Union Budget 2020 Expectations: Benefits To Technology Startups And Startup Employees Via ESOPs And SARs? Yes, Please!

Key Highlights:

  • New startups setting up in the IT sector could use a boost, much like the benefits provided to the companies in the manufacturing sector in India.
  • The taxability of ESOPs needs to a relook by the Central Board Of Direct Taxes (CBDT)
  • SARs and phantom shares are akin to bonus which can prove effective going forward for startup employees.
  • The IT sector being a major growth-driver has a multitude of startups setting up, which can significantly benefit if the Union Budget 2020 speech is accommodating of them

Despite the current government presiding stably and a perceived lower valuation in the Indian equities, 2019 turned out to be a year of consolidation for Indian equity.

The government of India has taken some measures to boost the economy and change its image of being pro-capitalist, such as tax cuts stimulus in the hand of the corporates for sustainable long-term growth. However, slowdown in the economic growth, lack of liquidity, and the NPA crisis led to a fall in corporate profit growth.

The other measure provided by the Indian government to boost the economic slowdown was to create an ecosystem that is conducive for budding entrepreneurs viz. simplification in the procedure for registration with DPIIT, providing funds at low cost, tax exemptions for three consecutive years out of any seven years, easing startups from detailed tax audits in India, etc., and the government in this budget is expected to continue with such measures.

However, there are some grey areas which DPIIT may suggest to the finance ministry for the forthcoming budget, some of which are as under:

  • Extension of tax incentive to startups viz. extending the date of incorporation of Company/LLP
  • Reduction in the GST rates on AIF management fees from existing 18%
  • Taxing ESOPs given to employees at the time of sale, as against at the time of exercising of the ESOP.

Cashflows are always an area of concern for the startups, however through ESOPs, the startups try to attract or retain the skilled workforce. ESOPs are often used by the Companies as a finance strategy to align employees’ interest with that of its shareholders.

ESOP is a financial derivative that gives a right to the employee, but not an obligation to buy or sell an underlying asset at an agreed price and future date. ESOPs are generally given at a discounted price than that prevailing at that time of offer.

The question that needs certainty from the board is whether this discount is a business expenditure for the employer. If yes, then in which financial year should the expense be claimed? However, there are judicial pronouncements on both sides on this issue.

In respect of taxability of ESOP in the hands of employee, the taxability arises in two stages, firstly at the time when the option is exercised by the employee as perquisite and second when the shares are actually sold.

The other measures which could be explored by a startup are Stock Appreciation Rights (SARs), and Phantom Stock, where no equity dilution takes place as startups are averse to losing control of the company during the early life cycle of its business.

Under SAR, the employees do not purchase anything but are given a right to encash assigned SAR at a future date. The value of assigned SAR is dependent on the performance of the Company and thus the SAR allotted is akin to Bonus. SAR gives a right to an employee to raise the value of assigned SAR over a specified period of time. Unlike ESOPs, they are not required to pay the exercise price but just receive cash or stock.

Phantom stocks are a promise to pay bonus in the form of either the value of company shares or the increase in the value of share. Phantom shares are usually made at a fixed or pre-determined date.

The taxation of SARs and phantom shares is equivalent to that of Bonus under the Income Tax Act, 1961. There are arguments on both sides which support to claim the expense at the time of accrual of expense or at the time of actual payment.

From the employee perspective, taxation of the SARs and phantom shares arise only at the time of actual receipt of such an amount or shares if shares are received. Where shares are received, the taxable event in the hands of employee will arise on the date the SAR is exercised, even if the shares are not sold. Any subsequent gain on the shares is taxable as capital gain.

Thus, under all the options, the timing of transaction in the hands of employee requires consideration by CBDT as incidence of tax, as salary income arises when ESOPs/SARs/phantom shares are exercised, and then as capital gain when the shares are actually sold.

Thus, the intent and purpose of such options should be understood by CBDT and provide clarity on the timing of the taxation.Another way which could support the start-up ecosystem via the Union Budget 2020 provisions could be through the following methods:

  • Non-taxing of the ESOPs at the time of the final sale as capital gains, by the employee. There are countries like the UK which are working under such a model.
  • Since start-ups have the propensity to incur huge losses in the initial years of their setup, it is expected that the losses should be carried forward for at least 15 years as opposed to the current limit of 8 years.
  • As done in the manufacturing sector, it is expected that a rate cut in terms of setting up a business in the technology start-up sector can be perceived as a highly encouraging move for IT-related start-ups.

If these moves are introduced swiftly, one can surely expect the start-up ecosystem as well as the IT sector to benefit from this, since it is a major growth driver for the future.

Written By

Ayush Mittal

Ayush serves as a Manager in the Tax and Regulatory Services team at Coinmen.

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