The Announcement: A Positive Move

On February 1, Finance minister Nirmala Sitharaman, in her budget speech declared that employees of startups (exempt under Section 80-IAC) could defer paying income tax on stock options. The proposal was put forward by the Department for Promotion of Industry and Internal Trade (DPIIT) which suggested extending tax benefits to employees of all startups registered with it.

This exemption was proposed for employees for:

  •  a period of five years or
  • until they quit the company or
  • sell their shares.

The Finance Minister applauded the role that startups play in the building the economy, and very rightly called them “engines of growth” and simultaneously pointed out that ESOPs played a vital role “to attract and retain highly talented employees”.

While detailing the problems being faced by employees in exercising their ESOPs, she observed, “Currently, ESOPs are taxable as perquisites at the time of exercise… leads to a cash-flow problem for the employees who do not sell the shares immediately”.

As she pointed out the core issues related to ESOP, she at the same time proposed measures that would help overcome the problems, stating, “To ease the burden of taxation on the employees by deferring the tax payment by five years or till they leave the company or when they sell their shares, whichever is earliest.”

This announcement in the Union Budget was hailed as an advantageous situation for startups by 27,000 DPIIT-registered startups who saw this as fulfilling a promise made long back, almost a decade.

CBDT’s Spoke In The Wheel

But the good cheer of this announcement in the union Budget 2020 did not live for long as the Central Board of Direct Taxes (CBDT) has rejected the plan to cover all startups and placed some additional conditions for the exemption to be availed by them.

The DPIIT, which is the nodal body for Start-up India initiative and which frames the policies for a startup, is universally adopted by all except one, i.e. CBDT.

DPIIT has laid down three primary conditions for start-ups:

1. Less than 10 years of existence

2. Revenue less than Rs 100 crore

3. Innovative business or has the potential to create wealth or employment.

But now the CBDT has come up with two additional conditions to qualify for ESOP tax benefits:

1) Incorporation after April 1, 2016

2) A certificate from the IMB for being “innovative”

The biggest hurdle here is that getting a certification from the IMB for being “innovative” is next to impossible as the authority has been very tight fisted in doing so in the past and thus, depriving entities of tax benefits like:

1. A tax holiday of three years out of 10 (Section 80-IAC)

2. Carrying forward losses if there’s a change in control (Section 79)

3. Wholesale Angel Tax exemption (Section 56(2)(viib))

4. Investments into startups qualifying for a capital gains exemption, which has several conditions (Section 54GB)

5. The ESOP change under Section 156

One person who was aware of these developments cited the tug of war going on between DPIIT and CBDT stated, “The DPIIT pushed hard, but the CBDT pushed back even harder.”

The Implications

Thus, instead of over 28,000 DPIIT registered startups benefitting from this exemption, the number has been drastically restricted to mere 500-700 startups; only those which are recognised by the Inter-Ministerial Board (IMB).

As the cut-off date announced by the CBDT is April 1, 2016, the number of startups automatically comes down to a miniscule percentage (1%) and hence, the majority of the old startups are left high and dry.

Secondly, even out of this 1% that is 500-700 startups that fulfil CBDT’s criteria, the industry stalwarts feel 50% i.e. 250-300 of them might have shut down or have been acquired or may have crossed the threshold of revenue mark. So, for all practical purposes, given the young age and revenue restriction, barely 250-300 startups will be benefitted by this announcement.

More so, out of the remaining few that shall be eligible, the average valuation may be assumed as Rs 200 crore and since the standard ESOP pool is around 10 percent, which needs to last for five years, it brings it down to two percent per annum.

Notwithstanding this, the calculation brings out the actual numbers to a ludicrous value of Rs 4 crore only; assuming that the total ESOP value that may be exercised will be Rs 200 crore x 2 percent, thus the total tax payable shall be Rs 1.2 crore only.

This absurdity has very naturally irked the startup community to no end and rightly so, because our Prime Minister, Mr Narendra Modi while speaking on India’s aspiration to become $5-trillion economy by 2025, said that he expected $1 trillion to be contributed by startups.

An industry, India’s startups which has raised $14.5 billion in 2019, with a $150 billion valuation, expects as well as deserves a better deal from the government.

“Right now the proposed CBDT ESOPs exemptions are beyond negligible and therefore, extremely disappointing.”

– Kritika Chabbra (Market Analyst, MUDS Management Pvt. Ltd.)

Concerns Of Startups

Since the FM’s announcement, there have been a plethora of demands by industry groupings to extend the benefits of ESOP tax exemptions to a wider pool.

As valuations of startups are volatile, thus, one of the long-standing demands of Indian startups has been that Esops should be taxed at the time of sale rather than when they are vested.

Groupings such as iSPIRT, Local Circles and Indian Private Equity & Venture Capital Association (IVCA), Indian Angel Network, Nasscom and CII have expressed their concerns to the government.

iSPIRT has advocated exemption for all startups and not just those recognised by the IMB, and it is also of the view that the current mechanism is not capable of solving the core issue of double taxation of Esops.

Community platform Local Circles wrote a letter to CBDT stating, “The scope of this exemption should be expanded to enable any startup incorporated within the last 10 years to be eligible for this, similar to the angel tax exemption.”

Whereas Siddarth Pai, founding partner at 3one4 Capital, states, “The Esop changes being restricted to such a small fraction of Indian startups does a huge disservice to Indian entrepreneurship and India runs the risk of becoming a land of subsidiaries if we don’t align our taxation to the global best.”

Explaining how the system currently works, Bhavin Turakia, Founder and CEO, Flock, and Co-founder and CEO, Zeta, says, “At present, startup employees are required to pay tax whenever they sign up for ESOPs with a vesting schedule, and also pay taxes on capital gains whenever they redeem their ESOPs. The minister has proposed deferring the tax payment by five years, or until employees leave the company, or when they sell their shares-whichever is earlier.”

As per the Income Tax Act, 1961, employees who are allocated ESOPs are taxed at two stages: once when they exercise the option to buy the shares on completion of vesting period and second time when they choose to sell the shares.  This causes stress on the employee as high liquidity is required to pay these taxes.

The domain experts are of the view that the issue of Fair Market Value, which was the bane of Angel Tax, is also at the core of the ESOP taxation issue and the pain points have not been tackled in the budget, 2020.  

Mohandas Pai and Siddarth Pai, expressing their opinion in the article “Decoding Budget 2020: ESOP taxation in India is harshest among all startup hubs” says, “Thus, the same issue plaguing Angel Tax, which still needs to be fully resolved, lies at the heart of the ESOP taxation issue. The double taxation issue hasn’t been solved; the issue of FMV deviation hasn’t been solved. What has been proposed is only a deferral of the tax, for select companies, which still lags what the rest of the world offers.”

Finance Minister’s Assurance

The Startup community which has felt totally let down has shared its distress as well as concern with the government, urging to look into the matter.

The Finance Minister, Nirmala Sitharaman, who was interacting with the industry leaders in Bangaluru, was questioned about the ESOP tax related benefits that would currently be advantageous to only 200 of the 28,000 DPIIT-registered start-ups.

Sitharaman said, “We’ve asked them (startups) to give their representation to the IMB and we shall also be following that up.”

She has assured the start-up community and promised to look into the issues related to it and at the same time, she has asked the industry to come up with suggestions in order to fine-tune the regulations.

A senior government official told Economic Times that the “views (on Esop taxation) of all companies are being examined. A final decision will be taken in the next week.”

The official further added, “Whatever the government’s response is, will be moved through a notice of amendment of the Finance Bill.”

CBDT Mulls Widening Of Framework

Conservatively, out of the total startups operating in India, only around one percent can avail of the change in the ESOP taxation regime. The impact of exemption has been severely curtailed to a fraction of the total Startup ecosystem, evoking strong reactions from all. 

CBDT has taken note of the suggestions pouring in and has assured that the views of all companies are being reviewed and the final decision is expected in a few days time.

What is seen as a silver lining, the Central Board of Direct Taxes is contemplating to introduce changes to the framework of the Inter-ministerial Board (IMB), the institution that grants exemptions to startups under Section 80-IAC

Although senior officials from the CBDT and DPIIT declined to comment on this issue, informed sources, who are in the know of the matter said, “(The CBDT) said the IMB mechanism is not going away, but they’re open to making changes to the framework, which will likely be sent over sometime this week.”

Way Forward

Employee Stock Ownership Plan (ESOP) these days is one of the most popular employee benefit plans that offer equity ownership to them. ESOPs work well for both the employer and the employees; it works as a motivator and acts as an incentive for employees on one hand, and on the other, it results in enhanced productivity and profitability of a company. But the taxation of ESOPs in India has been a pain point for employees.

In her second Union Budget, Nirmala Sitharaman has tried to change the tax burden that ESOPs cause to employees and also the complex legalities surrounding them, by announcing tax relief to Startup employees.

She acknowledged that startups during their formative years generally use ESOPs to attract and retain highly talented employees, and the decision was taken with the view to incentivise them. But CBDT’s refusal to extend relief to ‘all’ start-ups has taken away the excitement aroused by this announcement of the FM.

Former Infosys CFO and Aarin Capital partner, Mohandas Pai had sometime earlier commented, “ESOP is a classic example of well-intentioned but badly-designed government policies. While the FM has been gracious to look into the issue, it is an unworkable scheme.” 

In an article penned down by Mohandas Pai and Siddarth Pai, after the budget 2020, very aptly reflects the disappointment of the industry, “The translation of intent from the Prime Minister and the Finance Minister to policy has been lacking severely when it comes to taxation, especially for ESOPs.”

Ganesh Raju, Founder and CEO, Turbostart, and previously Partner, PwC, says, “Deferment doesn’t mean taxation has been removed or reduced. The taxation on two levels still remains. The liquidity for those taxes still remains high.”

The domain experts of the industry are of the view that the best ESOP policy would be one-time taxation and they recommend complete removal of tax at the time of issue; that is, ESOPs should attract tax only at the time of sale of the shares, not at the allotment.   

“This announcement is a typical case of “too little, too late”; “the government surely needs to do more for the startup ecosystem!”

-Shweta Gupta, Founder and CEO, MUDS

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November 2021