Decoding Budget 2020: ESOP taxation in India is harshest among all startup hubs
Entrepreneurs are used to disappointment—it is an inevitable part of life. It rolls off them like water off a duck. But what hits them hard is being promised change that doesn’t materialise. Nothing exemplifies this more than this year’s Budget speech. Nirmala Sitharaman articulated the role that startups play in the economy, calling them “engines of growth”.
For context, when our Prime Minister spoke about India’s aspiration to become $5-trillion economy by 2025, he said that $1 trillion must be contributed by startups. The Finance Minister highlighted the role ESOPs play in startups “to attract and retain highly talented employees”. She even hit the nail on the head when she mentioned one of the core issues faced by employees exercising their ESOPs: “Currently, ESOPs are taxable as perquisites at the time of exercise… leads to cash-flow problem for the employees who do not sell the shares immediately”.
She even proposed measures that would help alleviate this issue, 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.”
Which makes what followed in the Finance Bill 2020 even more bewildering.
DPIIT and CBDT conditions
Instead of being rolled out to the over 27,000 DPIIT-registered startups, the government restricted this to the mere 500-700 startups recognised by the Inter-Ministerial Board (IMB), leading to an immediate uproar amongst all entrepreneurs as they felt deprived of something they have been promised for over a decade.
The DPIIT is the nodal body for the Start-up India initiative—one of the personal initiatives of the Prime Minister. DPIIT articulates the policy for startups, which has been widely adopted by all government bodies, departments and regulators bar one—the CBDT.
The DPIIT places the following primary conditions for startups:
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.
CBDT placed two additional conditions to qualify for tax benefits: incorporation after April 1, 2016, and a certificate from the IMB for being “innovative”. The IMB process has been criticised for being parsimonious with its certification, depriving Indian startups of the tax benefits:
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
Conservatively, around one percent of the total startups operating in India can avail of the change in the ESOP taxation regime. This has severely curtailed the impact of exemption to a fraction of the total ecosystem.
Even out of these 500 startups with IMB certification, which can avail of the tax benefits, around 50 percent would have either shut down, been acquired, or exceeded the revenue threshold. Out of the remaining 250, given the young age and revenue restriction, the average valuation may be assumed as Rs 200 crore. The standard ESOP pool is around 10 percent, which needs to last for five years, bringing it to two percent exercise per annum.
Thus, the total ESOP value that may be exercised (assuming 100 percent is) will be Rs 200 crore x 2 percent, which is Rs 4 crore. Taking the tax payable at the highest slab rate of 30 percent, the total tax payable is Rs 1.2 crore.
India’s startups raised $14.5 billion in 2019, with a $150 billion valuation, the impact of the ESOPs change, thus, is beyond negligible. Startups deserve better.
Fair Market Value
India’s ESOP taxation issue has been the payment of tax on notional gains at the point of exercise. India’s taxation regime on ESOPs is as follows:
1. The difference between the Fair Market Value and the Exercise Price of the options is taxed as Income from Salaries
2. The difference between the Sale Price and the Fair Market Value at the point of sale is taxed as Income from Capital Gains
These work for listed companies, where an employee can sell the shares upon exercise of the options, thus giving them liquidity to pay their taxes. Unlisted companies and startups, being private companies who lack a market and free transferability by law, cannot sell their options upon exercise.
This does not solve the issue of double taxation. Finance Bill 2020 states that the tax payable upon the exercise of ESOPs will be determined at the point of exercise, but payable at the earlier of:
- Five years from exercise
- Employee departing the company
- Sale of the shares
So, after the point of exercise, if the Sale Price is less than the Fair Market Value at the point of exercise, the tax liability determined above will still be payable. That pain point hasn’t been eased. This is why entrepreneurs asked for the taxes to only be determined and paid at the point of sale, so such events out of the control of the employees don’t adversely impact them.
The issue of Fair Market Value, which was the bane of Angel Tax, is also at the core of the ESOP taxation issue. Rule 3(8)(ii), Income Tax Rules, 1962 state that the FMV for ESOPs has to be determined by a merchant banker. The Company’s Act (Section 42 and Section 62(1)(c), read with Rule 13 of Company’s (Share Capital and Debentures) Rules 2014) since that needs to happen at the Fair Market Value.
RBI reporting under FEMA also require the securities issued to non-residents to be done at the Fair Market Value. Furthermore, due to section 56(2)(viib), this “fair market value” report cannot deviate from the price of the latest issue of shares at a premium since it would lead to two fair market values for the securities at the same time, causing taxation issues.
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.
In a recent interview, IAS officer Ajay Bhushan Pandey stated that one must compare India’s ESOP regime with the other startup ecosystems across the world.
ESOPs at other startup hubs
India is the third largest startup ecosystem, behind only the US and China in terms of capital raised, the number of unicorns, and the number of startups. Hence, India can only compare herself to them when it comes to startup policies. Singapore has become the launchpad into India, with several Indian startups and India-focused businesses setting up base there only to access the Indian market. Hence, a comparison with Singapore is apt to gauge our startup policies.
In Singapore, ESOPs are taxed as per the IRAS e-tax Guide, titled Tax Treatment of Employee Stock Options and Other Forms of Employee Share Ownership Plans (Second Edition). Under the Singapore regime, ESOPs are taxed as the difference between the open market price at the point of exercise versus the exercise price.
However, for unlisted entities and startups, the open market price is defined as the net asset value, i.e., book value of the securities.
In the US, ESOPs are taxed as the difference between the FMV and the exercise price, with the FMV being governed by Section 409A. The Board needs to obtain an FMV report using a “reasonable valuation method” taking into consideration: the value of tangible and intangible assets; control premiums or discounts for lack of marketability; whether the valuation method is used for other purposes, and other financial and non-financial items.
In addition to the reasonable valuation method, the valuation is considered presumptively reasonable if it meets one of the safe harbour criteria, a qualified independent appraiser performs the valuation or for startup companies, someone other than an independent appraiser who has the requisite knowledge and experience performs the valuation, and the valuation satisfies other criteria under Section 409A.
Thus, deviations between the latest capital raise and the fair market value of the ESOPs so exercised is permissible.
Since 2016, China’s ministry of finance has created a more benign regime for ESOP taxation for unlisted companies allowing employees who have exercised ESOPs to defer taxation to the point of sale and will only be taxed once as ‘capital gains’, not twice-under salary and capital gains.
The global best practises, thus, are: defer taxation to the point of sale (China); allow for any method taking into consideration asset value, including book value, so long as it’s performed by a registered valuer (the US) and tax the difference between the book value and the exercise price (Singapore).
On the other hand, India’s ESOP tax policy limits the scope to a narrow section of the startup universe; doesn’t solve the issue of using the latest funding round to determine the FMV despite no single employee being able to command that price in the market due to startup financing agreements and liquidation waterfalls and even doesn’t solve the issue of double taxation. This was not the Start-up India that the Prime Minister had promised.
Indian startups deserve more conducive and sympathetic tax policies. Far too many entrepreneurs have left India to set up shop in other geographies while their business remains here. India cannot afford to become a land of subsidiaries.
The translation of intent from the Prime Minister and the Finance Minister to policy has been lacking severely when it comes to taxation. Indian startups are still treated as stepchildren compared to listed companies, with the “superrich surcharge” that was rolled back for listed companies, but still applies to startups. Angel Tax, too, went through multiple iterations, and is yet to reach a satisfactory conclusion. Start-up India is being undermined purely for tax policies. New India cannot afford to sacrifice her future at the altar of such perverse and adverse tax policies.
(Disclosure: TV Mohandas Pai and Siddarth Pai backed 3one4 Capital is an investor in YourStory)
(Edited by Evelyn Ratnakumar)
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)