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

3 min Read Jan 29, 2025

Section 17(2)(vi) - Taxation of ESOP in case of employees of eligible start-ups – Request for deferral of taxability for all start-ups registered with DPIIT

Over the years, Employee Stock Option Plans (ESOPs) have become a significant part of employee compensation as an attractive incentive for start-up employees. They are an opportunity for employees to participate in the growth of a company they have helped build. The existing provisions under tax acts under Section 17(2)(vi) only makes it difficult for many employees of the start-ups. This article thus brings attention to this issue and suggests a solution for DPI IT-registered start-ups to enjoy fairness.

The Law: Taxation of ESOPs

ESOP or sweat equity shares issued to an employee are a perquisite under Section 17(2)(vi) of the Income Tax Act. Although the employees may not sell these shares, its value will be taxable when the allotment of shares or transfer of shares by the employer takes place.

Deferment of tax collection on employees in "eligible start-ups" defined under Section 80-IAC. Tax must be paid at the earliest on one of the following dates:48 months from the end of the relevant assessment year.

Sale of shares.

When an employee quits the start-up.

This deferral, while benefiting the employees of eligible start-ups, leaves out a large number of start-ups that are registered with DPIIT.

The Issue: Narrow Scope of Deferral

The current provision applies only to employees in "eligible start-ups" approved under Section 80-IAC. However, most start-ups that are registered with DPIIT do not qualify under Section 80-IAC.

For these employees, tax liability is triggered at the time of allotment of the shares, though they have not liquidated them or realized any cash benefit out of them. Such a situation leads to financial distress and discourages talent from entering emerging start-ups.

The provision for issuing a demand notice to employees, as stated in Sections 140A and 156, only adds to the confusion. Liability for interest under Sections 234A and 234B is not clear and has been one of the sources of concern for employees.

Why This Matters

Start-ups rely heavily on ESOPs to attract and retain talent. Taxing employees before they see any financial gain from their shares undermines the purpose of ESOPs. Employees, especially in early-stage start-ups, often lack the liquidity to pay taxes upfront.

This issue is not just about fairness; it directly impacts start-up ecosystems. Employees in non-eligible DPIIT-registered start-ups are at a disadvantage compared to their peers in eligible start-ups.

A Call for Change: Suggestions for Fairer Taxation

The following changes are recommended to address this disparity:

  • Extend Tax Deferral to All DPIIT-Registered Start-ups

  • Tax deferral should apply to employees of all DPIIT-registered start-ups, not just those certified under Section 80-IAC. 

This will ensure a level playing field across the start-up ecosystem.

Trigger Taxation on Specific Events

The taxation event should rather be at the time of the liquidity events, which includes:

  • Sale of equity shares

The employee leaving the start-up 48 months from the end of the assessment year

  • Interest Liabilities

The law should clearly provide that in case the employer makes the deduction during deferment period, the employee will not be liable for the interest.

Adopt a Scheme Something on the Lines of Section 45(2)

Section 45(2) of the Income Tax Act defers taxation for the conversion of a capital asset into stock-in-trade until the asset is sold. A similar approach can be adopted for ESOPs.

A Step Towards Equity

These changes will not only benefit employees but also strengthen India's start-up ecosystem. By easing tax burdens, start-ups can attract top talent without placing employees in financial distress.

Conclusion

This mechanism is available only by a miniscule amount of employees working in eligible start-ups under Section 17(2)(vi). For that reason alone, the government must extend this mechanism for deferment of tax to all DPIIT registered start-ups.

Please refer to Mind Your Tax, your trusted partner in making complex tax matters simple. Our experts specialize in ensuring that individuals and businesses understand the nuances of tax laws and can navigate them easily and with clarity.