Taxation framework for Startups in India

Taxation of Startups under the Income Tax Act, 1961 is a crucial aspect for new businesses navigating the Indian economic landscape. The Government of India has implemented several provisions to promote the growth of startups, recognizing their role in fostering innovation, creating jobs, and contributing to economic development. However, understanding the various tax incentives, exemptions, and obligations is vital for startups to leverage these benefits effectively.

This Article aims to provide a comprehensive overview of the taxation framework for startups under the Income Tax Act, with a focus on key areas such as:

• Tax Holidays (Section 80IAC): Exploring the tax relief available to eligible startups during their initial years of operation.
• Unexplained Cash Credit: How startups must manage investments and sources of funds to avoid tax issues.
• Relaxation in Carry Forward of Losses: A look into the extended timelines for loss carry forward and set-off provisions.
• MAT/AMT Applicability: Highlighting the provisions around Minimum Alternate Tax (MAT) and Alternate Minimum Tax (AMT) for startups.
• Abolition of Angel Tax: Discussing the relaxation in the taxation of investments received by startups.
• ESOP Taxation: Understanding the tax implications of Employee Stock Option Plans (ESOPs) in the hands of Startup and its Investors

Tax Holiday (80IAC)

The recognized startups that are granted an Inter-Ministerial Board Certificate are exempted from Income Tax for a period of 3 consecutive years out of 10 years since the incorporation. Startups incorporated on or after April 01, 2016 but before April 01, 2025 can apply for exemption under Section 80IAC of the IT Act.

I. Applicability

• Eligible startups carrying on eligible business 
• Business profits are exempt
• Business profits for any 3 consecutive years [at the option of startup] during the first 10 years of startup.

II. Eligible Startup

Means a company or an LLP engaged in eligible business which fulfills the following conditions:

• it is incorporated on or after the 01/04/2016 but before 01/04/2025;

• the turnover of its business is up to INR 100 crore in the relevant FY in which deduction of profit is claimed;
• it holds a tax holiday certificate of eligible business from the Board.

Note: Company here means a private limited Company. On reading of Notification dated 19.02.2019 issued by Ministry of Commerce in DPIIT, it becomes clear that only a Private Limited Company and LLP can claim deduction u/s 80IAC.

III. Eligible Business

Means a business carried out by an eligible start-up engaged in:

• innovation, development or improvement of products or processes or services or
• a scalable business model with a high potential of employment generation or wealth creation

Conditions for availing 80-IAC exemption

• Startup should not be formed by splitting up, or the reconstruction of an existing business.
• It is not formed by the transfer to a new business of machinery or plant previously used (second hand) for any purpose
• Books of accounts should be audited.
• Where any amount of income is claimed as deduction under Section 80-IAC, then deduction to such extent shall not be allowed under any other provisions.

Second Hand Plant and Machinery :

Situations in which it shall be considered that the plant and machinery were not previously used

Situation I: Imported Plant and Machinery

• If used outside India by any person other than assessee
• Not used in India by any person prior to the date of installation by the assessee.
• It is imported into India
• No depreciation claimed previously under the provisions of the IT Act by anyone prior to the installation by the assessee

Situation II: If the value of used plant and machinery transferred to new business <20% of total value of plant and machinery of new business

How can a Start-up avail Tax Holiday:

In this regard, Ministry of Commerce and Industry in the DPIIT had issued a Notification No. G 127 (E) [F.No.5 (4)/2018-SI], dated 19-2-2019, which lays down the conditions and procedures to be followed for getting exemption u/s 80IAC of the Act. The Notification is summarized as under:

Step: 1  An Entity shall first meet the following criteria to be considered as a Startup:

• If it is incorporated as a Private Limited Company or registered as a Partnership firm or a LLP in India.
• Turnover for any FY since incorporation/ registration < Rs. 100 Cr.
• Entity is 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.
• Recognition as Start-up only upto a period of 10 years from the date of incorporation/ registration.

Note:

• An Entity formed by splitting up or reconstruction of an existing business shall not be considered as startups.
• An entity shall cease to be a Startup if its turnover for any PY > Rs. 100 Cr.

Step: 2  Entity shall be recognized as a Startup by the DPIIT Process for obtaining recognition as “Startup”:

• An Eligible Entity shall make an application at DPIIT portal
• Documents required:-
  • Certificate of Incorporation or Registration
  • a write-up about the nature of business highlighting how it is working towards innovation, development or improvement of products or processes or services, or its scalability in terms of employment generation or wealth` creation.

• The DPIIT may, after making enquires, recognize the eligible entity as Startup

Note:

Ministry of Commerce has issued guidelines [discussed later] clarifying the entities which will be eligible/ not eligible for DPIIT recognition as “Start-up”.

Step: 3 A Startup being a private limited company or LLP, which fulfills the specified conditions, shall file Form-1 File with the Board, along with the following documents:-

• Copy of MOA,
• Copy of LLP/partnership deed,
• Copy of board resolution
• Annual accounts for the last 3 financial years,
• Copies of ITR for the last 3 financial years, wherever applicable.

Board, upon receiving the same may issue the desired certificate for getting exemption u/s 80IAC or reject the application specifying the reasons of rejection

Guidelines clarifying the entities which will be eligible/ not eligible for recognition as a startup from DPIIT

Eligible Entities

• Resultant entity or entities formed due to merger or amalgamation u/s 233 of the Companies Act, 2013 between:
  • Two or more startup companies;
  • One or more startup company with one or more small company [as defined in Companies Act.]

• Conversion of an entity from one form to another shall not be a bar for availing recognition subject to the fulfillment of conditions provided in 80IAC(3)

Ineligible Entities

• Resultant entity or entities formed due to merger demerger/ acquisition/ amalgamation/ absorption.
• Entities formed due to compromise/ arrangement as provided under the Companies Act, 2013.
• Holding/Subsidiary Companies (including Foreign holding and subsidiary company] .
• Any entity formed by Joint Venture.
• Entities incorporated outside India
• Entities where the shareholding of Indian Promoters is less than 51%
• Entities having similar address with same production line/services with at least one common director/designated partner/partner.
• Sole proprietorship

Main reasons for rejection of application for obtaining tax holiday certificate

• Startup is formed by the splitting up or reconstruction of the business already in existence.
• Guidelines (discussed above) issued by Ministry of Commerce [DPIIT} are not complied with. For Example: The company is found to be holding /subsidiary/Joint Venture of an existing Indian or foreign company. Entity with shareholding of Indian Promoters less than 51%.
• Inadequate information in the application filed.

Splitting Up or Reconstruction of Business

An entity so formed is not eligible for exemption u/s 80-IAC of the Act. This condition is lightly examined at the time of startup obtaining DPIIT registration. However, this condition is rigorously examined by the Board when a start-up applies for tax holiday certificate u/s 80IAC. It is important to understand this condition so as to avoid the trouble of application getting rejected.

• In this regard It would be important to consider the findings of the following case laws under the IT Act:
• In the case of Commissioner of Income Tax vs. EDS Electronics Data System it was held that the setting up of a unit shall not be a device to claim deduction. The decision was rendered with respect to deduction u/s 10A of the IT Act.
• In the case of Textile Machinery Corporation Ltd. v. CIT [1977] 107 ITR 195 (SC) it was held that to constitute reconstruction, there must be formation of new unit by transfer of assets of the existing business to the new industrial undertaking. In the instant case industrial undertaking is formed by splitting up of the existing business undertaking since that can take place only when the substantial assets of the old business are transferred to the new undertaking. There is no such transfer of assets in the two cases with which this case is concerned. Reconstruction of business involves the idea of substantially the same persons carrying, on substantially the same business.
• In the case of ACIT M/s Himatisingka Seide Ltd (ITA No. 1379/Bang/2010), , the ITAT Bangalore conformed the following findings and observation of CIT(A):
  • the three words appearing in the section needs deep analysis and interpretation. The words are – (i) formed (ii) splitting up and reconstruction. Formation means beginning up or setting up of such industrial undertaking. Setting up of an Industrial undertaking requires four factors of production viz., (i) Man (employees); (ii) method (technology) (Knowledge)’ (iii) Machines/ Materials; & (iv) money (capital).
  • Therefore in order to be new, or to go out of the restraint provision of section 10B (2)(ii), the industrial undertaking should bring in everything new or at least should not bring any of these four factors from its old and existing business because that would bring it within the ambit of restrictions of ‘splitting up’ or ‘reconstruction’. In fact, splitting up occurs when the old existing business gets divided into two or more, almost equal parts, each part getting separate names and shares from the old business dividing all the four factors of production obliterating the identity of old undertaking and, hence, such case is much more discernible from the case of ‘Reconstruction’.

There are many different case laws on this aspect and these decisions were rendered with respect to exemption of profit of an entity involved in export of certain articles whereas in case of start-ups deduction u/s 80-IAC is based on innovative business ideas or business having scope of high employment generation or wealth creation. Thus, what can be concluded is that a new startup shall bring its own investment, manpower, machinery, technology etc and should come with an innovative idea. Further, the startup should satisfy the guidelines for recognition of Startups by the DPIIT.

Unexplained Cash Credit

If any sum is credited in the books of an assessee and they cannot satisfactorily explain its nature and source, the amount is treated as income and taxed accordingly under Section 68 of the IT Act. Currently, no exemption is available to startup companies. Hence, it is imperative to ensure genuineness of investors and make possible efforts to see that the invested funds are not from scrupulous channels. 

Legal Provisions [Section 68 of the IT Act]

“Where any sum is found credited in the books of an assessee maintained for any previous year, and the assessee offers no explanation about the nature and source thereof or the explanation offered by him is not, in the opinion of the Assessing Officer, satisfactory, the sum so credited may be charged to income-tax as the income of the assessee of that previous year:

[Provided that where the sum so credited consists of loan or borrowing or any such amount, by whatever name called, any explanation offered by such assessee shall be deemed to be not satisfactory, unless,— (a) the person in whose name such credit is recorded in the books of such assessee also offers an explanation about the nature and source of such sum so credited; and (b) such explanation in the opinion of the Assessing Officer aforesaid has been found to be satisfactory:

Provided further that] where the assessee is a company (not being a company in which the public are substantially interested), and the sum so credited consists of share application money, share capital, share premium or any such amount by whatever name called, any explanation offered by such assessee-company shall be deemed to be not satisfactory, unless—

• • the person, being a resident in whose name such credit is recorded in the books of such company also offers an explanation about the nature and source of such sum so credited; and
  • such explanation in the opinion of the Assessing Officer aforesaid has been found to be satisfactory:

Provided also] that nothing contained in the first proviso 37 [or second proviso] shall apply if the person, in whose name the sum referred to therein is recorded, is a venture capital fund or a venture capital company as referred to in clause (23FB) of section 10.”

Understanding of the above provisions of section 68

• The provision of Section 68 is applicable to all the assessee’s and thus, the same would also apply to a startup too. However, the second proviso specifically relates to loan or borrowing received by CHC i.e private company or unlisted public company. Thus, the 2nd proviso is also applicable to startup incorporated as Private limited Company.
• As per the above section if any assessee is not able to explain the source of any sum credited in books of account then the such amount shall be treated as unexplained income and shall be taxed @78% as per section 115BBE of the Act.
• As per the various judicial pronouncements, (prior to ammendment by the FA Act, 2022) the assessee was only required to prove the source of the sum found credited in its books of account. The onus of the assessee is discharged once it gives satisfactory explanation of the sum credited and produces the person who deposited the amount. The assessee was not required to establish the source of source i.e. from where the creditor got his money.
• To the above rule (i.e. non requirement source of source), there was only one exception regarding credits in the books of company pertaining to share capital, share premium received from residents. This exception was contained in the old 1st proviso (now 2nd proviso) to Section 68 of the Act. As per the old 1st proviso (now 2nd proviso) to Section 68 of the Act, there is additional onus on a CHC to prove ‘source of source’ in respect of credit recorded in the name of residents in respect of share application money, share capital, share premium or any such amount by whatever name called. If not proved to the satisfaction of the AO, such amount shall be treated as unexplained cash credit and charged to income tax @78% u/s 155BBE. Thus, if a startup (Pvt limited co) fails to prove the source of source in case of Share capital, Share premium or any such amount received form resident, then same shall be treated as unexplained cash credit and charged to tax.

Comments: The 2nd proviso is applicable only where the credit is recorded in books respect of residents who are further required to substantiate their source of funds.

2nd Proviso to section 68

Background:

• To overcome the judicial precedents and to curb the practice of converting unaccounted money by crediting it to books of account of assessee through loan or borrowing, the new first proviso to Section 68 was inserted. Section 68 was amended by the Finance Act, 2022 and the old 1st proviso to section 68 was replaced with a new 1st proviso which extends the requirement to prove ‘source of source’ also to credits in assessee’s books pertaining to loan or borrowing.
• As per the new 1st proviso to Section 68 inserted with effect from AY 2023-24, where any loan or borrowing or any such amount is credited in the books of account of the assesee, such sum shall be considered as explained only if the nature and source of such sum is also explained in the hands of the creditor or lender.

Understanding and Scope of new 1st proviso introduced by Finance Act, 2022:

• Applicable to all assessee’s and is not limited to Closely Held Company.
• Applies to loan or borrowings from both resident and non-resident. However, the 1st proviso not applies where the creditor or lender is a VCF or VCC registered with SEBI
• Applicable even if the lender is any reputed bank or NBFC. However, the explanatory memorandum to FA Act, 2022 uses the words that ‘the additional onus of proving source of source in hands of creditor shall not apply if the creditor is a well regulated entity, i.e., it is a VCF or VCC registered with SEBI. Thus, considering the said wordings ‘well regulated entity’ it can be argued that the new 1st proviso will not apply to loan or borrowing from Bank and NBFC’s as these entities are well regulated by RBI.
• Applicability to non resident assessee – As per Section 5(2) of the Act, income of non-resident accruing or arising outside India is taxable in India only if received in India. Therefore, if any income which is already received outside India, then same cannot be taxed in India merely on the ground that is brought in India by way of remittances. The onus u/s 68 lies only with reference to income of non resident which is otherwise taxable u/s 5(2). Thus, if the source of any credit (say loan) received by non-resident is not proved, then such credit from non-resident can be taxed u/s 68 only if it is otherwise taxable as per Section 5(2) of the Act.
• The word ‘such’ used in the 1st proviso refers to an amount similar to loan or borrowing. 

How to satisfy additional onus to prove ‘source of source’ under new first proviso:

The assessee may produce bank statements and ITR of the lender to prove that the lender had sufficient funds. However, if the lender refuses to provide necessary information to the assessee, then such situation is out of control of the asseseee and the obligation of assessee gets discharged due to impossibility of performance. Reliance can be placed on Rich Paints vs. ITO [2021] 123 taxmann 40 (Ahmedabad Tribunal).

Whether it is discretionary or mandatory for AO where additional onus to prove source of source is not satisfied ?

The words ‘may’ used in the Section 68 indicates that it is discretionary for AO to make an addition u/s 68 [Mukesh Electricals v. ACIT [2011] 12 taxmann.com 5 (Agra)] Therefore, in view of the same, if the additional onus under 1st proviso is not discharged, then 1st proviso shall be invoked to make addition u/s 68 in exceptional case such as where the lender is an entry provider and does not carries lending as its normal course of business. The Officer shall usually invoke section 69 (unexplained investments) against the lender if he cannot explain the source of funds in his hands i.e. from where he got the money. Reliance placed on Darshan Enterprise v. ITO [2022] 134 taxmann.com 188 (Gujarat). 

Relaxation in carry forward and set off of losses

Legal Provision [Section 79 of the Act]

Section 79 – Carry forward and set off of losses in case of certain companies .

“(1) Notwithstanding anything contained in this Chapter, where a change in shareholding has taken place during the previous year in the case of a company, not being a company in which the public are substantially interested, no loss incurred in any year prior to the previous year shall be carried forward and set off against the income of the previous year, unless on the last day of the previous year, the shares of the company carrying not less than fifty-one per cent of the voting power were beneficially held by persons who beneficially held shares of the company carrying not less than fifty-one per cent of the voting power on the last day of the year or years in which the loss was incurred:

Provided that even if the said condition is not satisfied in case of an eligible start-up as referred to in section 80-IAC, the loss incurred in any year prior to the previous year shall be allowed to be carried forward and set off against the income of the previous year if all the shareholders of such company who held shares carrying voting power on the last day of the year or years in which the loss was incurred, continue to hold those shares on the last day of such previous year and such loss has been incurred during the period of ten years beginning from the year in which such company is incorporated……”

Understanding of the above provisions of Section 79

As per the above provisions, the losses incurred by CHC in any year prior to the previous year shall not be carried forward and set off against the income of PY, unless the shares of the company carrying at least 51% of the voting rights are beneficially held by the same persons on the following two dates:

• On the last day of the PY in which loss was incurred.
• On the last day of the PY in which such brought forward loss has to be set off.

However, an eligible start-up referred to in Section 80-IAC of the Act enjoys some relaxation. Eligible startups are allowed to carry forward losses incurred during the initial ten years from the year of incorporation even if the shares carrying at least 51% of the voting rights are not held by same persons on above two dates, provided that the 100% shareholders who held shares carrying voting power on the last day of the year in which the loss was incurred continue to hold those shares on the last day of the previous year in which the losses are to be set-off.

Comments:

Clause (ii) of explanation to Section 80-IAC defines ‘eligible startup’ as under:

“Eligible startup [as referred to in Section 80-IAC] means a company or an LLP engaged in eligible business which fulfills the following conditions:

• it is incorporated on or after the 1st day of April 2016 but before the 1st day of April 2025;
• the total turnover of its business does not exceed 100 Crore in the PY relevant to PY in which deduction under sub-section (1) is claimed;
• it holds a tax holiday certificate of eligible business from the Inter-Ministerial Board of Certification as notified in the Official Gazette by the Central Government.”

To be considered as eligible startup for the purpose of Section 79 all the above conditions (a) to (c) needs to be satisfied. However, condition (b) regarding turnover >100 Crore needs to be satisfied only in the previous year in which deduction of profit is claimed under 80-IAC. For eg. If during a PY there is no profit remaining after setting off past losses, then there is no need to claim deduction u/s 80-IAC and therefore, there the condition (b) does not matter in such case.

Applicability of MAT/ AMT provisions to Start-up Company / LLP

• Applicability of AMT – If the tax payable by an asessee (other than company) under the normal provisions of the Act is less than AMT payable as per Section 115JC then it shall be liable to pay AMT at the rate of 18.5% (plus applicable surcharge and cess) on the adjusted total income.
• Applicability of MAT – if the tax payable by a Company on total income under normal provisions is less than 15% of Book Profit, then Book profit shall be deemed to be Total Income and tax shall be payable @15% (plus surcharge and cess) on such book profits.
• There is no exemption provided to the Start-up companies/ LLP from the applicability of MAT/AMT provisions provided under section 115JB and 115JC of the Act. Let us take an illustration on applicability of MAT to a start-up company to understand the issue:

Case- 1: A Ltd is a start-up company which is not eligible for 80-IAC and which does not opt for concessional tax regime. The company has no income other than business income. Total Income – Rs. 3,00,00,000/- & Tax Rate 25%.

Case – 2: B Ltd a start-up company has income from eligible business and no income under any other head and avails deduction u/s 80IAC. Total Income – Rs. 3,00,00,000/- Tax rate 25%.

Observations

 In case 2, it can be seen that that an eligible start-up earning profits/book profits of Rs. 3 crores has a NIL tax liability as per the normal tax provisions because it has availed the benefit of section 80IAC. But due to the applicability of MAT provisions, it has to pay Rs. 50,07,600/- as Income Tax despite availing the exemption benefits as shown above. Hence, it can be concluded from the above illustration that due to the applicability of MAT provisions of Section 115JB of the Act, the start-up companies end up paying a considerable amount of taxes to the Government even in the years in which they claim the exemption provided under Section 80IAC.

However, in the above Case 2, the MAT Credit for FY 2023-24 would be Rs. 50,07,600. Such MAT credit can be used to offset the difference between the tax on total income computed as per normal provisions and the tax payable under section 115JB in the following years.

Start-up Pvt. Ltd. Co (domestic Co) can also opt for lower tax rate of 22%/ 15% respectively under Section 115BAA and Section 115BAB subject to foregoing of tax holiday u/s 80IAC and other deductions from Income. In such case MAT provisions shall not apply. However, a Start-up Pvt. Ltd. Co has to evaluate the beneficial provisions.

Note: In a similar manner we can understand the Applicability of AMT to an Start-up LLP

Abolition of Angel Tax in India

What was Angel Tax

Applicability [Section 56(2)(viib)]

Companies in which public is not substantially interested i.e. Closely held Company (‘CHC’).

Note: Certain start-up companies registered with DPIIT, VC undertaking & Notified entities were exempt from Angel Tax.

CHC ?

• Private limited companies or
• unlisted public limited companies, where less than 50% of the voting power is held by the government or a corporation established by a Central, State or Provincial Act.

Taxability

• Where a CHC receives Consideration from any person in excess of Face Value of shares, the difference between the sum received and FMV of shares was treated as ‘Income from other Sources’.
• FMV of shares was determined as per Rule 11UA(2) of the Income Tax Rules or the Value as may be substantiated by the company to the satisfaction of Assessing Officer.

Note

At the time when Angel tax was introduced (FA Act 2012), it was applicable only on issue of shares to resident,. However, vide FA Act, 2023, the Angel tax was also made applicable on issue of shares to non resident.

Amendment made by Finance (No. 2) Bill, 2024

• It is proposed to put a sunset clause by inserting a proviso to provide that the provisions of this clause shall not apply on or after 01 April 2025, i.e, with effect from A.Y 2025-26. Accordingly the sum received in excess of FMV on issue of shares on or after 01 April 2024 will not be liable to Angel Tax. Where consideration was received before 01-04-2024 but shares are allotted on or after 01-04-2024 , clause (VIIb) will not apply.
• With the removal of Angel Tax, the CHC will be able to issue shares at premium above Face Value of shares, without such premium [sum received less FMV of shares] being taxed. However, the onus to prove the source of Share premium under second proviso to Section 68 will still be there on a CHC.

ESOP TAXATION

How does ESOP work?

• The Company provides an option to employee to acquire certain no of shares at a pre-determined price at a future date. ESOPs are granted subject to a vesting period, which is normally linked to a tenure and/or performance/ sales targets.

Relevant terms with respect to ESOP

• Grant date – Date of agreement between an employer and employee to grant own share.
• Vesting period – the time period between the grant date and vesting date.
• Vesting Date – Date on which employee is entitled to buy the Entitlement is no longer subject to satisfaction of any vesting conditions.
• Exercise Price – Pre-determined Price at which an employee can exercise the ESOP.
• Exercise Period – Period during which an employee has an option (not an obligation) to exercise the ESOP.

Key Stages in ESOP

• Grant of options
• Vesting of options
• Exercising the options
• Allotment of Shares
• Transfer of Shares .

Tax implications arises only at the stage of allotment and transfer of shares.

Tax implications in the hands of Employee

1. Tax Implications at the time of Allotment of Shares

Difference between FMV of shares at the time of exercise and the Exercise Price of Shares will be chargeable to tax under the head Salary as a perquisite u/s 17(2)(vi)

Calculation of Perquisite Value

A. Determination of FMV of shares

• FMV of shares at the time of exercise of option shall be determined as per Rule 3(8) of the Income Tax Rules.
• Separate valuation rules have been provided for Listed and Unlisted Shares. Discussed later.

B. Price Paid by the employee

C. Value of Perquisite = (A-B) * No of Shares Allotted

Determination of FMV in case of Listed Shares (at the time of calculation of Perquisite Value)

Determination of FMV in case of Unlisted Shares (at the time of calculation of Perquisite Value)

• FMV as determined by the merchant banker on the date of exercise of ESOP; or
• FMV as determined by the merchant banker on any date earlier than the date of exercise (not more than 180 days earlier than exercise date)

Payment of Tax on Perquisite

• Tax deduction u/s 192: The Employer shall deduct tax u/s 192 at the time of payment of Salary which shall include the value of perquisite arising from the allotment of Shares; or
• Direct payment of Tax u/s Section 191: As per the provisions of Section 191 of the Act, the employee is liable to pay tax directly in the form of advance tax or self- assessment tax if the employer fails to deduct the tax u/s 192.

Deferment of Tax in case of Eligible Startup

I. Background

ESOPs are taxable in the hands of employees as perquisites in the year of allotment of shares. As a result, even though there is no cash flow to the employees, they are subject to tax in the year of allotment and the employer is required to deduct tax at source. To remove such hardship, the Finance Act, 2020 made amendment to the relevant provisions of the Act to defer the payment of tax on the value of perquisite by the employees of eligible startup. Income shall be computed as per Section 17(2)(vi) in the year of allotment of shares but the payment of tax shall be made in subsequent years.

II. Amendments by the Finance Act, 2020

Deferment of TDS u/s 192 – An Eligible Startup as referred to in Section 80-IAC shall deduct tax on the value of perquisites arising from the allotment of shares within 14 days of the occurrence of any of the event (whichever is earlier) :

• after the expiry of 48 months from the end of the AY in which shares are alloted; or
• from the date of the sale of such specified security or sweat equity share by the assessee; or
• from the date of the assessee ceasing to be the employee of the person

Deferment of direct payment of tax u/s 191 – If the employer [Eligible Startup as per 80-IAC] fails to deduct tax on the value of perquisite arising from the allotment of ESOP then tax shall be payable by employee within 14 days of the occurrence of any of the event (whichever is earlier) –

• after the expiry of 48 from the end of the AY in which shares are alloted; or
• from the date of the sale of such specified security or sweat equity share by the assessee; or
• from the date of the assessee ceasing to be the employee of the person.

2. Tax implications in the hands of Employee at the time of transfer of shares

Difference between the Sale consideration and the FMV of shares is taxable under the head Capital Gain

Computation of Capital Gains

Taxation in the hands of Employer

Claim of discount on issue of ESOP u/s 37 of the Act:

• Discount on issue of shares can be claimed as an expense over the vesting period u/s 37 of the Act.
• Discount = FMV of the shares at the time of grant – Exercise price
• Section 37 provides that any expenditure (not being expenditure of the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee), laid out or expended wholly and exclusively for the business or profession shall be allowed in computing the income chargeable under the head ‘Profits and Gains of Business and or profession’.

Relevant case laws:

There are various decisions on this issue and some of which are reproduced hereunder:

• Hon’ble Karanataka High Court in the case of CIT Biocon Limited [2020] 121 taxmann.com 351 has held that discount on issue of ESOPs was allowable as a deduction under section 37(1) as primary object was not to waste capital but to earn profits by securing consistent services of employees.
• The Madras High Court in the case of CIT v. PVP Ventures Ltd. [2012] 23 taxmann.com 286/211 Taxman 554 has held that the difference between the market value of shares and the value at which shares are allotted is allowable as revenue expenditure under section 37(1).
• The Delhi High Court in the case of CIT v. Lemon Tree Hotels Ltd. also allowed the deduction related to expenses incurred in issuing ESOPs.

Mostly, the judgments are in favor of the employer but still, the IT Act does not provide explicitly the deduction regarding the discount on the shares allotted under the ESOP scheme. In the absence of clarity under the provisions of the IT Act and given the contrary rulings, there continues to be uncertainty on the issue. In lack of uncertainty, the revenue will keep on raising this issue.