An Overview of Employee Stock Option Plan (As amended by Finance Act, 2020)

Introduction

ESOPs are a significant component in the compensation of the employees of start-ups as it allows the founders and start-ups to employ highly talented employees at a relatively low salary amount with balance being made up via ESOPs. ESOPs are taxed as perquisites under section 17(2) of the Act read with Rule 3(8)(iii) of the Rules.

The taxation of ESOPs is split into two components:

Tax on perquisite as income from salary at the time of exercise.

ii) Tax on income from capital gain at the time of sale.

Employee Stock Option Plan

In the year of allotment of shares, the difference between the fair market value of shares on the date of exercising the option and the amount  paid by the  employee  for such shares is taxable as perquisite under section 17(2)(vi) of  the  Income-tax Act and chargeable to tax under the head salary. Consequently, the employer is required to include the amount of perquisite in the salary of the employee and deduct tax thereon under section 192 in the year in which shares are allotted.

From a long-term perspective, holding ESOPs will allow employees to be a part of the success of the start-up. However, the major drawback for employees was that they were liable to pay taxes when the ESOPs are issued. The tax on perquisite is required to be paid at the time of exercising of option which may lead to cash flow problem as this benefit of ESOP is in kind.

Hon’ble Finance Minister Smt. Nirmala Sitharaman has considered the challenges faced both by employees and start-ups and has sought to offer some relief in the form of deferring the Taxation of ESOPs. Vide Finance Act, 2020 amendment has been made related to the taxability of shares issued by an eligible start-up to its employees under the Employee Stock Option Plan (ESOPs). To reduce the burden of taxes, Section 192 (TDS on salary), Section 140A (for calculating self-assessment tax), Section 191 (for assesse to pay the tax direct in case of No TDS) and Section 156 (for notice of demand) have been amended to defer the TDS and payment of tax on the perquisites arising from allotment of ESOPs.

Various Stages in ESOP’s

Grant of Options: No Tax implications

Vesting of Options: No Tax implications

Exercising of Options: No Tax implications

Allotment of shares: Taxable Perquisite = FMV of shares (-) amount recovered    from employee

Transfer of Shares: Taxable Capital Gain = Sale Consideration (-) FMV of Shares

Taxability of ESOP’s

The benefit accruing to the employee from allotment of shares under ESOP scheme is treated as perquisite and chargeable to tax under the head ‘Salary’ in the year of allotment of shares. The perquisite value shall be:

FMV of shares (-) amount recovered from employee

Deduction of Tax (Prior to amendment by Finance Act 2020)

  • The employer shall deduct tax under Section 192 at the time of payment of salary
  • The salary shall include the value of perquisite arising from allotment of shares
  • Employee is liable to pay the advance tax or self-assessment tax if employer fails to deduct tax [Section 191]

The Finance Act, 2020 has made amendments to the relevant provisions of the Income-tax Act to defer the collection of tax on perquisite value of ESOPs. The benefit is given to the eligible Start-ups only

Amendments made by Finance Act 2020 applicable w.e.f AY 2021-22

Section Amendment

192
Eligible start-ups shall be able to defer the deduction of tax on perquisite value of ESOPs to subsequent years.

140A
Employees shall be able to defer the tax liability in respect of perquisite value of ESOPs to subsequent years.

191
If employer doesn’t deduct tax in subsequent year, employee shall be liable to pay tax directly.

156
If employee doesn’t pay tax directly, Assessing officer is empowered to issue notice of demand.

Note: As Section 17(2)(vi) has not been amended, the income shall be computed in the year in which shares are allotted but tax shall be paid in subsequent year.

What is an Eligible Start-up?

Tax on the perquisite value arising from ESOPs shall be deferred only if the employer is an eligible start-up. An entity is considered as an eligible start-up if it satisfies the following conditions.

Incorporation: The start-up should be incorporated as a Company or LLP. It should be incorporated between 01-04-2016 and 31-03-2021

Eligible Business: The entity should be working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation

Total Turnover: Turnover of entity for any of the financial years since incorporation should not exceed Rs. 100 crore. Finance Act 2020 has increased the turnover limit from 25 crore to 100 crore.

Certification: It must hold a certificate of eligible business from the Inter-Ministerial Board (IMB).

Deferment of TDS and payment of tax on perquisite arising from ESOPs

­Section 192, which provides for  deduction  of  tax by the employer  from  salary of an employee, is amended to provide that an eligible start-up as referred to in section 80-IAC shall deduct tax from perquisites income arising from ESOPs within 14 days of following (whichever is earlier):

a) After the expiry of 48 months from the end of assessment year in which shares are allotted;

b) From the date of which the assessee ceases to be the employee of the organization; or

c) From the date of sale of shares allotted under ESOP by the assesse.

Note: For this purpose, the tax shall be deducted on the basis of rates in force for the financial year in which shares are allotted or transferred under ESOPs.

Amendment in Section 191

If an employer does not deduct tax on perquisites arising from ESOPs then tax shall be payable by the employee directly on the basis of rates in force for the financial year in which shares are allotted or transferred. Tax shall be paid within 14 days of following (whichever is earlier):

a) After the expiry of 48 months from the end of assessment year in which shares are allotted; or

b) From the date of which the assessee ceases to be the employee of the organization; or

c) From the date of sale of shares allotted under ESOP by the employee.

Note: If an employee does not pay tax directly, the Assessing Officer can issue a notice of demand under section 156. If employees fails to deposit tax in response to such notice, he shall be deemed to be assessee-in-default.

As tax payment has also been deferred in respect of perquisite arising from ESOPs, Section 140A is also amended to provide that tax on perquisite arising from ESOPs shall not be considered while computing the self-assessment tax at the time of filing of return.

Consequences of Failure to Deduct Tax

Section 201 of the Income-tax act, 1961, provides that where a person who was liable for deduction of tax at source fails to deduct or after deduction fails to pay such tax to the credit of the central government, he shall be deemed as assessee-in-default. Following are the consequences for such failure:

Particulars Description
Interest u/s Section 201(1A) 1% per month for failure to deduct tax or 1.5% per month for failure to pay tax
Penalty u/s Section 271C Amount of tax which he fails to deduct or pay
Prosecution u/s Section 276B For a period not less than 3 months but which may extend to 7 years and with fine

 Conclusion

The amendments by Finance Act 2020 with respect to the deferment of tax liability would reduce apprehension on part of the employees for participation in ESOP schemes. In turn, this would further reduce the attrition prevalent in start-ups. It is therefore, commendable that the government has acknowledged the concerns around ESOP taxation by proposing a significant relief to the employees of eligible start-ups.

Author Bio

Qualification: CA in Practice
Company: Khemka A and Company
Location: New Delhi, New Delhi, IN
Member Since: 25 Apr 2020 | Total Posts: 3

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