How can ESOP taxation in India be improved?

Ideas are great to have, but useless if you do not have the manpower to execute. Attracting talent requires money and contrary to what we read in the news, most startups are resource-constrained for most of their lives, with a few stars cornering most of the funds.

In today's post, we look at ESOPs and how they help such early-stage resource-constrained startups, look at the changes the government has implemented in ESOP taxation, and conclude by looking at the potential changes that can be implemented to help.

Why are ESOPs important to a startup?

With the best option of hard cash largely missing in early-stage startups, the second-best option to attract talents is giving ESOPs. Giving employees some stake in the company ties-up the employee's growth to firm growth. While this is generally used to incentivize top management at larger firms, it finds much broader use in these early-stage firms. Flipkart & HDFC AMC are just a few amongst many who reaped the benefits of an attractive ESOP plan.

While these are attractive, it is important to note that these shares are extremely illiquid. In the absence of an IPO or an attractive exit, they have only notional value. With the over the counter market fairly small and illiquid in India, the benefits of these ESOPs are not immediately available to the employee.

Yet, for the longest time, the government chose to tax vested shares (ESOPs which mature) from the employees of the company.

After repeatedly flagging this issue that hampers their growth and ability to retain top employees, the Finance Minister decided to partially listen and sought to bring about the change. The move was hailed by the industry but looking at the fine print one realizes that the changes aren't quite the solution the industry was hoping for.

What changes has the budget proposed regarding ESOP taxation?

The new proposal states that ESOPs will be taxed in case any of the following events occur, whichever is earlier:

• Expiry of 48 months from the date of shares getting vested/issued

• As and when the employee sells the shares

• As and when the employee leaves the company

At first glance, this looks like a good start. However, there are a few details we need to know before forming an opinion on the benefits of the move.

What can be improved further?

As per the current proposal, companies should be ‘Eligible startups’ for the rules to be applicable. Important criteria to qualify as eligible startups are revenue of less than 100cr and incorporation after April 2016. So, as soon as the startups cross INR100 cr they fall out of the definition of the eligible business. By most accounts however a US$14mm revenue business is still a reasonably small company.

The age and the turnover of the startup as prescribed mean that the benefits are not extended to a lot of startups. While a report by KPMG puts the number of startups in India beyond ~30,000 the total companies in the list are just around 18000. The high probability of failure of these startups also mean that if the shares get vested, the individuals will end up paying the taxes only to have to wait and see the fate of their holdings. If the startups are to disrupt the industries then they need to focus on growth, not just focus on profits. High risks will have to be taken for the hockey stick growth which everyone seeks. For all of that companies need talent.

One step towards improvement would be changing the definition of ‘Eligible Startup’, relaxing turnover limits. Employees leaving the company may be a criterion which can be removed as well. That being said, there is the other side of the argument as well, and numerous companies have had their share of run-ins with the IT department over the use of these instruments to defer tax payments. That, however, will require a whole other post to cover!

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About the Author: The post is written by our EZPP partner Raunak Bhiwal with relevant edits from our editorial team. Raunak is a graduate from IIM Ahmedabad, currently working with Ninjacart.

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