Personal Finance

ESOPs: Tread carefully in the time of Covid-19

Shalini Jain | | Updated on: May 31, 2020
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For ESOPs already exercised, there is no tax relief for any subsequent fall in stock value

As the global economy faces a harsh slowdown owing to Covid-19, many companies are downsizing operations and cutting down on manpower, including skilled employees and managerial staff.

The pandemic may prove to be particularly harsh for start-ups in all sectors, which may require the promoters to take quick decisions in relation to their holdings, while keeping in mind the steps to be taken to sustain the going concern of the company.

Amid this uncertainty, companies may now consider implementing the Employee Stock Option Plan (ESOP) to compensate employees partially by way of ESOPs, in lieu of cash compensation, and, thereby, retain key employees.

In case the company already has an ESOP in place, now would be a crucial time it may review the plan to ensure that the ESOP remains relevant to employees.

A lot of stock options may become ‘underwater’ now due to a fall in valuation of the company and its share price.

This would definitely be a deterrent for employees to exercise the option.

Due to the changes in the external factors which may have a potential impact on the company’s net worth, and with a view to provide some relief to the employees who hold stock options, the company may look at re-pricing/buyback of stock options as per the terms of the ESOP.

The re-pricing could entail conducting an interim valuation of the company, taking into account the material impact of Covid-19 on the future revenue streams.

Take note

From an employee’s perspective, accepting ESOP is a critical financial decision as it may not only involve a significant cash outflow at the time of exercise by way of exercise price, but also applicable perquisite tax. The Income Tax Act provides for taxation of ESOPs as a perquisite, subject to the valuation of the perquisite as prescribed by income-tax rules.

As per the rules, the taxable value of ESOP is the fair market value (FMV) of shares on the date of allotment or transfer, reduced by the exercise price paid by the employee.

The FMV for shares of Indian listed companies is based on the ruling stock market price in India, whereas for unlisted companies (including foreign-listed companies), it needs to be valued by a Category I Merchant Banker registered with the Securities and Exchange Board of India (SEBI).

Usually, the tax on ESOP, arising on exercise, is funded by the employee out of salary income.

The Covid-19 situation being unprecedented, the possibility of a drastic fall in fair market value of the shares post exercise of stock option cannot be considered as per the income-tax rules for determination of taxable benefit.

Therefore, ESOPs already exercised at the earlier higher price would have suffered tax at the fair market value of the share on the date of exercise, as reduced by the exercise price paid by the employee. There is no tax relief on account of any subsequent fall in the value of the stock unless the employee sells the shares and books a capital loss.

In respect of employees of specific start-up companies (subject to conditions), the Indian tax authorities recently announced a relaxation of timing for the payment of taxes on ESOPs with effect from 2020-21.

Even in such cases, since it is merely the timing of payment of tax that is deferred, the tax liability would still be determined based on the fair market value of the share on the date of exercise.

If the value of these shares were to fall, the employee would still need to pay taxes on the perquisite value determined on the date of exercise of the stock option.

One may hope for a clarification from the government for stock option holders, keeping in mind that the employees of start-ups and other private companies have no exit mechanism to be able to relinquish their ESOPs, in the unfortunate event that the valuation of the share falls drastically.

In the meantime, employees are advised to exercise abundant caution while taking decisions related to ESOPs.

The writer is Tax Partner, People Advisory Services, EY India

Published on May 31, 2020

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