Staff at Unicorns on the Horns of a Dilemma Over ESOP Gains Tax

Employees with stock options in unicorns are facing a tax dilemma as valuations surge.

The quandary is whether they should exercise their options now and pay income tax now or wait and risk the valuations going further up, which could lead to higher taxes in future.

The tax rates could just be 12% and therein lies a dilemma.

“In the current bullish scenario, the valuation of start-ups and several other companies are generally moving higher. Hence, apart from several other factors, the employees of such companies need to be mindful of tax impact around the time of exercise as it may significantly impact their overall gains, particularly if the company is not a DPIIT recognized start-up,” said Amit Maheshwari, tax partner at tax consulting firm AKM Global.

Employees stock options or ESOPs are taxed in two stages: first, when the employee exercises the option to buy the shares at the exercise price, and again, when the shares are sold.

When ESOPs are exercised, the difference between the exercise price and the fair value of the share is treated as a perquisite in the hands of the employee. This difference is taxed as salary income, say tax experts.

“It is a tricky tax issue for employees who have ESOPs; of when to exercise the options as valuations keep increasing. If they exercise it at lower valuations then the tax has to be paid now at 43%, this could also become a cash flow issue as executives and employees will have to raise this money, before they actually sell it, which may happen in the future,” said Girish Vanvari, founder of tax advisory firm Transaction Square.

Experts point out that if planning is not done property then a huge chunk of the gains could be wiped out in taxes alone. There could also be situations where an employee exercise options, pays tax, but the start-up’s valuation goes down from thereon.

In most cases, the tax at the time of exercising options is linked to the valuations which keep changing – three to four times a year in most cases, Also, in many cases where unicorns are looking to get listed on capital markets, employees look to structure their share sale in a way that they don’t get taxed again.

After employees’ exercise options, if they can sell it as soon as possible then the capital gains tax can be saved, tax experts said.

Say an employee has received ESOPs at a valuation of Rs.10 per share, in most cases, there is a time frame typically between one and four years where the ESOPs cannot be sold. In this case, if the employee decides to exercise his options, say, four years later and the valuation has gone up to Rs.1000 then the gain (Rs.990) will be taxed as salary.

Now, if the unicorn gets listed a year later and the share price is Rs.4000, and he decides to sell the share then capital gains will be levied on Rs.3010 (Rs.4000 minus Rs.990).

Tax experts say that the way valuations are rising, the biggest question is when the employee should exercise the option. Also, if it done closer or after listing, then capital gains tax could be minimized or saved.

“An early exercise may enable the taxpayers to plan the exit somewhat later so that the gains would be treated as long term gains due to longer holding period (one year for listed shares and two years for unlisted shares) which are taxed at a lower rate (10% for listed companies and 20% for others). Besides, the employees can also look to split their exercise in different years particularly where due to exercise, the perquisite value due to the exercise of ESOPs increase their overall taxable income above a there should for higher surcharge rate,” said Maheshwari. S-ET

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