) has to pay full income tax after a certain period following the vesting of the options. The tax has to be paid either within 48 months from the end of the relevant assessment year in which the Esops were allotted or if the person ceases to be an employee-whichever is earlier.

So, an employee exercising sop has to arrange funds to buy the shares and then fork out around 35% tax as the allotted shares are considered as part of the salary.

For Instance, if the shares are allotted at Rs10 and the fair market value of the company is Rs110, thru employee has to pay about Rs 35 as income tax (on each share) on the different of Rs100.

Later when the person sells, the shares, says, for Rs510, there would be capital gains tax on Rs400-the difference between Rs510 and Rs110-on each stock sold.

As this can be tough on employee who often receive lakhs of options, the government, in a bid to encourage startups, should collect tax at a later point on the capital gain of Rs500- the difference between Rs510 and Rs10- when the stock is sold.

“Hiring and retaining talent in startups is only possible through Esops. The current scheme of taxation in case of Esops is onerous on employee because of cash flow mismatch. Deferment of taxation on ultimate sale only facilities cash flow management. The revenue does not lose any taxes per se,” said Amarjeet Singh, partner (Emerging Giants and International Tax) at KPMG.

A year ago the government had given some leeway on taxation of Esops to startups. Before 2020, they were taxed immediately as a perquisite, on the difference between grant price and fair market value, at the time of exercising the options.

With Esops being actively deployed as a hiring strategy and as a means of stabilization of cash flow the government deferred the payment of tax on Esops for employees of’ eligible startups’ only.

“The deferral in payment of perquisite tax on Esops may seem like an adequate measure, but Isn’t First, the employer has to be an eligible startup, subject to fulfilment of conditions. Second, the benefit is only available to employees of eligible startups as on the exercise date.

Considering a situation where a startup post vesting of option ceases to be an eligible startup, the employees will be unable to avail the benefit of this proposal. Here, the employee is indirectly penalized for the company doing well, which seems unfair,” said Priyanshi Chokshi, founder of Beyond the Degree, a startup providing consultancy platform for young entrepreneurs.

Also, it could limit the mobility of an employee for better opportunities if the person is unwilling to cough up the perquisite tax within 14 days of quitting. Under such circumstances an employee may be forced to allow the Esops to lapse.

However, it’s felt that if Esops were taxed only on actual sale and not on national income, it would resolve cash flow issues of the employees and provide a boost to such schemes. It could also address the issue of valuation of startups being volatile and creating difficulties in determining such national income.

The Industry feels that the conditions that a startup must fulfil to be recognized by the government should be reviewed as well. To quality as an eligible startup, a firm has to be incorporated after April 1, 2016, have a turnover not exceeding Rs100 crore and must be engaged in business which is legally classified as ‘Innovative or scalable’ (a conditions that is subject to interpretation). A more realistic set of criteria could reduce the delay in receiving government approval. “It would be a game changer if the government could offset any gains from Esops by letting it reinvest in other startups.

This would spur the startup culture even further,” said Chokshi.

Between the grant of Esops and their vesting, the company issuing the options has to account for notional expenditure and mortise the amount during the period. Some of the startups believe allowing a longer period for amortization could help it show lower losses and shorten the road towards profitability. S-ET

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