According to a National Association of Software and Service Companies report, more than 90% of the Indian startups have adopted Employee Stock Option Plans as part of their compensation strategy. However, probably the most daunting issue in offering ESOPs is its taxation.
What is ESOP?
An Employee Stock Option Plan, more popularly known as an ESOP, is a type of benefit that a startup provides to its employees wherein equity ownership of the company is granted to them. ESOPs are in a fabulous way of attracting and retaining talent while aligning the employee’s interests with that of the company’s, giving that feel of ownership. But then comes a tax implication that it carries and which can be managed only with great care.
ESOP Taxation in India occurs at two stages:
- At the time of exercising the option: The difference between the exercising price at which the shares are acquired and the FMV of the shares is taken as a prerequisite, chargeable to tax as salary income when an employee exercises the options and receives the shares.
Tax Rate: It is taxed as part of the income of the employee under the head “Income from Salary” and rates of the applicable slab of income tax. - At the time of selling the shares: The capital gains tax is applied while the shares are sold by the employee. In this case, the capital gain is computed by calculating the difference between the sale price and FMV of the shares at the time of exercise.
Short-Term Capital Gains (STCG): The profits, if redeemed within 24 months from the allotment date, are short-term and will therefore be subject to a tax of 15%.
Long-Term Capital Gains (LTCG): Profits acquired after 24 months from the date of allotment will be long-term and subject to a tax of 10% over INR 1 lakh.
Key Considerations for Startups Offering ESOPs
- Deferred Tax Payment for Startups (Budget 2020 Amendment): Dealing with the burden on the pocket of the employees, the Indian government in its Union Budget 2020 stated that the payment of tax under ESOP for the eligible employees of the start-ups would be deferred. This employee can defer the payment of tax on his ESOP for as long as five years from the date of exercise or till he ceases to be in the employment of or sells his shares in the company whichever is earlier.
- Valuation of Shares: It also values each share, so all shares issued under an ESOP should be valued at the FMV existing at the time of exercising the ESOP. Startups should constantly get their shares valuated to stay accurate and updated according to tax regulations.
- Managing Cash Flow for Employees: Most of the time, employees suffer cash flow during the ESOP mode of exercise. They need to pay taxes upfront, even when they do not sell the shares. Alternative arrangements have been given by some of the companies, especially through loans or buy-back options in managing such shortfalls.
- Capital Gains Tax Optimization: For shareholding employees, long-term capital gains will be allowed only after shares have stayed in the hands of the employees for more than 24 months. In these situations, the holding period can be used to reduce the tax liability.
ESOP Taxation: Impact on Startups and Employees
- For Employees: ESOPs are an attractive incentive but require a clear understanding of the tax implications at both the time of exercise and sale. Employees should evaluate the timing of exercising and selling their shares to minimize their tax burden.
- For Startups: ESOPs can be a cost-effective way to compensate employees without immediately impacting the company’s cash flow. However, startups must ensure proper documentation, compliance with tax rules, and regular valuation of shares.
Statistical Insight
A recent study by Tracxn reported that more than 300 Indian startups executed ESOP buyback programs between 2021-2023, offering employees an opportunity to cash in their options. This demonstrates the growing importance of ESOPs in startup compensation packages, with the government’s tax deferment policy helping ease the burden for employees.
How Coinshell Helps?
Coinshell is a one-stop-shop structuring of an ESOP; it gives professional advice and tax efficiency for making your startup’s plans on ESOPs compliant. Let it be ESOP structuring, tax consequences, and compliance; rest assured you will have an employee compensation plan that would benefit the firm as much as it will benefit the employees involved in it.
Whether you are a startup looking to implement the ESOP or an employee asking for guidance on tax optimization, Coinshell is here to provide well-rounded solutions tailored for you.
