Fables Of ESOP: Worried about Taxes on ESOP? #AskTheExpert
As promised, we are back with our maiden edition of #AskTheExpert where we invite experts to demystify complex topics in the area of ESOPs, Investment and Equity Management.
#AskTheExpert — ESOPs and Taxation
In this edition, we had the privilege to speak with Smita Goel, a partner at Algo Legal who heads their Taxation and ESOP practice. Algo Legal recently announced their bundled ESOP offering for startups with tiered packages catering to startups across the spectrum.
Qapita and Algo Legal also announced a preferred partnership in offering a holistic ESOP structuring and implementation solution to customers through its legal and taxation expertise as well as an end to end technology tool to manage ESOPs during its lifecycle. The overall solution would take care of complete needs of startups in executing their ESOP strategy.
In our #AskTheExpert session, we asked Smita several questions that we typically get asked in our customer and user interactions. Smita clarified all the questions clearly illustrating with relevant examples at every stage. Do find the excerpts below and do listen in.
1. Firstly we asked Smita to explain taxation of ESOPs in the context of its lifecycle and point out the stages where it is applicable.
Smita patiently walked us through the lifecycle of ESOPs right from:
ESOP program adoption⇒ Awarding grants ⇒ exercise of vested options⇒ eventual sale of shares
At each step Smita explained applicability of tax liability.
Summary: Tax is applicable only on two events:
- Exercise of Shares (Perquisite Tax): At this point any value appreciation that happens from the price at which shares are exercised (which is as per the ESOP grant), i.e. Fair Market Value of shares — Exercise Price is taxable as perquisite ⇒ this amount is treated as income and taxed as per the income tax bracket of the individual
- Sale of Shares (Capital Gains Tax): At the time of sale of the actual shares, the usual capital gains tax is applicable. However the base price is now the price during exercise against which perquisite tax has already been paid out. Hence the taxable amount is: FMV at sale — FMV at exercise
So, yes, there is a good possibility that you might have to shell out a good chunk in cash in terms of tax as well as the actual exercise price of the ESOPs at the time of exercise before you make any money on the ESOPs.
While this might be counter-intuitive to a few of you, it is the way it works. So beware of getting into such ESOP grants. How can you avoid this — well, read further. Listen to Smita here:
2. Illustration with an example
We further asked Smita to illustrate the same concept using an example to make it clear for our readers. Here’s a quick example
3. Obligations of employers on taxes related to ESOPs
Smita also clarified that the perquisite tax applicable on the employee as per their income tax slab needs to be withheld by employer and hence employer would need to keep track of the tax bracket and the actual tax liability. Here’s what Smita had to say on this.
4. Tax Refund if Share Prices Drop?
We also asked Smita, if hypothetically, the price of shares reduces once the ESOP has been exercised, will the employee who paid tax on the higher price get a refund?
The answer unfortunately is no. Given that the perquisite amount is taxed as income, no future netting-off is possible. Do listen in here.
5. Ways to avoid Upfront Tax Liability?
We further probed further into ways in which this upfront tax liability can be avoided. Smita eluded to a couple of approaches:
- As per Startup India’s DPIIT’s latest provision on getting 80-IAC approval, employees can enjoy a tax holiday until a few events happen such as a) the actual sale of shares, b) employee leaves the firm, c) roughly about 4–5 years in timeframe.
However, this might not be helpful especially when you would like to quit the organization, which is the most frequent use-case to exercise
- Second approach is to coincide tax events with liquidity event. While the tax liability will still be the same (or in some cases more), the benefit to the employee is they see the cashflow coming in which coincides with the cash outflow — tax applicable + cost of exercise. This however requires a generous exercise regime on the part of employers. A few startups these days are talking of an indefinite exercise regime to benefit their employees. Do keep in mind of this while you sign and accept your next ESOP grant.
6. Taxation and Jurisdictions
Lastly we asked on taxation based on jurisdictions. We asked a specific question on a US incorporated company where an employee is employed by a fully owned Indian subsidiary while EOSPs are granted by the US entity directly.
First Smita confirmed that such structures are possible legally and quite common as the value creation is at the holding company. While from taxation point of view, there is no difference as such as taxation is a domestic matter and all relevant norms will apply to both kinds of taxes we discussed above.
We hope these questions were helpful in terms of busting some of the myths you might have had with respect to ESOPs. We hope with this you’ll have much more clarity in negotiating your next ESOP discussion with your employer.
You can also find the full video here:
If you have any follow-on question, do reach out to us through our coordinates below. You can also comment on this blog and we’ll definitely take it up and get back to you with answers. Do look up: www.algolegal.in/esop for details on Algo Legal’s ESOP offerings.
Thanks for reading. Take care and stay safe until the next edition.
