Union Budget 2020 didn’t disappoint India’s startup ecosystem in terms of mindshare in finance minister Nirmala Sitharaman’s budget speech. However, the overall measures and incentives aimed at startups, though well intentioned, fall short of delivering the impetus that was expected by the ecosytem.
Specifically, as a measure to make ESOPs (employee stock option plan) more attractive for startup employees, the government deferred taxes payable on the exercise of ESOPs by five years.
“During their formative years, startups generally use Employee Stock Option Plan (ESOP) to attract and retain highly talented employees. ESOP is a significant component of compensation for these employees. Currently, ESOPs are taxable as perquisites at the time of exercise. This leads to cash flow problem for the employees who do not sell the shares immediately and continue to hold the same for the long-term… I propose 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,” Sitharaman said in her speech at the lower house of Parliament on Saturday, February 1.
The move provides only interim relief to ESOP holders and doesn’t ease their overall tax burden in the long term, given that such shares are also subject to capital gains tax at the time of sale.
“The actual tax liability remains exactly the same, just that its payment is deferred. The only benefit for an employee is he/she can now become a shareholder without paying ‘exercise tax’ (income tax rate being ~35% in most cases) at the time of exercise. But here’s the downside or risk that an employee has to take: The exercise tax is calculated based on the fair market value (FMV) of shares at the time of exercise. If for any reason, the valuation of the startup declines, the employee is at a loss as the tax has been calculated based on a higher valuation,” Ganesh Nayak, director, LetsVenture, said in a blog post.
Further, “...the employee cannot leave the startup, without triggering the payment of the tax, severely restricting the employee’s career choices,” Nayak added.
LetsVenture recommended that rather than deferring the ‘exercise tax’, removing it altogether would be more meaningful for startup employees. “There must be only tax levied at the time of actual sale of the ESOP without any caveats on the duration of employment or timing of exercise,” Nayak said in his post.
“The biggest issues with ESOPs is that income tax at the applicable rate is levied on the employee (on the difference between the fair value of shares and the exercise price) immediately upon exercise of ESOPs. Since there is no cash flow to an employee merely upon exercise of ESOPs (unless except for in the rare event of such exercise being followed by an immediate sale), tax incidence upon exercise is an unnecessary and burdensome cash outflow on the employees,” said Sanjay Khan Nagra, partner at law firm Khaitan & Co.
Another big limitation of the deferred tax on ESOPs is that the benefit is extended to only those startups that are recognised by the government and have received an inter-ministerial board approval for tax benefits. “There aren’t too many startups which have (or are likely to easily get) this approval,” he added.
"We expected some path breaking changes in ease of doing business and support for startups. From a direction perspective there is some intent in the form of taxing ESOPs and no audit until Rs 5 crore or tax exemption. But in the current way it doesn't solve any of the current issues," said Sreejith Moolayil, co-founder of Pune based health food company, True Elements.
In the Indian startup ecosystem, apart from Walmart-owned ecommerce company Flipkart, companies such as payment platform Razorpay, ed-tech company Unacademy and online stock trading platform Zerodha have all enabled liquidation events via ESOPs for their employees.
Among other incentives for startups, the government also expanded the pool of startups eligible for tax holidays. Earlier, only startups with annual revenues not exceeding Rs 25 crore could avail of a 100% tax exemption on profits for three consecutive years out of seven years since inception. Budget 2020 has raised the revenue limit to Rs 100 crore and extended the eligibility period from seven years to ten years.