Budget 2020: The SOP story for startups continues

Updated: February 02, 2020 11:51 AM

Union Budget 2020 India: Countries such as China, Singapore or the US allow the Board to adopt the 'liquidation value' of the ESOPs as their fair market value or even defer taxation to point of sale. E

Union Budget 2020 India, Budget 2020 IndiaBudget 2020-21: The tax at the point of exercise is a tax on notional gains, but paid out in form of hard liquidity.

By Siddarth Pai

Union Budget 2020 India: ESOPs, or Employee Stock Option Plans, are a means to reward employees of companies with equity in the company. In India, ESOP schemes such as the ones created by Infosys, have helped create over 18,000 millionaires.

However, India’s ESOP taxation regime has been designed for listed companies and not for startups. In India, ESOPs are taxed twice— first they are taxed as income from salary (perquisite) at the point of exercise, as the difference between the grant price (price at which the ESOPs are offered to employees) and the fair market value (taken as price of most recent round of funding due to our tax laws); at the point of sale, they are taxed again as income from capital gains.

The tax at the point of exercise is a tax on notional gains, but paid out in form of hard liquidity. Given the high delta between fair market value and grant price, the economic outflow is considerable and employees can’t sell these shares, as startup securities are illiquid. This leads them to taking loans to pay their taxes to become shareholders—a dismal state of affairs.

Countries such as China, Singapore or the US allow the Board to adopt the ‘liquidation value’ of the ESOPs as their fair market value or even defer taxation to point of sale. Employees of listed entities can sell their shares on the stock market, allowing them to pay their taxes from the liquidity generated. But employees of Indian startups aren’t afforded these considerations and the latest changes don’t add to this either.

If one reads the fine print of the Finance Bill 2020, under Section 156, there exists a pernicious insertion in the form of a qualifier for a startup to avail of this—the startup should be recognised by the IMB (inter-ministerial board), a government body that certifies a startup as ‘innovative’. Of the over 50,000 startups in India, only about 27,000 are registered with DPIIT; of these, only a fraction have received IMB certification due to the process.

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Even for IMB-certified startups, the only difference is that the tax payable is deferred, but the liability is fructified at the point of exercise. If the company collapses, or if it is sold at a loss, then the tax liability calculated as per the slab rates at the point of exercise is still payable, even if the employee loses money on the sale. The only change is a timing and cashflow issue, not a change in the fundamental issues plaguing ESOP taxation in India. The tax payable at the point of exercise is independent of the tax payable at the point of sale. If the employee loses money at the point of sale, tax at the point of exercise is still applicable.

The dismay amongst entrepreneurs is palpable. Some feel cheated by the Budget and the volte-face in the Finance Bill, and others are dismayed by the efforts made to rectify this. Even the ‘super-rich surcharge’ of 25% and 37%, which was rolled back on listed securities, still remains on unlisted securities and ESOPs—further penalising startup employees .

It is unfortunate that the tax piece has remained the Achilles heel of startup India—be it angel tax, which is yet to be fully exorcised, the riders placed to get a tax holiday or this change in ESOP taxation. While other government departments have done tremendous work in opening up to startups, the tax department still treats them as subordinate to their listed counterparts. India can ill afford to sacrifice the golden goose of startups at the altar of such adverse tax policies.

The writer is founding partner, 3one4 Capital

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