ESOP Taxation for Startups: Section 17(2)(vi) and the Need for Tax Deferral

Introduction

Employee Stock Option Plans (ESOPs) have become a popular option for companies to attract, retain, and nurture talent. Companies often offer employees a stake in the company,s, creating a sense of ownership and commitment.

However, the taxation of ESOPs in India has sparked considerable debate, especially for employees working at start-ups. While receiving equity as part of compensation may seem like a great opportunity, many employees face an unpleasant surprise: they’re taxed on those shares even before they’ve sold them or made any profit.

This ESOP tax liability , under Section 17(2)(vi) of the Income Tax Act, triggers tax liability when shares are allotted, even though employees haven’t realized any financial gain. This creates a major cash flow problem, particularly for employees in early-stage start-ups where liquidity is often tight.

In this blog, we’ll break down the challenges around ESOP taxation, why it’s a burden for start-up employees, and how extending tax deferral to all DPIIT-registered start-ups could create a fairer and more equitable solution for everyone involved. Let’s dive into how we can make the taxation process work better for employees at start-ups.

The Law: Taxation of ESOPs

Under section 17(2) (vi) of the Income Tax Act 1961, ESOPs or sweat equity shares shall be issued to an employee, considered a perquisite. In simple terms, even if the employees do not sell or realise any value from these shares, they are still liable to pay tax on the market value (FMV)of these shares when they are allotted or transferred by the employer.

Let’s say you're an employee at a startup, and as part of your compensation package, you are granted 2000 shares at an exercise price of 50 per share. The market value of each share at the time of allotment is Rs 150.

Under section 17(2) (vi), the difference between the exercise price and the market value of these shares is considered a perquisite. So, in this case, the perquisite would be:

This Rs 2.00,000 is taxable in the hands of the employee as perquisites under the Income Tax Act, even though you have not sold the shares or made money yet.

Tax Deferral for Eligible Startups

The Government of India has introduced some relief for employees working in eligible startups under Section 80-IAC. Startups that qualify under Section 80-IAC are given certain benefits, one of which includes ESOP tax deferral.

This simply means instead of paying taxes at the time of allotment employees have the option to defer their defer tax liability until the following events happen.

• Sale of Shares: Tax is payable when the employee sells their stock and realizes a profit triggering a short term capital gain or long term capital gain based on holding period.
• Employee Departure: Tax is payable when the employees leave the company. Provided that 48 months have passed from the end of the relevant assessment year. This vesting period rule is linked to liquidity

These are referred to as liquidity events taxation, which many believe should be the true point of taxation.

The Problem: Limited Tax Deferral for ESOPS

Currently, employees employed by the eligible startups as defined under Section 80-IAC are eligible for tax deferral on ESOPs.However, most of the startups in India registered with the DPIIT are not eligible for this part.

Thousands of employees still face taxability of ESOP under the Income Tax Act before they’ve made a single rupee. Some may look up an ESOP tax calculator to understand their due, but it doesn't change the financial strain. This creates a serious cash flow problem and discourages top talent from joining emerging startups.

On top of that, employees sell after vesting but must pay taxes upfront. Requirements under Sections 140A and 156 for demand notices and unclear interest liabilities under Sections 234A and 234B further complicate things.

Even foreign ESOPs in India face unclear rules, making taxation of foreign ESOPS in India a separate challenge.

A Call For Change: A Fairer Taxation System

Employee Stock Option Plans, or ESOPS, are a tool used by startups to recruit and retain qualified workers. However, the goal of ESOPS is undermined if workers are taxed before they receive any money from their shares.

Employees need to only be subject to taxes when they sell their stock and make money. Only employees of "eligible" start-ups under Section 80-IAC are currently eligible for this incentive. However, this clause does not apply to the majority of DPIIT-registered start-ups, which disadvantages their employees.

To resolve this issue, the following adjustments are required:

• Tax Deferral Should Be Extended to All DPIIT-Registered Startups
  All DPIIT-registered start-ups should be eligible for tax deferment, not just those under Section 80-IAC. Fairness will be guaranteed, and the startup ecosystem will have level playing fields.
• ESOPS Taxed During Liquidity Events
  Tax only when the employee sells shares or exercises their option. These are true liquidity events. It would also help define the time of exercise clearly in tax rules.
• Shares are sold when employees turn a profit.
  Terminating employment (but only 48 months after the appropriate assessment year)
  Leaving the company (but only after 48 months from the relevant assessment year)
• Clarify Interest Liabilities
  The existing legislation does not clarify whether employees are responsible for interest if their employer deducts taxes during the deferment period. It should be stipulated that employees are not liable for interest under Sections 234A and 234B in such cases.
• Implement a model akin to that in subsection 45(2)
  According to section 45(2) of the Income Tax Act, when a capital asset is converted into stock-in-trade, taxes can be deferred until it is sold. An analogous method for ESOP taxation would guarantee that employees are not taxed before their actual financial gains.

Conclusion

These changes will benefit employees and strengthen India’s start-up ecosystem. By deferring tax until liquidity events, start-ups can continue to attract and retain top talent without placing employees under unnecessary financial stress.