India continues to be the world’s third largest technology startup ecosystem, with more than 1600 new startups added in 2020. The Indian start-up ecosystem faced the crucible of COVID-19 in 2020 and emerged more robust, adding the second highest number of unicorns in 2020, after United States of America (USA).
The novel coronavirus (COVID-19) pandemic led to the disruption of business operations all over the globe and startups was amongst the segment that was badly hit due to the pandemic during first half of 2020. In this regard, we have made a detailed submission to Department for Promotion of Industry and Internal Trade (DPIIT) on March 18, 2021 highlighting the following policy areas where support is needed from the government to boost recovery of startups:
A. Defer tax liability on grant of ESOPs to the time of sale of shares only
Overtime, ESOPs have become instrumental in Indian start-up ecosystem to encourage high-value employees and retain their talent.
Taking into consideration the plight of employees exercising ESOPs in start-ups, Finance Minister Nirmala Sitharaman, in Budget 2020 speech, acknowledged that “start-ups generally use ESOPs to attract and retain highly talented employees and this is a significant component of compensation for these employees. Currently, ESOPs are taxed as perquisites at the time of exercise. This leads to cash flow problems for employees who do not sell the shares immediately and continue to hold the same for the long-term.”
Consequently, the amendment introduced in the Income Tax Act, 1961 (Act) vide Finance Act 2020 is a step in the right direction, but it does not fully address the problem:
- The amended provisions still require employees to pay tax on ‘notional profit’ after 4 years of shares being allotted even if shares are not sold in this period and there is no cash flow.
- Moreover, a large percentage of start-ups fail initially. However, the provisions still tax employee on ‘notional profit’ which may never materialise. This will particularly result in an undesirable situation where employee bears the tax burden and grapples with failure of the start-up itself. Further, there can be a situation wherein valuation of shares at the time of sale goes down, thereby leading to capital loss, whereas the employee would have paid perquisite tax based on the earlier notional value.
Options provided to employees under Incentive Stock Option (ISO) plans in USA are not subject to tax at the time of grant nor at the time when employee exercises the option and buy the stock. As a result, the employee recognises capital gain/ loss in the amount of difference between sale price and grant price only at the time of sale of such shares. Similarly, in Israel, employer-provided stock options are not taxable at the time of grant or exercise. Income tax at individual’s marginal tax rate is imposed at the time of sale on the difference between sale price of the shares and the strike price.
Further, we also attempted to deliberate on potential tax abuse of ESOPs considering various scenarios, like if ESOPs are issued to related parties or promoter director who are employees of the company or if ESOPs once exercised are used as collateral for borrowing, etc. However, we do not find any situation of abuse in case of shifting the incidence of tax at the time of sale. However, it may be possible that an employee does not sell the shares at all and therefore, there would be no taxation event as per our proposed recommendation. This would mean that the employee continues to enjoy ownership of shares acquired as part of ESOP. In such a situation, any dividend received by the shareholder would anyways be taxable.
Recommendation #1: Taxation of ESOP in the hands of employees of all unlisted companies should only be at the time of sale of ESOP. Government may prescribe conditions relating to mandatory holding of stock options by employees for a certain number of years as provided in guidelines for issue of ISO plans by USA, to prevent misuse.
B. Allow all DPIIT recognised start-ups to avail the ESOP tax treatment
As per S.80-IAC of the Act, tax benefits on ESOPs are available to those start-ups which fulfil the following conditions-
- start-up must be incorporated between April 1, 2016 and March 31, 2022;5
- total turnover of the start-up must be less than INR100 crores for the year in which benefit is sought;
- it must be certified as eligible start-up by Inter-Ministerial Board (IMB) of the Government of India.
In this regard, it is important to note that out of 38000+ start-ups which are recognised by the DPIIT, only 264 start-ups are eligible to avail the tax benefit on ESOP.6 This excludes over 99% of the DPIIT recognised start-ups from scope of ESOP relaxation. Further, purpose of certification by IMB is designed to evaluate start-ups for granting tax exemption under S.80IAC of the Act. However, relaxation on ESOPs is not a tax exemption, but only deferral of tax payment to remove difficulties faced by employees. Hence, it would not be fair to extend ESOP relaxation to only IMB certified start-ups.
Recommendation #2: Government should extend the ESOP relaxation in terms of deferral of tax liability, to all unlisted companies and at-least to all start-ups recognised by DPIIT, to begin with.
C. Harmonise tax rates on sale of shares of unlisted companies
Long Term Capital Gains (LTCG) arising from sale of unlisted shares are taxed @ 20% for resident investors and @ 10% for non-resident investors, subject to relief if any under the tax treaty. Considering the risk taken by investors to invest in start-up companies and to promote investments (which could act as a strong engine for revival of the economy in the current times), it is important to align tax rate on LTCG for resident and nonresident investors.
Recommendation #3: In order to promote start-up ecosystem, government should harmonise capital gain tax on sale of unlisted shares issued by start-ups recognised by DPIIT.
D. Exempt all DPIIT recognized start-ups from Minimum Alternate Tax (MAT)
Currently, MAT provisions have no threshold limit and all companies, notwithstanding their size, are subject to MAT. As a result, start-ups are liable to pay MAT, even if they claim profit linked exemption under S.80IAC. This provision defeats the very purpose of providing tax incentives for start-ups.
Recommendation #4: In order to promote start-ups, it is important to exempt all DPIIT recognised startups from MAT.
E. Allow grant of ESOP to promoters of start-ups beyond a period of 10 years
S.62 of Companies Act, 2013 (Companies Act) read with Rule 12 of Companies (Share Capital and Debentures) Regulations, 2014 (Rules) provide for terms and conditions for issuance of ESOPs by a private company. The Rules states that an unlisted company can offer ESOPs to its employees after passing a special resolution. Further, the Rule states that following class of persons will not be considered as employee to be eligible for grant of ESOP:
- An employee who is a promoter or a person belonging to the promoter group; or
- A director who either himself/through his relative/ through any body corporate, directly or indirectly, holds more than 10% of outstanding equity shares of the company.
However, pursuant to an amendment in Rules in 2016, the above restriction is not applicable in case of a start-up company, as defined by DPIIT, for a period of 10 years from the date of its incorporation/ registration. This is a step in the right direction, but it does not fully address the issue. It is important to note that that majority start-ups have long gestation periods and take time to derive profits in their business operations. As start-ups grow and seek equity-based funding from investors, a natural consequence for the founders is dilution of their equity holding. Accordingly, promoters/ founders seek ESOPs particularly when their shareholding in the start-up reduces considerably pursuant to various funding rounds and when they are working hard for survival of the start-up.
This could not only result in founders losing principal control over their start-up but would also reduce their ability to reap the benefits of the start-up’s success — unlike other employees who get to share the upside through ESOPs.
Recommendation #5: In order to incentivise entrepreneurship, we have requested the government to allow grant of ESOPs beyond a period of 10 years from the date of incorporation to employees who are part of the promoter group and employee directors holding more than 10% of the outstanding shares.
We hope you will find the update useful. We will keep you posted on further developments in this regard.
