There are serious flaws in Budget 2020's ESOP gift for startups

• Finance Minister Nirmala Sitharaman gave a five-year tax holiday on ESOPs.
  
• But it would be applicable to startups registered under section 80-IAC of Income Tax Act with the Inter-Ministerial Board set up for startups – which is currently less than 200.
  
• Startups also want that the only condition for ESOP taxation should be the date of sale, and not when the employee exits the company or five years after the shares were exercised.
  

The Indian startup ecosystem welcomed the government’s decision to give a five-year tax holiday on Employee Stock Ownership Plans. But it seems that founders jumped in joy, without realising that it affects merely 200 out of the 50,000 startups in the country.

During the Budget speech, Finance Minister Nirmala Sitharaman said that ESOPs will now be taxable when the employee sells the shares or exits the company or five years after the shares were exercised, whichever is earliest.

However, there’s a catch. Startups are also worried about the confusion the conditions of ESOPs will bring about. “It would have been better if ESOPs entry tax was simply at exit, because the liability is deferred by 5 years, not eliminated,” said Jain.

The exit clause

It could mean that employees who quit the company before five years, might have to shell out tax during the time of the exit. As startup valuations go through a rollercoaster ride, an exiting employee might end up paying much more than the value that they will accrue later.

“For instance, if an employee exercises shares and holds them and the sale event does not take place in the 48 month period, the employee will be liable to start paying taxes on paper gain in value of shares. Startup valuation is subject to change and in case the value of the shares goes down in future or the startup shuts down, the employee would have already paid taxes,” explained LocalCircles, a social media platform startup in an open letter it wrote to the government.

Also if an employee leaves a startup to join another after five years, they either have to exercise and pay taxes on their shareholding of the first startup and hold those shares; or simply leave their vested shares.

Less than 200 startups can gain

Added to that, with the current restrictions, less than a 100 startups in India can avail of the benefit. It was also specified that the exemption will be applicable to startups registered under section 80-IAC of Income Tax Act with the Inter-Ministerial Board set up for startups.

To be recognised under the IMB, a DPIIT recognised startup has to meet the following conditions:

• It has to be a private limited company or a limited liability partnership,
• It must have been incorporated on or after 1st April 2016 but before 1st April 2021

This rules out 99.5% of Indian startups who can avail of the benefit. And others too are cognizant of this issue. “This benefit is currently available only to the 200 odd IMB registered startups, thus it is best that all startups who intend to issue ESOPs get an IMB certificate,” said Anup Jain, Managing Partner, Orios Venture Partners.

India currently has approximately 50,000 startups. The main call from the startup community is that it should be applicable to all DPIIT registered startups. “The relaxation for ESOP taxation was welcome but linking it to Sec 80-IAC makes it meaningless as it impacts only a 100 odd startups. We had requested for this to apply to all DPIIT registered startups. I do hope they correct that urgently,” said Saurabh Srivastava, Chairman, Indian Angel Network.

LocalCircles has recommended the Finance Ministry to rework its offering to startups. It has requested that ESOP taxed at date of sale should be extended to all DPIIT recognized startups and the criteria for ESOP taxation should be simply the date of sale and the other two conditions should be removed.