Will clarity and relaxation on ESOP taxation rules find a place in the finance minister's Budget 'bahikhatha'?
Employee stock option plans (ESOPs) have been gaining importance in India as an effective tool to attract, retain and motivate talent.
Taxation of ESOPs has its own set of complications given that its accrual typically straddles three or more years, and the complexity further increases in case of mobile employees serving in more than one country during the vesting period.
Considering the growing use of ESOPs by companies in the employee remuneration package, it is pertinent that the tax provisions around ESOPs are made simple and clear for smooth compliances by an individual taxpayer.
Also read: MC Explains: How an ESOP is different from RSU and ESPP
Here are a few issues that would hopefully be addressed in Budget 2023:
Clarity on perquisite taxation for globally mobile employees
As per the provisions of the Income Tax Act, 1961, the fair market value (FMV) of shares allotted under an ESOP as reduced by the exercise price is taxed as ‘salary’ in the hands of the employee in India at the point of allotment or transfer of the shares.
Employees of multinational companies may also work in countries outside India during the vesting period (i.e., period between the grant and the vest dates). In that case, those countries may also tax a part of the FMV relating to the services rendered in that country, often giving rise to double taxation.
The issue intensifies further if the shares allotted under the ESOP are those of an Indian company. In such cases, an employee who has never rendered services in India could end up paying perquisite tax in India when he receives the shares in an Indian demat account.
The income tax law at present does not provide for any concession or guidance as regards taxation of ESOPs for globally mobile employees. Employers and employees often take recourse to judicial precedents while reporting taxable income in India to avoid double taxation.
Since global mobility has become a common trend in recent times, a clear provision in the tax laws is required to eliminate the ambiguity and to lend the much-needed clarity regarding taxation of ESOPs for employees who have also served outside India during the grant to vest period.
Challenges in capital gain computation on sale of foreign ESOPs
As per current provisions, when shares allotted by way of ESOPs are sold, the FMV considered to determine the perquisite at the point of allotment of the shares is considered as the cost of acquisition of such shares.
In cases where foreign shares are allotted under an ESOP to a globally mobile employee and no perquisite was taxable in India on allotment by reason of the employee having been non-resident and serving outside India at that time, there is no ‘FMV considered to determine the perquisite value’ available to determine the cost of acquisition.
Hence, this employee could end up paying capital gains tax on the entire sale consideration. This situation is disadvantageous for mobile employees who were not in India during the grant to vest period or at the point of allotment but are residents of India at the time of sale of the shares.
Hence, the tax provisions need to be amended to consider the FMV at the time of allotment as the cost of acquisition, irrespective of whether the perquisite was taxed in India or not.
Enhanced relaxation to startups and its employees
Budget 2020 introduced provisions to defer the tax payment on ESOPs allotted to employees of eligible startups to the point of sale of the shares or exit of the employee from the company or around five years from the date of allotment.
However, the concession was given only with respect to point of taxation and not the FMV of the shares, which needs to be considered to calculate the taxable perquisite, i.e., the tax is to be paid at the point of sale with reference to the FMV of the shares on date of allotment.
In such cases, if the share value declines after the allotment and the employee has to sell the share at a price lower than the FMV on the date of allotment, he is still required to pay the tax on the perquisite value which is only a notional gain. The employee may be able to claim capital loss. However, such loss is not adjustable against salary.
Startups are susceptible to dynamic market conditions, steep competition and constantly changing trends that can negatively impact valuation. Employees in such cases end up paying tax on income that they never realised.
Hence, for such cases, the provisions should be amended to consider the FMV at the time of sale, instead of FMV at the time of allotment, to calculate the tax payable on the ESOPs.
Further, the provision to defer tax withholding is currently available only for eligible startups satisfying the criteria prescribed. As per a Department for Promotion of Industry and Internal Trade report, as on November 30, 2022, the government had recognised over 84,000 startups.
However, a small percentage of the total startups qualify for this relaxation. Hence, the criteria with respect to eligibility of startups should be widened.
