An employee stock ownership plan (Esop) is an employee benefit plan that enables employees to own a part of the company they work for. Esops in India are presently taxed at two stages – one at the time of exercise of shares (i.e. when the employee sends his/her request to subscribe to the shares and the company allots those shares) and the second at the time of sale of the allotted shares. However, very often, there have been instances wherein the tax at the time of receiving the shares has caused difficulties in the hands of the employees and they may not be able to benefit from the scheme.
Typically, companies would deduct the tax payable at the time of allotment of shares from the remuneration of employees, and in cases where the remuneration is not sufficient for the payment of the tax liability, companies may ask the employee for the amount of TDS, and if, the employee is not able to pay, the companies may pay or in some cases they may even hold or delay the exercise. In a few scenarios, the companies may choose to bear the tax, which will add to their cost. Hence, in this aspect, the law in its present form seems to favour employees having deep pockets.
The rationale of this treatment is explained with the help of an example. An employee is, let’s say, getting 1,000 shares of a company, at say, an exercise price of ?50 per share and the fair value of the share could be say, ?400 per share. The employee would be taxed for a difference of ?350 per share i.e., ?3.5 lakh in total for 1,000 shares. When the employee actually sells these shares at a later stage for, say, ?600 per share, he/she will be subject to a capital gains tax on an income of ?2.5 lakh.
The rationale seems to be that if an employee is getting some upside today itself at the time of this exercise, they should be taxed now even though there is no real income in the hands of the employee. Hence, the taxability at the time of exercise is nothing but preponing the taxation on the upside. In fact, if the company’s valuation drops for any reason, the employee would be in a more prejudicial position wherein he/she may have already paid the tax but may not be able to realize that much value on exit.
Though the employee would be allowed a capital loss, which could be set off from other capital gains income, the rationale to prepone the tax does not hold well in this scenario. Besides, if the earlier upside is taxed as salary, it could be taxed at a much higher rate up to 42%, but the long-term capital gains (LTCG) tax is much lower.
In the case of startups having DPIIT registration, there is a relaxation available that tax can be collected after 48 months or when the employee leaves, or if these shares are sold due to any liquidity event. This again raises the question as to why this benefit is available to employees of startups only.
Ideally, the law should be uniform for employees of all companies. Though, this scheme of taxation of Esops is much advertised as an incentive for startups, in fact, a fairer treatment should be applied uniformly to all companies.
It is worth noting that such a tax treatment is usually found in anti-avoidance provisions. For example, the much-touted angel tax was introduced to tackle the menace where the allotments were being done in several companies at sky-high valuations and were being used as a money laundering device. On the face of it, the provision may seem illogical but was much needed to counter the menace. The law has been rationalized to some extent to ease the difficulties.
However, Esops have never been used as a tax avoidance strategy and the present tax treatment without accrual of any real income in the hands of the employees may seem unreasonable.
To ease the difficulty, the companies may resort to using other means like the use of phantom equity wherein the employee could be taxed only on the upside paid in cash since no actual instruments are issued. However, the employees are not allowed any equity participation and hence may not serve as an effective incentive as typical Esops.
Since the exercise of preparing the Budget 2023 has kicked off, there is a need to relook the tax on Esops from this perspective and necessary proposals should be introduced in the Finance Bill.
About The Author - Sandeep Sehgal is partner- tax at AKM Global, a tax and consulting firm.
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