India Inc over the recent years has propelled and nurtured a robust start-up eco-system. With innovation at the core, several start-ups have achieved notable success, thereby fueling the overall economic growth.
It is, however, incumbent on these start-ups to attract and retain the best talent in the marketplace, notwithstanding their limited resources. Employee Stock Option Plans (ESOPs) can play a vital role here, as a part of the compensation strategy. While ESOPs were conventionally used as a tool to incentivise long-tenured senior management, recent trends indicate that ESOPs are actively deployed as a hiring strategy to attract talent. It is generally seen that several start-ups are incentivising employees early across different levels, as a part of their growth, reward, and retention strategy.
Employee motivation and creating a sense of ownership is critical in a start-up culture. ESOPs also serve as a retention-cum-cash conservation tool considering that pay-outs under ESOPs usually happen after three to four years from the date of grant.
The modus-operandi of ESOPs largely remains the same across seasoned companies and start-ups. However, employees in start-ups generally leverage on an early stage access to ESOP, thereby aligning their gains to the company’s growth. On completion of vesting and exercise, employees are allotted shares of the company which can be monetised once the company announces a liquidity event such as buyback or cash acquisition or an IPO (Initial Public Offering). Considering that most start-ups achieve a decent valuation over a period, the cash pay-out on most occasions could result in sizeable income for the employees, thereby providing them attractive monetary windfalls.
From employer perspective, start-ups registered as private limited companies will have to adhere to the guidelines prescribed under the Companies Act, 2013 read with the Companies (Share Capital and Debentures), Rules. These Rules outline the ambit and scope of ESOPs in so far as private limited companies are concerned and it is important that these provisions are adhered to. For instance, the Rules provide that only certain category of employees and Directors of Companies can be remunerated under ESOPs. It may be noted that start-ups registered with the Department of Industrial Policy and Promotion (DIPP) have been granted certain advantages in terms of the employee coverage under ESOPs.
From employees’ perspective, ESOPs are taxed at two stages in their hands:
# At the time of exercise of ESOPs – as a perquisite
# At the time of sale of shares – as capital gains
On exercise, the difference between Fair Market Value (FMV) of the shares on the date of exercise [as determined by a Category I Merchant Banker registered with the Securities and Exchange Board of India (SEBI)] and the Exercise Price is taxed as perquisite.
The employer will have to withhold tax on such perquisite and report the same while filing their quarterly returns (Form 24Q). The perquisite as well as tax deducted on such perquisite should reflect in the employee’s Form 16 / Form 12BA. It may be noted that effective FY 2020-21, an employee receiving ESOPs from an eligible start-up need not pay tax in the year of exercising the option. The TDS on the perquisite stands deferred to earlier of the following events:
# Expiry of five years from the year of allotment of ESOPs
# Date of sale of the ESOPs by the employee
# Date of termination of employment.
On sale, the difference between the sale price and FMV on the exercise is taxed as capital gains. Taxability as short-term or long-term depends upon the period of holding from date of exercise to the date of sale.
To summarise, having ESOPs as a part of recruitment and retention strategy provides a competitive edge and helps create an energised and motivated workforce. It inculcates a sense of pride in the employees through a feeling of ownership and partnership in the company’s growth trajectory along with their own wealth creation. It is imperative that the employer be fully aware of the relevant regulatory provisions prior to providing ESOPs as also the employees should be aware of the tax consequences arising on exercise and monetisation of securities under ESOPs.
(By Parizad Sirwalla, Partner and Head, Global Mobility Services – Tax, KPMG in India)
