Budget 2020: India’s ESOP taxation harshest amongst all start-up hubs

Published: February 5, 2020 2:45:09 AM

Budget 2020 India: Indian start-ups are still treated as stepchildren compared to listed companies, with the “superrich surcharge” that was rolled back for listed companies, but still applies to start-ups.

Thus, deviations between the latest capital raise & the fair market value of the ESOPs so exercised is permissible.Budget 2020-21: Thus, deviations between the latest capital raise & the fair market value of the ESOPs so exercised is permissible.

By TV Mohandas Pai & Siddarth Pai

Union Budget 2020 India: Entrepreneurs are used to disappointment—it is an inevitable part of life. It rolls off them like water off a duck. But what hits them hard is being promised change that doesn’t materialise. Nothing exemplifies this more than this year’s budget speech. Nirmala Sitharaman articulated the role that start-ups play in the economy, calling them “engines of growth”. For context, when our PM spoke about India’s aspiration to become $ 5-trillion economy by 2025, he said that $1 trillion must be contributed by start-ups. The FM highlighted the role ESOPs play in start-ups-“to attract and retain highly talented employees”. She even hit the nail on the head when she mentioned one of the core issues faced by employees exercising their ESOPs “Currently, ESOPs are taxable as perquisites at the time of exercise… leads to cash-flow problem for the employees who do not sell the shares immediately”. She even proposed measures that would help alleviate this issue, stating, “to ease the burden of taxation on the employees by deferring the tax payment by five years or till they leave the company or when they sell their shares, whichever is earliest.”

Which makes what followed in the Finance Bill 2020 even more bewildering.

Instead of being rolled out to the over 27,000 DPIIT registered start-ups, the government restricted this to the mere 500-700 start-ups recognised by the Inter-Ministerial Board (IMB), leading to an immediate uproar amongst all entrepreneurs as they felt deprived of something they have been promised for over a decade.
The DPIIT is the nodal body for the Start-up India initiative—one of the personal initiatives of the PM. DPIIT articulates the policy for start-ups, which has been widely adopted by all government bodies, departments and regulators bar one—the CBDT. The DPIIT places the following primary conditions for start-up:
1. Less than 10 years of existence
2. Revenue less than Rs 100 crore
3. Innovative business or has the potential to create wealth or employment

CBDT placed two additional conditions to qualify for tax benefits, incorporation after April 1, 2016 and a certificate from the IMB for being “innovative”. The IMB process has been criticised for being parsimonious with its certification, depriving Indian start-ups of the tax benefits:
1. A tax holiday of 3 years of out 10 (Section 80-IAC)
2. Carrying forward losses if there’s a change in control (Section 79)
3. Wholesale Angel Tax exemption (Section 56(2)(viib))
4. Investments into start-ups qualifying for a capital gains exemption, which has several conditions (Section 54GB)
5. The ESOP change under section 156

Conservatively, around 1% of the total start-ups operating in India can avail of the change in the ESOP taxation regime. This has severely curtailed the impact of exemption to a fraction of the total ecosystem.

Even out of these 500 start-ups with IMB certification, which can avail of the tax benefits, around 50% would have either shut down, been acquired or exceeded the revenue threshold. Out of the remaining 250, given the young age and revenue restriction, the average valuation may be assumed as Rs 200 crore. The standard ESOP pool is around 10% which needs to last for 5 years, bringing it to 2% exercise per annum. Thus, the total ESOP value that may be exercised (assuming 100% is) will be Rs 200 crore x 2% which is Rs 4 crore. Taking the tax payable at the highest slab rate of 30%, the total tax payable is Rs 1.2 crore.

Watch Video: What is Union Budget of India?

India’s start-ups raised $14.5 bn in 2019, with a $150 bn valuation, the impact of the ESOPs change, thus, is beyond negligible. Start-ups deserve better.
India’s ESOP taxation issue has been the payment of tax on notional gains at the point of exercise. India’s taxation regime on ESOPs is as follows:
1. The difference between the Fair Market Value and the Exercise Price of the options is taxed as Income from Salaries
2. The difference between the Sale Price and the Fair Market Value at the point of sale is taxed as Income from Capital Gains

These work for listed companies, where an employee can sell the shares upon exercise of the options, thus giving them liquidity to pay their taxes. Unlisted companies and start-ups, being private companies who lack a market and free transferability by law, cannot sell their options upon exercise.

This does not solve the issue of double taxation. Finance Bill 2020 states that the tax payable upon the exercise of ESOPs will be determined at the point of exercise, but payable at the earlier of:
Five years from exercise
Employee departing the company
Sale of the shares

So, after the point of exercise, if the Sale Price is less than the Fair Market Value at the point of exercise, the tax liability determined above will still be payable. That pain point hasn’t been eased. This is why entrepreneurs asked for the taxes to only be determined and paid at the point of sale, so such events out of the control of the employees don’t adversely impact them.

The issue of Fair Market Value, which was the bane of “Angel Tax”, is also at the core of the ESOP taxation issue. Rule 3(8)(ii), Income Tax Rules, 1962 state that the FMV for ESOPs has to be determined by a Merchant Banker. The Company’s Act (Section 42 and Section 62(1)(c), read with Rule 13 of Company’s (Share Capital and Debentures) Rules 2014) since that needs to happen at the Fair Market Value. RBI reporting under FEMA also require the securities issued to non-residents to be done at the Fair Market Value. Furthermore, due to section 56(2)(viib), this “fair market value” report cannot deviate from the price of the latest issue of shares at a premium since it would lead to two fair market values for the securities at the same time, causing taxation issues.

Thus the same issue plaguing Angel Tax, which still needs to be fully resolved, lies at the heart of the ESOP taxation issue. The double taxation issue hasn’t been solved; the issue of FMV deviation hasn’t been solved. What has been proposed is only a deferral of the tax, for select companies, which still lags what the rest of the world offers.

In a recent interview with CNBC-TV 18, Ajay Bhushan Pandey stated that one must compare India’s ESOP regime with the other start-up ecosystems across the world.

India is the third largest start-up ecosystem, behind only the US and China in terms of capital raised, the number of unicorns and the number of start-ups. Hence, India can only compare herself to them when it comes to start-up policies. Singapore has become the launchpad into India, with several Indian start-ups and India-focussed businesses setting up base there only to access the Indian market. Hence, a comparison with Singapore is apt to gauge our start-up policies.

In Singapore, ESOPs are taxed as per the IRAS e-tax Guide titled “Tax Treatment of Employee Stock Options And Other Forms of Employee Share Ownership Plans (Second Edition)” Under the Singapore regime, ESOPs are taxed as the difference between the open market price at the point of exercise versus the exercise price.

However, for unlisted entities and start-ups, the open market price is defined as the net asset value, i.e., book value of the securities.

In the USA, ESOPs are taxed as the difference between the FMV and the exercise price, with the FMV being governed by section 409A. The Board needs to obtain a “FMV” report using a “reasonable valuation method” taking into consideration: the value of tangible and intangible assets; control premiums or discounts for lack of marketability; whether the valuation method is used for other purposes, and other financial and non-financial items.

In addition to the reasonable valuation method, the valuation is considered presumptively reasonable if it meets one of the safe harbour criteria, a qualified independent appraiser performs the valuation or for start-up companies, someone other than an independent appraiser who has the requisite knowledge and experience performs the valuation, and the valuation satisfies other criteria under Section 409A.

Thus, deviations between the latest capital raise & the fair market value of the ESOPs so exercised is permissible.

Since 2016, China’s ministry of finance has created a more benign regime for ESOP taxation for unlisted companies allowing employees who have exercised ESOPs to defer taxation to the point of sale and will only be taxed once as ‘capital gains’, not twice-under salary and capital gains.

The global best practises, thus, are: defer taxation to the point of sale (China); allow for any method taking into consideration asset value, including book value, so long as it’s performed by a registered valuer (USA) and tax the difference between the book value and the exercise price (Singapore).

On the other hand, India’s ESOP tax policy limits the scope to a narrow section of the start-up universe; doesn’t solve the issue of using the latest funding round to determine the FMV despite no single employee being able to command that price in the market due to start-up financing agreements and liquidation waterfalls and even doesn’t solve the issue of double taxation. This was not the start-up India that the PM had promised.

Indian start-ups deserve more conducive and sympathetic tax policies. Far too many entrepreneurs have left India to set up shop in other geographies while their business remains here. India cannot afford to become a land of subsidiaries.

The translation of intent from the PM and FM to policy has been lacking severely when it comes to taxation. Indian start-ups are still treated as stepchildren compared to listed companies, with the “superrich surcharge” that was rolled back for listed companies, but still applies to start-ups. Angel tax, too, went through multiple iterations, and is yet to reach a satisfactory conclusion. Start-up India is being undermined purely for tax policies. New India cannot afford to sacrifice her future at the altar such perverse and adverse tax policies.

Mohandas Pai is chairman, Aarin Capital, and Siddarth Pai founding partner, 3one4 Capital 

Do you know What is Finance Bill, Short Term Capital Gains Tax, Fiscal Policy in India, Section 80C of Income Tax Act 1961, Expenditure Budget? FE Knowledge Desk explains each of these and more in detail at Financial Express Explained. Also get Live BSE/NSE Stock Prices, latest NAV of Mutual Funds, Best equity funds, Top Gainers, Top Losers on Financial Express. Don’t forget to try our free Income Tax Calculator tool.

Next Stories
1Budget 2020: FM Sitharaman exhorts industry to shun hesitation, make investments to drive economic growth
2Budget 2020: Amfi seeks clarification from tax authorities on removal of DDT, TDS introduction
3Budget 2020: Ayushman Bharat expansion a great step, but lot more still required