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#Budget2020 & ESOPs: One Step Forward, Two Steps Back?

What’s Changed, What Stays The Same & What Needs To Be Done

Ganesh Nayak, LetsVenture | Feb 1, 2020

From a common citizen’s perspective the income tax slab changes in Budget 2020 have got the most attention, with everyone computing their new taxes! But if you are a startup founder or employee, then you should be focusing more on the ESOP tax changes as well. 

Startup ESOPs which are now worth $5 billion in India, finally found their first ever mention in Budget 2020; and it won’t be the last for sure. Let’s understand what’s changed, what’s going to stay the same and what more needs to be done! 

Exercise Tax on ESOPs in “eligible startups” has been deferred to time of sale of shares, 5 years or when the employee leaves the startup – whichever comes earliest. This is the only change.

Here are a few things startup founders & employees need to note: 

  1. 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, which they had to do earlier. Additionally, if the employee holds the shares for more than 2 years he/she can save 10% on Capital Gains Tax as well.
  2. 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. 
  3. Also, the employee cannot leave the startup, without triggering the payment of the tax, severely restricting the employee’s career choices.

The other disappointment is that this change applies to only “eligible startups” which are essentially just about 200 early stage startups who have applied & received 80 IAC tax exemption (with criteria like incorporation after 1st April 2016); not the ~28,000 recognised by DPIIT . So, none of the mature startups where bulk of the ESOP value currently resides qualify. Therefore it’s safe to assume that there is no change for most startups.

Practically speaking will employees find the changes useful? At this point, it’s very difficult to find use cases where the benefit is certain. 

LetsVenture’s recommendations on what can be done next

  1. While the move to defer exercise tax is a welcome first step, removing it altogether will be the most meaningful change. 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. We will then have thousands of employees exercise their ESOP, become shareholders and pay Capital Gains Tax to the government upon exit. We believe net positive value will be created for all stakeholders with such a move.
  2. ESOPs are being used across all private companies to attract, reward & retain talent. The government should expand the scope of ESOP tax relief to all private & unlisted companies and not restrict it to only startups incorporated post April 2016 and approved by the Inter-Ministerial Board.
  3. Animal spirits in the economy will truly be unleashed when Capital Gain Tax on unlisted companies is reduced to the same level as that of listed companies. The real growth which India needs can come from startups who need to convince angels, VC-PE Funds to invest capital in them, and convince talented employees to invest their careers in them. Taxing these investors and employees at much higher levels for choosing unlisted versus listed companies is holding back a lot of potential.

Having said this, we believe the process to look at ESOPs and find a resolution has begun! LetsVenture will continue working with ecosystem partners like iSpirt, IVCA, NASSCOM and others to find a solution that has wider and far reaching impact. 

If you want to understand ESOPs better and see how you can create a robust policy, check out www.mystartupequity.com 

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