Budget rationalises ESOP taxation, but residue of resentment remains

S Murlidharan | Updated on February 03, 2020

The new ESOP regime seems fair, barring the stipulation of a 48-month deadline to pay the tax

Start-ups often face a dilemma. How to attract talent at the top, so crucial to take its novel idea forward given the fact that they invariably face a cash crunch during the initial years whereas the desired talent would not wait for its rewards? The US found an answer — pay low cash salary but reward the persons concerned with shares of the company offered at a huge discount with reference to its valuations.

The idea caught on, so much so that Employees Stock Option (ESOP) has become the norm even in companies that aren’t start-ups. It has also travelled beyond benefiting the select few. Infosys the Indian IT major took pride in offering its shares to all its employees so much so that its drivers and peons made a fortune by selling the shares allotted to them.

On the taxation front, the issue is how to tax it. A part of the value of the share to be sure is attributable to employment given the fact that outsiders would not have been shown the same munificence. Thus if 1,000 shares of a start-up are awarded to the chief executive at ₹25 per share whereas it is valued at ₹100, ₹75 is attributable to employment.

The Income Tax Act as it is brings ₹75,000 in this case into the tax net straightaway, thus obliging the employer to deduct tax at source which he willy-nilly had to do from the small cash salary component, leaving the employee with very little liquidity. The problem is the employee has only made a notional profit that has not translated into liquid cash.

The Finance Bill, 2020 has addressed this problem by saying that ESOP will be taxed as salary: After 48 months from the end of the assessment year when the employee exercised the stock option (that is, lapped up the offer of shares; or when he (the employee) actually sells the shares he has gotten through ESOP; or when he quits employment or is fired, whichever is the earliest.

Appears fair

The new regime seems to be fair except for the first scenario — 48 months from the end of the assessment year. Stock option is an employee retention technique and if one quits before completing the minimum period stipulated by the employer (the vesting period), the employee loses the shares. As simple as that.

In view of this, where was the need to stipulate a 48 month deadline to pay the tax? How will he generate the requisite cash to pay the tax unless he sells the shares? Of course he can dip into his slender cash but that precisely has been the nub of the problem. It seems the government’s view is that it cannot wait indefinitely for either the employee to quit employment or sell the shares.

But then there is a parallel when it waits indefinitely. Suppose a person converts his personal asset, say, land into stock-in-trade, that is, a business asset with a view to developing it and selling it, the tax treatment is as follows:

The difference between the market value of the personal asset on the date of such conversion and its acquisition price is treated as capital gain; and the excess amount realised over such market value is taxed as business profits.

But even the capital gains are taxed only in the year in which the business asset was sold. This is as it should be. It poses no cash or liquidity problem for the employee. Perhaps the government thought that the two are not on all fours — a business asset would be sold at the earliest whereas shares of a growing company might be sat on indefinitely.

Which is why it might say it chose a via media and allowed four years from the end of the assessment year in which ESOP was granted to elapse before putting up its shovel demanding tax. Net-net, the new regime is infinitely better than the existing one but for the small but significant irritant that might force employees to borrow just to pay the tax once the four year deadline nears.

The writer is a Chennai-based chartered accountant

Published on February 03, 2020

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