The Absurd World of ESOP taxes

In today’s newsletter, we’ll talk about why taxation on Employee Stock Option Plans is pissing off India’s business community.

The Story

Startups are big drivers of growth in India. They influence consumer spending, boost employment at all levels, and provide innovative solutions for unaddressed problems. And for them to succeed in what they do, they need to attract and retain highly skilled employees. The problem is, they might not necessarily have the resources to afford this talent.

What they do have, however, is a belief that they’re going to be the next big thing. And so, more often than not, startups capitalize on it.

Enter Employee Stock Option Plans (ESOPs). These little bad boys give talented employees a chance to invest more than just their time and effort in the company while also giving employers an opportunity to recruit the people they need without shelling exorbitant amounts of cash.

In other words, ESOPs give you the right to buy company shares for a modest sum (at a price lower than what they are actually worth). Very neat.

However, the process of granting ESOPs isn’t as simple as paying someone’s salary. There are several stages involved. First, the employee is given the ESOP and asked to wait for a while before he can actually buy the shares. Then, at a specified date in the future, he may choose to exercise his right to buy these shares. He will have to pay a modest sum as we have already discussed and this is where the problems begin.

Suppose you’re buying shares under ESOPs. You’ll have to shell out some money to buy them. And then, you will also have to pay a tax the moment you buy the shares even though, you haven’t received the actual cash in hand. See the problem here? You are expected to pay tax on the purchase even though you haven't sold them (because the government treats this as part of your salary).

And ever since former Finance Minister P. Chidambaram introduced this inane law in 2007, the business community has been clamouring for its takedown. Until that is, Nirmala Sitharaman finally chose to fix things (partially) this last budget.

And if you are not following all this, here is an example to drive home the point.

First, you are granted the ESOPs and you wait 3 years (or any other time frame) until you can exercise the option to buy these shares. Let’s say you decide to buy them anyway and pay Rs. 10. It’s a modest sum and you are convinced these shares are worth a lot more. So it’s a good investment you think.

Then we have the fair value of the share — as determined by a valuation expert or a large group of people in the markets (in which case it’s the share price of the company). Let’s say it’s 150.

Back in the old days, the government taxed you the moment they saw this gain of 140. But here’s the thing, you are yet to receive the actual cash. You think its unfair but you pay income tax on the Rs. 140 and you move on with life.

Finally, there is the selling price. The thing about the erstwhile fair value we talked about is that it might not necessarily reflect the final sale price. If for instance, your company is desperate to buy these shares off of you, you could bargain for a higher price than the fair value as determined by valuation experts. So yeah, let’s presume you sold the share at 200. Then you will have to pay Long term capital gains tax on the extra 50 you made above the fair value and you will finally have paid all your dues.

Now, most of these old calculations still persist in the new system. But unlike in the old method where you pay taxes on two separate occasions you are expected to pay your dues when you actually sell the shares or 5 years after deciding to buy them, or when you leave the company (whichever comes first).

So this means you won’t have to pay tax when you actually receive the shares thus offering you additional leeway.

Get it now?

Yes?

Okay :)

Unfortunately, this isn’t applicable to all the 27000 startups India harbours. It is restricted to only 500–700 startups recognised by the Inter-Ministerial Board (IMB) of the Government- mainly those which were incorporated after April 2016. So realistically, only around one per cent of India’s startups will see any change.

…and we’re back to square one.

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