An employee stock ownership plan (ESOP) is an employee benefit plan that enables employees to own a portion of the company they work for. Esops in India are currently taxed at two stages – one at the time of exercise of shares (i.e. when the employee sends his request to subscribe for shares and the company allots those shares) and second at the time of sale of shares allotted. share. However, many times, there have been instances where the tax at the time of receiving the shares has created difficulties for the employees and they are not able to avail the benefits of the scheme.
Generally, companies will deduct the tax payable from the remuneration of the employees at the time of allotment of shares, and in cases where the remuneration is not sufficient to pay the tax liability, the companies may ask the employee for the amount of TDS, and if, If not able to pay, the companies may pay or in some cases they may even stop or delay the exercise. In some scenarios, companies may choose to bear the tax, which will increase their costs. So, in this aspect, the law in its present form appears to be in favor of deep pocketed employees.
The rationale for this treatment is explained with the help of an example. An employee is, say, receiving 1,000 shares of the company at, say, the exercise price. 50 per share and the fair value of the share can be said to be, 400 per share. The employee will be taxed for the difference of Rs. 350 per share ie, 3.5 lakhs in total for 1,000 shares. When the employee actually sells these shares at a later stage, say, 600 per share, he/she will be subject to capital gains tax on the income of 2.5 lakhs.
The logic seems to be that if an employee is getting some upside today at the time of this exercise, it should be taxed now, even if there is no actual income in the hands of the employee. Therefore, the taxability at the time of exercise is nothing but the upward movement of taxation. In fact, if the valuation of the company falls for any reason, the employee will be at a more disadvantageous position, in that he may have already paid the tax, but may realize more value upon exit. Could not
Although capital loss will be allowed to the employee, which can be set off against other capital gains income, the justification for preponing tax in this scenario is not correct. Also, if the earlier growth is taxed as salary, it may be taxed at a higher rate of up to 42%, but the long-term capital gains (LTCG) tax is much lower.
In case of startups having DPIIT registration, exemption is available that tax can be collected after 48 months or when the employee leaves, or if these shares are sold due to any liquidity event. This again raises the question as to why only the employees of startups get this benefit.
Ideally the law should be uniform for employees of all companies. While this scheme of taxation of Esops is promoted as an incentive for startups, in reality, a uniform treatment should be applied to all companies.
It is worth noting that such tax treatment is commonly found in anti-avoidance provisions. For example, the much publicized angel tax was introduced to combat this menace, where allocations in many companies were being made at sky-high valuations and were being used as a money laundering device. This provision may seem illogical but it was very necessary to counter this menace. To reduce the difficulties, the law has been rationalized to some extent.
However, Esops have never been used as a tax avoidance strategy and without any real income in the hands of the employees the current tax treatment may seem unfair.
To mitigate the hardship, companies may resort to other means, such as the use of phantom equity, in which only the upward cash payment to the employee may be taxed because no actual instrument is issued. However, employees are not allowed any equity participation and hence may not serve as an effective incentive as in typical Esops.
As the Budget 2023 preparation exercise begins, the tax on ESOPs needs to be revisited from this perspective and necessary proposals should be introduced in the Finance Bill.
Sandeep Sehgal is Partner – Tax at AKM Global, a tax and consulting firm.
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